Santos Drills Deeper Into Favour

This story features SANTOS LIMITED.
For more info SHARE ANALYSIS: STO
The company is included in ASX20, ASX50, ASX100, ASX200, ASX300 and ALL-ORDS

-WA gas field potential some way off
-Budget for GLNG not confronting
-Drilling costs fall
-PNG LNG picks up pace
 

By Eva Brocklehurst

Santos ((STO)) has drilled its way into favour as attention remains rivetted on the progress of the GLNG and PNG LNG projects. These big gas developments are scheduled to kick off in 2014 and 2015 and provide a leg-up in the company's earnings and cash flow.

The first half result pleased most brokers with earnings of $844 million, underlying profit of $251 million and a 15c interim dividend. The result signals, on a consensus view, full year profits of around $625 million while production guidance is set at 52-55mmboe. Projects are on track and capital expenditure is in line with expectations. PNG LNG is 90% complete and on track for first LNG in 2014 while GLNG is over 60% complete and on track for first LNG in 2015. Elsewhere,e Dua and Peluang are both on track for first oil in the first half of 2014.

Credit Suisse could not fault the result but found nothing exciting. The recent exploration success offshore in Western Australia may reveal impressive gas fields but resources have not yet been booked and commercialisation is another issue. The broker does not think the stock is cheap and retains an Underperform rating, the only one on the FNArena database. Of the WA gas wells, Winchester, in the Carnarvon Basin, was upgraded to 58m net gas pay but no resource definitions have been made as yet. In Credit Suisse's view, Crown and Basset West in the Browse Basin are well placed for negotiation with other producers once the Browse Basin as a whole is unlocked.

Meanwhile, the unconventional new well in the Cooper, Gaschnitz-1, flowed to the surface at highs of 2mmcfd but has now moved down to 1mmcfd. Credit Suisse is excited about the potential but it is still early days, with another 6-8 months of additional drilling. Macquarie also thinks these developments are well and good, but still some way off being commercial.

There's been no change to capex or development timelines at the two big projects and that has been welcomed. Macquarie hailed accelerating construction, improving land access and easing cost pressures at GLNG but was a little more cynical about management suggestions that falling drilling costs were bolstering project contingencies. Macquarie suspects these gains are being offset by continued pressure in the Flour gas gathering contract. Deutsche Bank thinks the market has, rightly, been concerned for some time on capex pressures at GLNG. This broker thought a key feature of the half year was continued material reductions in drilling costs. Average drilling costs are now 30% lower than at the time of final investment decision. Increased use of pad drilling, improved logistics, and a skew towards lower cost Roma wells all support the reduction.

Macquarie thinks the risks are more on the cost side than the schedule side. Management remains confident that the existing US$18.5bn budget to the end of 2015 will cover all capital costs associated with trains 1 and 2 but the broker observes the company is unwilling to remove the timing caveat. Based on current forecasts, including the Australian dollar, Macquarie estimates the budget rises to US$19.9bn and, assuming a 10% over-run, brings the total to US$22bn. Deutsche Bank expects total GLNG capex to be 15% ahead of company guidance. Reduced drilling costs are a positive and help reduce capex pressures but, the broker hastens to add, overall project capex risks are still to the upside, just less so than before.

Citi is a lot more positive on the capex budget and drilling costs than the former two brokers, suspecting GLNG has around US$1.2 billion in head room in the current budget and that Santos is under-running the drilling and completions budget. This should free up US$300m in capital to offset over-runs in other areas. Citi thinks the guidance is conservative and there is potential to outperform on both guidance and market expectations. While it may take 2-3 years for Train 2 to be fully operational, the broker expects it can be substantially ramped up in 2016.

Meanwhile, PNG LNG development drilling is also picking up pace, all pipeline access agreements are in place and commissioning gas is expected soon. Citi thinks the vast majority of project execution risk has passed for this project. Another capex over-run is unlikely from the current budget of US$19bn, and first LNG by mid 2014 is achievable. Macquarie considers that, on the back of solid progress and consistent development plans, the perception of the stock is perhaps starting to change. Supported by a run of recent exploration successes, evidence of rising east coast gas prices, falling development risk and a sector-leading valuation, the market is seen moving Santos' way.

Any major negatives? The balance sheet is somewhat tighter than many expected but still manageable. Macquarie thinks Santos has a small funding surplus within the confines of its BBB-plus credit rating. If PNG didn't come on until the end of 2014, things would get tight and the company would seemingly be in breach of the rating. That said, Macquarie notes management is comfortable dropping to BBB and thinks Santos should cope even with modest cost and schedule pressures. Citi expects the outlook could return to stable with greater certainty in project costs and schedules as they move closer to completion, and clear visibility of earnings and debt profiles for 2014 and 2015. The company is seen having the liquidity to fund projects and its credit rating could be lowered if future credit metrics are weaker than anticipated. This could come from further LNG project cost over-runs or delays, or from a weakening in oil prices.

Dividend plans? Santos remained non-committal and says this depends on the performance of major assets, intending to review policy once PNG nears completion. Back in May, Credit Suisse noted the dividend was expected to be stable for 18 months. This then assumes the dividend pay-out goes to 60% in 2015, implying a 4% dividend yield in 2015/16 and 6% going forward. The CFO stated that operating cash flow should more than double in the next three years, driven by an increase in the oil-linked sales. This helps make the stock the most attractive of the large cap energy stocks for 2016 and 2017 in Citi's view, particularly since Santos will have additional lucrative growth options beyond this period.

There are five Buy ratings on the FNArena databases, two Hold and one Sell. The consensus target price is $15.69, suggesting 8.7% upside to the last share price.
 

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