Treasure Chest: Overhang Or Takeover Potential For Oil Search?

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By Greg Peel

After somewhat of an eternity, the PNG LNG project is now expected to produce first gas in the second half of 2014. PNG LNG, the stakeholders of which include Oil Search ((OSH)) and Santos ((STO)) will become the second of the new wave of Australian LNG projects after Woodside Petroleum’s ((WPL)) Pluto to reach first train ramp-up. The first of the Queensland coal seam gas LNG projects is expected to reach the same milestone by 2015.

These Australian LNG projects will enjoy a window of opportunity of selling into a market suffering strong demand growth but weak supply out to around 2020. It’s been a long wait for often sceptical shareholders, but the cash flows on offer suggest significant stock re-rating and dividend increase potential.

The PNG LNG project is co-owned by Exxon-Mobil (33.2%), Oil Search (29.0%), the PNG government (16.8%), Santos (13.5%), Nippon Oil (4.7%) and PNG landowners (2.8%). Complicating the shareholder base further is a 14.7% stake in Oil Search also owned by the PNG government. It is the PNG government’s ultimate objective to fully own the project, or perhaps at least a majority stake along with operator Exxon, but funding remains an issue. By contrast, it has never been Oil Search’s intention to ultimately remain invested in an operating LNG facility.

Ahead of the PNG LNG final investment decision in 2009, the then major stakeholders Exxon, Oil Search and the PNG government needed to secure capex funding.  This was a stroll in the park for Exxon, and Oil Search had no problem tapping into Australia and offshore equity/debt markets, but the PNG government struggled with a lowly credit rating. The solution was to sell an exchangeable bond over the government’s 14.7% stake in Oil Search shares to the Abu Dhabi state-owned International Petroleum Investment Company (IPIC), which would convert into Oil Search shares in March 2014.

Four years on, the PNG government would now like to buy back those bonds before conversion and thus retain its Oil Search stake. The question is: At what price would IPIC be happy to sell and could the PNG government afford it? With the answer as yet unknown, JP Morgan has highlighted several permutations of what might follow – some good, some not so good.

If the government can buy out IPIC, Oil Search should be happy to retain an investor on board with aligned PNG LNG aspirations. Furthermore, and knowing Oil Search is an explorer/developer and not an operator, the PNG government could look to lift its stake in Oil Search to the 20% takeover threshold.

Alternatively, IPIC could stand fast on price and itself look to a takeover of Oil Search, or perhaps offer up its stake on the market with a control premium.

Or perhaps IPIC might simply hold onto its stake after conversion for the foreseeable future, thus lumbering Oil Search with a share overhang similar to Shell’s 24% stake in Woodside.  Shell reduced is stake from 34% in 2010 but has shown no signs of wishing to exit the balance ever since. This 24% uncertainty continues to act as a drag on Woodside share price upside potential.

Or perhaps IPIC might decide it will sell its bonds at the price the PNG government can come up with, then start shorting Oil Search stock ahead of the sale date to achieve an arbitrage-enhanced exit price.

So the exchangeable bonds have now thrown up a somewhat binary situation for Oil Search and its shareholders – takeover possibility or overhang drag – with the outside chance of that “drag” having an immediate negative share price effect.

JP Morgan sees the risks as skewed to the downside. Part of the broker’s reasoning is that the stock is already “priced for perfection” after a long period of scepticism, with project de-risking and an initial two-train assumption already well accounted for by the market. Not to mention the generally held view a third train is all but in the bag and a fourth is a possibility.

JP Morgan already had an Underweight rating on OSH for that reason, before considering the Abu Dhabi issue.

The broker joins Citi on a Sell or equivalent rating, with Citi having downgraded on Monday. The two Sells are balanced by one Hold and four Buys in the FNArena database, which is showing a consensus target of $9.23.
 

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