Drillsearch Potential Outshines Cooper Peers

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-Best economics in Cooper
-Cash flow even at current prices
-More upside to unconventional
 

By Eva Brocklehurst

Drillsearch ((DLS)) has a simple investment case. Cash flow from oil production is being invested to sustain production and grow a gas business to profit from the east coast gas market. Alone, this is sufficient to provide 40% upside to the current share price but also allows Drillsearch to retain the potential for large, tight oil and unconventional gas resources, in Credit Suisse's view.

The broker sums up the Cooper Basin investment case in three themes: current oil production, near-term conventional gas growth and long-term unconventional gas upside. The broker prefers Drillsearch among the Cooper Basin players as it is the cheapest on conventional metrics. It is the only junior still generating cash flow and, as a result, the company has embarked on its largest exploration campaign to date. The broker's preference, as a new analyst takes up the cudgels, is based on the core value of producing assets. Conventional gas adds 32% to the 85% of market cap the broker tots up from the oil assets. Unconventional offers pure upside.

Drillsearch, along with Beach Energy ((BPT)), brought the first wet gas project into being outside of the SACB JV in 2011 and has plans for 4-5 more. While potential gas volumes are less than its peers, Credit Suisse considers the company has the best economics. Santos ((STO)) has farmed into three acreages and is carrying $160m in work programs. Drillsearch is targeting over 40 wells and expenditure of $130-170m over the next five years.

What about the oil price? Credit Suisse acknowledges this is getting plenty of airplay now the price is reaching a level where companies may start to struggle to fund capex programs from cash flow. The broker suspects the numbers may get worse over the next quarter so capex programs will have to be curtailed. Drillsearch is most sensitive to the oil price because it has the largest oil production relative to company valuation. Nevertheless, with margins remaining around US$50/bbl, Credit Suisse considers this a strength as, unlike the two other Cooper mid caps, Beach and Senex Energy ((SXY)), the company does not need to fund any expensive growth projects.

Credit Suisse expects free cash flow to be generated even at current prices and spending. No income tax is modelled until FY17 and no petroleum rent tax until FY19. The broker acknowledges much of Drillsearch's valuation and cash flow hinges on the Bauer field, which showed first signs of starting to decline in the September quarter and has less than a three-year reserve life.

The company reported a production decline in the September quarter, driven by an 8% fall in oil output. Sales revenue was down 13% on the June quarter, affected by the drop in the realised oil price. There was also a delay in connecting two new development wells at Bauer field, while wet gas output was affected by technical hitches.

UBS observes more oil was discovered at Balgowan and Burners but this was offset by disappointing results from appraisal at Stunsail and Pennington. This broker contends that investors are waiting for signs of oil price stability before entering the market but, with plenty of drilling news ahead, remains comfortable with a Buy call. This sums up other views on the stock. JP Morgan was a little disappointed at the lower wet gas production but expects this will increase by mid 2015 when the joint venture will install compression.

The stock offers exposure to the Cooper Basin renaissance and remains JP Morgan's top pick in the area. Cooper wet gas is underestimated by the market in the broker's opinion and is also becoming more valuable thanks to east coast gas market dynamics. Drillsearch is also less leveraged than its peers to Cooper unconventional exploration, which Credit Suisse also highlights as a positive as there is only upside.

Macquarie is a little less sanguine, with a Neutral rating, but expects production improvements as further wells are tied in should help overall declining production. The broker suspects growth is becoming increasingly reliant on wet gas. Operating costs remain high too, as the high cost eastern oil production represents a greater part of the production base. Morgan Stanley upgraded Drillsearch to Equal-weight from Underweight on the back of the quarterly report, viewing wet gas exploration and appraisal as the key to unlocking further value in the company.

There are four Buy and two Hold ratings on the FNArena database. Drillsearch has a $1.55 consensus target price, suggesting 42.2% upside to the last share price. Targets range from $1.28 to $1.80.

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