Dividends Sought As Oil Search Steams Ahead

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-PNG LNG start coming into view
-How far off are increased dividends?
-Many resource options at hand
-Are valuations too generous?
 

By Eva Brocklehurst

The PNG LNG project is gaining traction for Oil Search ((OSH)). This big development is 90% complete and start up in 2014 is now firmly in view. Is it now a case of deflated anticipation? The production and cash flow is expected to be transformational for Oil Search but brokers are divided on whether the company can deliver on production, cash flow, expand resources and raise the dividend all at the same time.

The stock is now trading in line with valuation so BA-Merrill Lynch is looking for other catalysts. The company has plenty of resource options and the infrastructure to harvest from these but a lack of clarity on the size and shape of expansion appears to be impacting on perceptions. What muddies the water as well is the complex joint venture arrangements that must be negotiated in such large infrastructure and resource developments. Merrills contends that, whatever the size or shape of the expansion, it will be highly value accretive to Oil Search, which is long on infrastructure in a country which has little of that, and there is significant additional aligned and non-aligned resources as alternatives.

Deutsche Bank looks forward to the cash flows from PNG LNG and notes capex pressure is easing with a more favourable currency move. The expansion timeline for PNG LNG may be moving out but the broker sees ExxonMobil, the project operator, as the cause, as it seeks to maximise the economics. In Deutsche Bank's view it is too early to ascribe any value to Oil Search from a development at Elk/Antelope given any potential mechanism remains unclear. Deutsche Bank takes a similar line to Merrills in that additional expansions at PNG LNG are considered positive for existing infrastructure owners, regardless of the owner of the resource. Oil Search still trades at a discount to Deutsche Bank's valuation and, hence, a Buy rating is maintained.

On the FNArena database the ratings fall into two camps, bar one exception. In sum, there are five Buy and two Hold. There is one Sell. The consensus target price of $9.19 suggests 12.2% upside to the last share price and reflects an increase from $9.07 before the result.

The major difference between brokers is the question of when and to what extent the company will raise the dividend. At the moment it is paying out 4c annually and did so in 2011 and 2012.

PNG LNG cash flows will support investments in growth and distributions, in Deutsche Bank's view. With Oil Search indicating its board is assessing the potential of increased dividends once LNG cash flows commence, the broker has increased dividend assumptions and now assumes a 40% pay-out ratio from 2015, implying a 3.4% yield on current share prices. In addition, the company should be well placed to fund growth opportunities including PNG LNG expansions, as well as the appraisal and development of the Mananda and Taza oil discoveries.

On Merrills' numbers liquidity will be tight in 2014 and the broker would not be surprised if more debt was sought in order to retain balance sheet flexibility prior to PNG LNG cash flow. The scope for capital management is therefore limited in 2014. Like all project financed developments, it will be subject to a completion test before corporate guarantees are released. Prior to this the cash generated by the project is typically held in escrow which complicates early dividend increases. The broker forecasts a 10c dividend in 2014, equivalent to a 25% pay-out ratio.

JP Morgan has a lone Underweight rating on the database (albeit JPM rates on a sector-relative, rather than market-relative, basis). The broker thinks the future beyond the start of PNG LNG is all a bit unclear, as much is riding on the outcome of discussions between Exxon and Interoil, which will shape the likely development path for further PNG LNG trains. As for the question of a higher dividend, JP Morgan thinks a significant return of capital to shareholders is further away than most believe.

The company has committed to materially increase its dividend payment after PNG LNG's financial completion. Practical completion for project financing purposes is expected to be 6-9 months after production commences from T2. This implies the dividend increase would not occur until around mid 2015 at the earliest, in the broker's opinion, and debt servicing and other funding priorities such as T3/T4 and Taza appraisal and Mananda development will limit the quantity of cash flow that can be returned. Bluntly put, PNG LNG operating cash flow will not necessarily translate into a large dividend increase.

JP Morgan sees a number of obstacles/delays to a high pay-out to the JV from the project level, such as the point at which the debt facility becomes non-recourse to the project finance syndicate. Most project finance facilities have a debt service reserve account to tide over payments in the event of an operational difficulty and this may need to be topped up before pay-outs can commence. Also, once the project starts distributing cash to the corporate level, further issues arise. What about potential PNG LNG T3/T4 expansion via Hides, P'nyang or other Highlands resources, or potential to participate in any Elk/Antelope deal (Exxon permitting)? There is also Mananda expansion and the Gulf of Papua and Kurdistan programs, which may look more likely by late 2014. These could all be a significant call upon funding resources. This is a quality problem to have, the broker admits, but it may limit the company's willingness to distribute dividends.

Citi also thinks the call on funds for upcoming development will be strong and suspects Oil Search may need to increase its corporate debt facility. Citi notes liquidity of US$792m, including an undrawn corporate debt facility of US$500m the majority of which will be needed to draw on in the next 12 months. The broker thinks the company is well able to increase the dividend because it is so modest, and this could start in 2015, but the scale of a capital return would depend on the growth opportunities. With a 50% pay-out ratio, Citi thinks the dividend yield will increase to 3.9%, still less than for Santos ((STO)) and Woodside Petroleum ((WPL)).

Beyond PNG LNG the field is wide open. Citi notes the numerous LNG expansion options but contends there's a good deal of uncertainty over the scale, timing and value. All potential resources for expansion require appraisal (P'nyang, Hides, Elk/Antelope) and this is unlikely until the second half of 2014. Hides appraisal wells have been pushed towards the end of the program and P'nyang requires seismic study as well as, potentially, another well. On InterOil's Elk/Antelope gas, Citi thinks it is increasingly unlikely the Oil Search/Santos joint venture will be invited to farm into this resource as InterOil wants equity in an expansion train underpinned by its gas, which lowers the valuation upside for the JV from a fourth train.

The Kidukidu well is approaching the target reservoir and success is required for Gulf of Papua gas to be a contender for expansion, although Oil Search concedes this is relatively high risk. FEED for LNG expansion is unlikely to commence until 2015 in Citi's view, which would mean final investment decision no earlier than the second half of 2016 and LNG in late 2020. The broker's discounted cash flow valuation of the base business is $6.74 so Citi thinks many valuations are too generous regarding LNG expansion, given the numerous uncertainties.
 

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