Oil Search And The Question Of Dividend Timing

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– Oil Serach posts solid production growth
– PNG LNG on schedule
– OSH may need a funding top-up
– Timing of the dividend ramp-up remains a point of disagreement

By Greg Peel

Oil Search surprised brokers yesterday on the release of its September quarter numbers by reporting a 10% increase in production, roughly 10% above average forecasts. Revenues were lower than expected but this was down to shipment timing and should recover in subsequent quarters.

As Macquarie notes, there is no sign of a mature oil decline for the company. Exploration is ongoing, but mixed results mean an increase to exploration expenses which offset the value of increased production. But what the market is waiting for is first production from the PNG LNG project. Management confirmed the project is now 90% complete, the budget is unchanged at US$19bn, and first LNG deliveries are scheduled for the second half of 2014, but joint venture partners ExxonMobil and Santos ((STO)) had already updated the market on that score.

It’s been a long time coming, and when the gas starts to flow in PNG so will the cash, leading to a ramp up in dividend payments for patient shareholders. As to when that ramp-up will occur is nevertheless a little more complicated.

During the September quarter, the first commissioning gas was delivered to the LNG plant from the Kutubu field. Earlier this month, Exxon secured US$1.5bn of supplemental project financing. The precise timing of the Hides gas water contract well nevertheless remains uncertain. More importantly, Oil Search continues in its attempts to prove up reserves for a third train at PNG, while at the same time pursuing opportunities in Kurdistan. While PNG 1&2 may be on budget, ongoing developments cost money.

BA-Merrill Lynch thus sees Oil Search’s funding position as relatively tight. On the broker’s numbers, OSH will only have $368m in liquidity by mid-2014 and this should tighten further in the second half as initial LNG cashflows are placed in escrow. Morgan Stanley suggests sufficient funds remain to cover PNG but a topping up may be needed to finance ongoing developments.

Indeed, management suggested at the release of its report that it may have to “top up liquidity” prior to PNG cashflows coming out of escrow in light of near terms appraisal and development at Manada and Taza. But given management’s suggestion this would be “shorter term funding”, brokers agree debt funding is likely and an equity raising is not on the cards.

Citi notes OSH has already drawn down US$150m of its US$500m corporate debt facility and, as suggested, may need more ahead of first PNG cashflows. Originally the broker had assumed only a $350m facility would be required, but now suspects the availability of cashflows may be later than previously forecast and that 2014 exploration and capex may also be higher than forecast. The broker now assumes a drawdown of corporate debt plus US$600m in bridging finance in late 2014, followed by repayment of short term facilities in 2015.

What this all adds up to is a deferment of Citi’s expectation for ramped-up OSH dividends to the second half of 2015.

UBS is expecting a review of capital management initiatives in 2014 ahead of 2015 implementation, at which point the broker forecasts a 40% increase in payout ratio, or 34c in 2015. The increase in dividends is clearly a material driver of market valuation for Oil Search, given the company has been paying a fixed 4c per annum dividend for years. Brokers are nevertheless not in agreement with regards the timing of that dividend boost.

All brokers assume the regular 4c for 2013. Thereafter, Merrills has pencilled in 9.8c for 2014 and Macquarie is suggesting 12c. Merrills expects 17.2c in 2015 but Macquarie has 41c. On the other hand, JP Morgan, Citi, Credit Suisse and UBS do not expect an increase until 2015, retaining a 4c forecast for 2014. Then for 2015, JP Morgan forecasts 26c, Citi 27c, Credit Suisse 29.7c and UBS 34c.

Take your pick.

Oil Search offers up further value-add from the addition of a third train at PNG and developments elsewhere, such as Kurdistan, but these are a-ways off. More immediately there are long-awaited PNG cashflows for the market to drool over. The question is as to just how much of this immediate value has already been priced in, ahead of a dividend increase the timing and initial quantum of which analysts cannot agree upon.

Most of it, says JP Morgan. The broker maintains an Underweight rating, but as a sector-relative recommendation, JPM is weighing up OSH’s value against its gas major peers. Similarly, Citi has a Sell on Oil Search but a Buy on both Woodside Petroleum ((WPL)) and Santos ((STO)), but Citi rates stocks relative to the market.

These two remain the pariahs for now. On the strength of what is ultimately on offer (presumably without too much concern over exact timing), all of Macquarie, Merrills, UBS Credit Suisse and Deutsche Bank retain Buy or equivalent ratings.

Target prices vary wildly within the group, from JP Morgan at $7.40 to Merrills at $10.22. The average is $9.37, which suggests around 10% upside to the current trading price.

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