LNG Future Still Bright For Santos

This story features SANTOS LIMITED, and other companies. For more info SHARE ANALYSIS: STO

-Deferred offtake seen temporary
-Niggling concerns over capex
-Most focus on GLNG in 2015
-Capital management in 2016?
 

By Eva Brocklehurst

Santos ((STO)) clouded the positive aspects of the big GLNG and PNG LNG developments with a downgrade to production guidance for 2013 at its investor day. The company now expects 51mmboe instead of the prior guidance of 52-55mmboe. The company blamed lower Cooper gas take by Origin Energy ((ORG)) and AGL Energy ((AGK)) as partly responsible for the production downgrade. The other major cause was weak gas demand from resources projects in Western Australia.

It appears the two gas re-sellers are deferring contracted gas volumes for delivery until after the LNG start-up and this is playing with Santos' production strategy. With the pair deferring offtake until 2015/16, Cooper gas output over the rest of 2013 and 2014 will be lower than previously expected. Santos can only put 100TJ/day into storage. Delays in offtaking gas will also place more pressure on the ramp-up of delivery from the Cooper Basin.

Citi has dismissed the issue of deferred offtake as temporary. Santos faces capacity constraints if the customer nominations are low and will have to shut in wells. But in early 2014 the Horizon contract commences. This 147TJ/d contract that's not impacted by seasonality will make the issue go away, in the broker's opinion. Deutsche Bank was also disappointed but philosophical, noting the new guidance is only 7% below the mid point of the original guidance range and there's been a lot worse from resources companies of late.

While the 2014 guidance of 52-57mmboe was in line with UBS expectations, hopes had been raised that this might have been upgraded. The capex budget of $3.5bn for 2014 was ahead of the broker's expectations by around 10% and this raises the question of the longer term capex requirements – for which there was no guidance. What concerns UBS is that the investment needed to achieve the increased production over the next five years from PNG LNG and GLNG is substantial. The broker thinks incremental Cooper Basin gas volumes are costly, although at a price of $8/GJ the pain eases somewhat. UBS also expects more gas deals will be done over the next 12 months to optimise supply between the company's three projects in Queensland.

The briefing highlighted a dilemma for investors, according to UBS. In recent times production has disappointed and capex has been higher than expected. The start of LNG from PNG in late 2014 and GLNG in 2015 promises to double operating cash flow by 2016 and lead to higher dividends. The problem is, sustaining capex could stay higher for longer and UBS suspects, if so, this would erode the company's cash flows over the medium to long term. Further growth  – in terms of the PNG LNG train 3, Bonaparte LNG and NSW CSG – represents the upside but these projects are not without risk. The potential for dividends to keep rising is core to broker viewpoints. UBS expects an increase to 40c next year from the current 30c, and 80c by 2017.

Santos gave all the right assurances, in JP Morgan's opinion, and reiterated an intention to materially increase capital returns heading into first LNG from PNG. The prospect for delivery of GLNG, on time and on budget, preoccupies investors and the broker does not think this preoccupation will change over 2014. Moreover, JP Morgan thinks the risks at GLNG have been overestimated. The gas is contracted to quality off-takers and the construction cost risk is mitigated by fixed price downstream capex contracts. So, why a Neutral rating? It boils down to the share price. In the broker's view the current price is a less compelling entry point to GLNG exposure than it was previously, as the stock has re-rated strongly this year. The broker observes Santos is still trading at discount to fair value, but then so much of the ASX oil and gas sector shows a similar tendency.

Credit Suisse was also concerned that the investor briefing did not appease concerns about sustainable free cash flow generation. The lack of clarity on the sustaining capex costs for GLNG is worrisome and the broker struggles to see how the timelines to commercialisation will meet expectations. If Santos can execute on budget and on schedule at GLNG, then the broker is prepared to accept that value exists. In the meantime, Credit Suisse is nervous about what the next 6-9 months may do to the share price. Hence the Underperform rating.

Citi disagrees with regard to compelling value. Santos stands ready to capitalise on high gas prices and drilling technology and this lowers well costs. Lower well costs could lower the GLNG sustaining capex and potentially add 44c a share to the discounted cash flow. Lower well costs would also mean all current conventional Cooper 2C resources are booked as reserve and could enable the Gunnedah CSG or Cooper unconventional gas to be commercialised. The broker thinks the risks to the growth drivers for the company, and the timeframe to 2016, are low. BA-Merrill Lynch is also of the view that the production downgrade was negative for the near-term only and the longer-term investment thesis is intact. The broker believes the start of both PNG LNG and GLNG in 2014/15 means Santos will become cash flow positive in 2016 and be well positioned for capital management.

Merrills also maintains the view that the company has plenty of scope to deliver on efficiency and drilling cost reductions. There are 200-300 wells required on an ongoing basis and the company has plenty of options on productivity and cost, depending on how these are prioritised. Macquarie's view is along the same lines. The current production may be downgraded but the commitment to 80-90mmboe by 2020 is intact and that implies healthy long-term production growth of 7-8%. Despite the share price rally, Macquarie thinks Santos is one of the sector's best long-term value propositions.

Deutsche Bank's investment thesis is built on LNG and east coast gas growth and not on the current production numbers. Risks are there, ahead of delivery of the two big projects, but the broker thinks capex pressures are reducing. A further 16% increase in well productivity at Fairview and a 25% cost reduction per well is a clear positive for GLNG. The well performance at Roma is a source of risk and Deutsche Bank maintains a 15% capex buffer above company guidance, which the broker thinks adequately reflects these risks.

There are four Buy ratings, two Hold and one Sell (Credit Suisse) on the FNArena database. Prior to the briefing the consensus target was $16.24. It's now $15.93 and suggests 11.4% upside to the last share price.
 

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