Santos-Oil Search: Who Wins?

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

Now the Santos bid for Oil Search is out in the open what does it mean for the future of both companies?

-Highly opportunistic bid, given Oil Search is without a permanent CEO
-Merged company would improve access to debt capital markets for Santos
-Reducing the Oil Search stake in Alaska may be key to any deal
 

By Eva Brocklehurst

Santos ((STO)), it seems, is seriously eyeing off Oil Search ((OSH)). From all reports there was a bid in the wind on June 25 and the latter has finally indicated this was rejected, although remained willing to engage.

Following the controversial resignation of CEO Kieran Wulff, Oil Search confirmed speculation it had received and rejected an indicative non-binding bid, and Santos subsequently disclosed it was the suitor. Santos had approached with an all-scrip offer of 0.589 shares for every Oil Search share.

The merger of the two would significantly improve scale and quality, taking advantage of the weakness in the Oil Search share price. Hence, it is considered opportunistic. Yet this does not mean it is without strategic merit, Jarden asserts.

The broker notes the takeover approach from Woodside Petroleum in 2015 was considered to grossly undervalue the company, yet at that time the bid/ask spread was too wide and a deal did not progress.

This time the circumstances are different, as the Santos CEO, Kevin Gallagher, is well regarded while Oil Search is currently without a permanent CEO. Morgans agrees that this time the timing is fortunate for Santos with the sudden departure of the Oil Search CEO because of "unacceptable behaviour".

UBS also suspects that in the wake of Dr Wulff's resignation, Santos may now believe it has more leverage in discussions. The broker considers the rationale remains sound as the merged company would be the largest Australian listed oil & gas company by market capitalisation.

The bulk of Oil Search's value is tied up in relatively long-life, low-cost assets in PNG. This would mean Santos, with its PNG interests, can reduce exploration expenditure and develop the resource base at an appropriate time.

Santos would obtain a further 29% stake in PNG LNG, a top tier project to add to its existing stake. Yet, in the case of Gladstone LNG, the company's interest would be diluted in a merged entity to just 14% of net asset value, from 24% currently.

The market capitalisation of Santos has been nearing an all-time high, Jarden observes, while Oil Search has failed to rally in 2021 despite the 50% increase in the Brent crude price.

What Now For Santos?

The challenge for Santos is how to proceed, and there is a question for shareholders as to whether to support the company if it chose to pursue Oil Search and/or raise the offer. Santos shareholder stakes would be diluted but the quality of the company's asset base would also improve and the growth trajectory become more diversified, Jarden asserts.

UBS believes, for an all-scrip deal to be pursued, the Santos share price would need to lift from the July 20 close of $6.49, and/or the company may need to offer a higher scrip ratio. The broker estimates the scrip ratio could rise to 0.60 Santos shares. beyond which the economics would become dilutive.

From the Santos point of view an all-scrip offer would avoid the need to raise equity or draw down debt at a time when gearing is above 33%. Moreover, UBS assesses the merged company could improve access to debt capital markets for Santos and support growth while the company can still pay sustainable dividends.

Ord Minnett points out energy company valuations have disassociated from benchmark oil prices recently, amid a growing focus on environmental, social and governance (ESG) considerations. While this is unlikely to change in the short term, the broker believes exploration & petroleum companies could take advantage of low debt and attractive equity valuations to make acquisitions.

In this vein, UBS wonders how ESG-sensitive investors would view Pikka, the greenfield oil development in Alaska, and its fit with the Santos 2040 net zero emissions target and plans to be a "green gas company" in ten years.

The proposal assumes almost nil value for the Oil Search Alaskan asset, in Morgan Stanley's view and, yes, there are risks for Santos in terms of its ESG credentials, meaning it would be better if Alaska was offloaded, as not only is there financial risk but Santos has negligible experience in that part of the world.

What's In It For Oil Search?

Concerns regarding Oil Search centre on Alaska, and the departure of the CEO has raised corporate governance risks. Morgans asserts. Yet, with investor sentiment having taken a hit, shareholders may be willing to accept a lower premium in return for Santos taking over management of their investment.

Furthermore, an all-scrip bid at a small premium would mean any potential upside to value would come from the share price performance of the merged entity and most of this would be from unlocking the growth assets of Oil Search rather than from within the Santos portfolio.

The main question Jarden poses for shareholders is whether it would be better to own a smaller share of growth and an improved chance of this being unlocked, or a larger potential exposure with the associated risk of Oil Search delivering production on its own.

The broker believes the Oil Search board needs to offer a "Plan B" and address the perceived corporate governance risks while outlining a path to value creation for the next 1-2 years. This would enable shareholders to judge the relative merits of any proposals.

Morgan Stanley notes, on the present offer, it appears more favourable to Santos than Oil Search shareholders. Still there will be pressure on the board of Oil Search to engage amid concerns about the Alaskan sell-down and high executive turnover recently.

Alaska

Oil Search has commenced a sale process for a stake in the Alaskan project, ahead of a final investment decision later this year. Morgan Stanley believes the issue is now about whether the sale process will be halted until a new CEO is on board.

Without a sell-down of the Alaskan asset, Oil Search is too leveraged in the broker's view, and has underperformed global peers and Santos while outperforming Woodside Petroleum ((WPL)) and Beach Energy ((BPT)) in the year to date.

Before the Alaskan acquisition in late 2017, Macquarie assesses Oil Search was the most attractive oil & gas takeover target in the Asia Pacific region. The broker asserts natural owners of PNG gas/LNG assets are unlikely to be natural owners of Alaskan oil and therefore reducing the stake in Alaska is key to any deal.

Jarden, not one of the seven stockbrokers monitored daily on the FNArena database, has a Neutral rating on Oil Search with a $4.00 target and a Sell rating on Santos with a $5.90 target.

The database has four Buy ratings for Santos and three Hold. Is $7.96, suggesting 19.5% upside to the last share price. For Oil Search there are three Buy ratings, three Hold and one Sell (Credit Suisse, yet to comment on the bid or the Oil Search CEO exit).

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" – Warning this story contains unashamedly positive feedback on the service provided.

FNArena is proud about its track record and past achievements: Ten Years On

Click to view our Glossary of Financial Terms