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Australia | Dec 11 2023

This story features WOODSIDE ENERGY GROUP LIMITED, and other companies. For more info SHARE ANALYSIS: WDS

Brokers consider the pros and cons of a Woodside Energy-Santos merger.

-Woodside Energy and Santos in merger talks
-Brokers see many advantages for both
-Woodside would have to pay up
-ACCC will need to consider

By Greg Peel

Australia’s two largest oil & gas producers, Woodside Energy ((WDS)) and Santos ((STO)), have confirmed they are in early merger discussions. These are preliminary and may not lead to a merger, and nor is the structure of a potential transaction known.

But brokers agree there is a lot to like about the possibility.

Everyone’s a Winner?

Citi has been unconvinced Woodside and Santos have the scale to maintain or create value through the energy transition. For example, the broker recently argued that Woodside’s free cash flow outlook and declining base business mean around US$80/bbl oil is needed to pay a 6% yield, spend on New Energy, and keep production flat. If Woodside increases free cash flow from plateau projects like PNG LNG, then this burden should reduce.

Santos would also likely improve its balance sheet, which Citi forecasts peaking at around 24% in 2025, and would no longer require a sell-down of PNG.

UBS estimates synergies from such a merger may range from $150-$300m and be derived from corporate costs, exploration capex, -20-30 basis points of savings on cost of debt plus trading synergies via the larger portfolio. Under the broker’s framework, UBS estimates a merger could be earnings per share accretive from year one, which is a positive for Woodside shareholders having seen considerable consensus downgrades to dividends per share over the last month.

Given Santos’ heavier relative capex burden over the next three years, UBS estimates a proposed merger to be free cash flow per share accretive from 2027 and beyond.

Woodside could “hide” the quality-eroding aspects of its business, Citi suggests. As North West Shelf and Pluto decline, Woodside should no longer be as high quality due to increasing unit costs and being increasingly capex hungry to maintain flat production. Citi also believes Woodside is quietly downgrading its BHP Petroleum assets. But these problems should essentially be diversified away in a combination.

Beyond the speculative Calypso project, Woodside’s growth pipeline is empty, Citi notes, risking a -7% production compound annual growth rate from 2030. Woodside could benefit from Santos’ projects Barossa, Papua LNG and Pikka.

Financial flows into a combined entity could presumably be quite strong after deal completion given a globally relevant, dual-listed company, Citi suggests. MergeCo could also command a scarcity premium on the ASX, being the only large cap energy producer. And Santos likely gets its NYSE listing, reducing cost of equity risk through the transition, given US investors appear to be, for now, less ESG-aware than Australian investors.

David and Goliath

Since Santos acquired Oil Search in late 2021, Woodside shares have outperformed Santos by some 50%, including dividends which have been considerably higher from Woodside. This clearly advantages Woodside with the approach, Macquarie suggests, despite the recent pullback. Woodside has delivered strongly on the BHP Petroleum acquisition in recent years, gaining some credibility in M&A delivery and organisational integration, Macquarie notes.

The rationale to merge is clear, suggests UBS, as it could create a giant Asia-Pacific LNG company, with a well diversified asset base and a product mix of  more than 70% LNG/gas providing a globally unique LNG exposure, with the scale to self-fund energy transition and pursue further material growth in the Gulf of Mexico and PNG.

While the companies are talking “merger”, realistically it would be a takeover by the much larger Woodside, thus requiring a premium for Santos (and ex-Oil Search) shareholders to be appeased.

UBS estimates an all-scrip merger, plus a 20-30% premium to the Santos share price on December 7, would value Santos at $8.20-8.88, which at the top would be the highest price Santos shares have traded at since 2014.

The biggest sticking point, says Citi, is likely Woodside’s board finding the right value that would appease frustrated Santos shareholders. However, Woodside has such a large cost of equity advantage that the broker suggests a more than $9.00 outcome for Santos is plausible.

The Regulator

Key risks include shareholders reject the relative value split created by the merger. UBS’ current Santos sum-of-the-parts valuation has considerable value for key assets that could be non-core to a future MergeCo, such as Cooper Basin, some WA assets, and Alaska. If these assets are undervalued by Woodside, given their limited strategic value, it drags on the merger economics.

UBS also highlights some ACCC considerations on the combined concentration of East Coast domestic gas in particular under the MergeCo scenario, noting that if divestments are required, the pool of potential buyers (and market valuation) may also drag on the merger economics.

In Play

Merger discussions now put Santos firmly "in play", and Macquarie expects this will trigger interest in Santos from other parties given attractive assets at a discounted value, particularly in PNG, and accelerated consideration of structural alternatives by the Santos board (eg, de-merger).

It is not lost on Macquarie that Santos’ share price is now virtually identical to the Harbour takeover proposal in 2018 that was rejected by the board, but Santos shares are now more valuable in the broker’s view.

Macquarie maintains an Outperform rating and $9.60 target on Santos as it now appears more likely that value will be recognised in the coming months.

UBS is on Buy with $9.05, and Citi is on Buy with $8.25.

For Woodside, Macquarie is Neutral with a $31.00 target, UBS is Neutral with $35.40, and Citi is on Sell with $26.50.

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