After going to hell and back over the past five years, shareholders in Santos can sit back and enjoy the show as a powerful American private equity group tries to get control of their company on the cheap.
The imminent $5.30 a share offer from Harbour Energy patently undervalues Santos at $11 billion. The offer happened to become public, through my colleague Matthew Stevens, straight after the market was forced to absorb the $3.5 billion sellout of Woodside Petroleum by Royal Dutch Shell.
The Woodside sell-down knocked about 30¢ off the Santos share price as institutions were forced to rebalance portfolios. It was only at this artificially depressed price of $4.38 a share that Harbour Energy could boast that its Santos bid would be at a 20 per cent premium.
Thanks to sweeping changes to management and the board of directors, Santos is no longer an accident-prone, over-leveraged oil and gas producer with a patchy corporate governance reputation.
In the bad old days it was not uncommon to hear anecdotal stories of a dysfunctional management team inside the glass head office in Flinders Street, Adelaide.
Fundamental mistakes in risk management during the financing phase for the GLNG project in Gladstone resulted in Santos shareholders having to stump up for new equity multiple times.
Over the past several years the number of shares on issue has doubled, thanks to equity issues at $3.85 a share and $4.06 a share. But under chief executive Kevin Gallagher, Santos has well and truly got its act together. Even the most avowed cynics would have to agree that Gallagher has acted decisively in executing a turnaround strategy that has shaken the company to its core. Better fortunes
His three key objectives were to dispose of non-core assets, restore strength to the balance sheet and position the company for growth. The strategy was predicated on oil at $US40 a barrel.
The fact that oil is now trading at a 27-month high of $US62 a barrel is a sign that winds of good fortune are blowing Gallagher's way.
The Santos share price is, as a matter of course, highly correlated with movements in the oil price. The reason is obvious when you consider that every $US10 rise in the price of a barrel of oil lifts the Santos' free cash flow by more than $US250 million.
Santos provides the most leverage to oil price movements out of all the oil and gas stocks listed on the ASX.
Oil has rebounded 10 per cent since January, and is up about 40 per cent since hitting $US44 a barrel in June.
The oil price surge is part of a substantial recovery in many commodities over the past 18 months on the back of consistently strong GDP growth in China and a recovery in the US and European economies.
Oil is highly volatile, but there is evidence to show it has moved to a new higher average price based on analysis by Macquarie Research.
Macquarie tracked a basket of real commodity prices relative to their 100-year average and found oil had a positive 10 per cent to 15 per cent deviation from its long-term trend.
HSBC says oil has risen because of a number of supply side issues. These include "rising geopolitical uncertainty in the Middle East, expectations of continued curbs on OPEC production, absorption of existing capacity – given underinvestment and field decline from the non-OPEC majors – and a levelling out in production by US shale producers – as oil prices are not high enough to motivate more new entrants".
Stocks rise
When Harbour Energy first approached the Santos board in August with a conditional price of $4.55 a share, oil was trading about 20 per cent lower than it is now. Since August the Santos stock price has risen about 30 per cent.
The board of Santos could see in August that the bid undervalued the company. It is reasonable to argue that it still does given what the market is saying following Gallagher's latest strategy day.
It so happens analysts are this week on a tour of Santos' facilities around the country to see exactly how the company's operations have been streamlined.
It is pretty obvious from the analysts' commentary that Gallagher has shed the practices of his predecessors who overpromised and underdelivered.
Mark Samter, a respected analyst at Credit Suisse, yesterday said the "new Santos" deserves a chance to build on its momentum.
Samter was one of the most persistent, forthright and prescient critics of the old Santos, so his opinion carries some weight.
He provided sage advice to the old management and board to go for an equity capital raising several years ago when the company had excessive debt but was trading around $14 a share. His advice was ignored. $6.50 a share
Now, he is urging the company to not have any serious takeover discussions with Harbour Energy until it offers a 30 per cent premium to his $5 a share valuation. That means an offer of about $6.50 a share.
His thesis goes along these lines. The Credit Suisse oil forecast for the next 18 months averages $US54 a barrel, so he says there is scope for upside.
Second, if Santos truly believes in its growth opportunities then there is scope for considerable de-risking of Samter's valuation. For example, carrying contingent resource at Barossa and Narrabri at $1 a gigajoule could add close to $1 a share to his valuation.
Third, he says Santos is a considerably improved business, with a strong management team and will soon have a fresh set of eyes as chairman when Peter Coates steps down.
Other analysts are equally bullish about Santos. Macquarie analysts said last week that the company's hurdles for debt reduction were easily surmountable. They claim Santos can hit its target for a $US2billion debt reduction by the end of 2018, almost a full year early.
The proposed takeover offer has a couple of intriguing aspects. A director of Harbour Energy, Hock Goh, is a director of Santos, and another director on the Santos board, Eugene Shi, represents Chinese energy group ENN Group and private equity group Hony Capital.
Goh recused himself when Harbour Energy made its first approach in August. Agreement
Shi finds himself in an interesting situation because of an agreement between ENN/Hony and Santos when there is a change of control transaction. The agreement forces ENN/Hony to support a takeover recommended by the board unless the board fails to gain shareholder approval or if the offer is below the average entry price of ENN/Hony.
Ben Wilson, an analyst at Royal Bank of Canada, says it is reasonable to assume weighted average entry price of ENN and Hony is below the reported revised possible bid price of $5.30 a share.
Wilson said he based this on Hony having transferred its shareholding to ENN at a notional price of $4.85 a share and then purchasing further large stakes at prices below $4 a share in 2016 and 2017.
Finally, it is worth noting that this transaction is a big deal by global standards, according to data prepared for Chanticleer by Dealogic.
At $11 billion it would rank among the top 10 deals by a financial sponsor in the oil and gas industry in the past decade. At Samter's preferred valuation of $6.50 a share, or $13.5 billion, it would rank as the biggest private equity deal in the oil and gas industry in history.
Massive takeover deals in the oil and gas sector have been common when the acquirer is from Big Oil. The record is the $US85 billion takeover of Mobil Corp by Exxon in 1999. There is a $US30 billion cut-off to gain entry to Dealogic's top 10 oil and gas M&A deals.
The largest oil and gas M&A deal in Australia was the $US8 billion deal by ConocoPhillips to buy coal seam gas assets in Queensland. The largest deal involving a financial sponsor was the $US755 million deal by ENN to buy 11.72 per cent of Santos.
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