Economic Moat Given a new lower energy price paradigm, we don't...

Economic Moat
Given a new lower energy price paradigm, we don't expect Santos to generate returns in excess of its cost of capital, meaning that it has no moat. LNG projects in Papua New Guinea and Gladstone will see Santos generate improved returns based on our long-term oil price of USD 60 per barrel. Santos has 20-year contracts that tie the gas price to the oil price--USD 60 per barrel equates to USD 8.40 per gigajoule. However, returns will now be insufficient to support a moat. Returns on invested capital, or ROICs, have been in the single digits and below the weighted average cost of capital, or WACC, since the mid-2000s. Santos suffered industry cost inflation without the benefit of higher international pricing because of a heavy weight of domestic gas contracts. In addition, the construction phase of Gladstone and Papua New Guinea LNG projects further crimped returns precommissioning. We expect the trend to improve with ramp-up from Gladstone LNG and domestic gas contracts rolling off.
With the USD 60 per barrel midcycle Brent oil price, however, we expect ROICs to only meet the cost of capital. Less-than-stellar returns are driven by PNG LNG and Gladstone being constructed at Australian energy boom inflated capital cost, permanently bloating the invested capital base and detracting from returns.
If a third LNG train were built at Gladstone, returns could be expected to improve after 2023. Santos can expand its Gladstone LNG project from two trains to four, which would allow it to drive greater capital efficiency on the two-train startup configuration. Current infrastructure, such as pipelines and wharfage, is sufficient for the expansion, and no further expensive dredging would be required. However, we don't credit expansion in the number of trains, given the likelihood that the LNG market will be in a state of excess supply for at least the medium term. Furthermore, it is not clear that expansion would sufficiently correct for the inflated expenditure of the past, to drive returns sufficiently in excess of WACC. Deflating industry capital costs will also benefit competitors yet to enter the market.
Santos is Australia's largest domestic gas supplier, only cemented with the August 2018 USD 2.15 billion purchase of Quadrant Energy. Profitability will improve with the higher domestic gas price. With the advent of LNG exports in Eastern Australia, the domestic gas market has become more attractive, with contract prices being written near AUD 8 per gigajoule, versus historical contracts near AUD 4 per gigajoule. Group average domestic gas price achievement was AUD 5.20 per gigajoule in 2016. Our long-term Australian domestic gas price assumption is AUD 6.50 per gigajoule in 2021 dollars. In this space, Santos is largely owner-operator of assets, with little additional capital required to take advantage of the higher domestic gas prices. Competitive advantage is from efficient scale, particularly at the important Moomba hub, where it makes no sense for a competitor to replicate infrastructure. But again, Santos' domestic businesses comprises less than a third of our fair value estimate, which is insufficiently material to offset no-moat attributes in LNG.

Bull Points (Last Updated: 27-Sep-2018)

• Santos is a beneficiary of continued global economic growth and increased demand for energy. Aside from coal, gas has been the fastest-growing primary energy segment globally. The traded gas segment is expanding faster still.
• Santos is in a strong position, with 0.9 billion barrels of oil equivalent proven and probable reserves, predominantly gas, conveniently located on the doorstep of key Asian markets.
• Gas has about half the carbon intensity of coal, and stands to gain market share in the generation segment and elsewhere as carbon taxes are rolled out.

Bear Points (Last Updated: 27-Sep-2018)

• Santos committed to substantial LNG capital expenditures, which will see the balance sheet geared in the medium term.
• Much of the company's perceived value is in coal seam gas to LNG projects that are yet to prove themselves and could have teething issues during ramp-up.
• Landholder opposition to coal seam gas development could hinder production growth.