Business Strategy and Outlook (Last Updated: 27-Sep-2018)
Santos is the second-largest Australian pure oil and gas exploration and production company (behind Woodside Petroleum, ASX:WPL), with interests in all Australian hydrocarbon provinces, Indonesia, and Papua New Guinea. Reliance on declining Cooper Basin assets and years of exploration inactivity saw Santos come under production pressure late in the past decade. Stronger energy prices supported earnings, while high-risk exploration under past management disappointed. Well-timed East Australian coal seam gas purchases and subsequent partial sell-downs bolstered the balance sheet and set the scene for liquid natural gas, or LNG, exports. Santos is now one of Australia's largest coal seam gas producers and continues to prove additional reserves. It is the country's largest domestic gas supplier.
Given our energy price outlook, we don't expect Santos to generate returns in excess of its cost of capital, meaning that it has no moat. This is despite operating-cost advantage on a number of fronts, including the potential for capital-efficient expansions from the existing LNG base, which is nearing full capacity; gas resources that have been acquired or owned at a substantial discount to replacement value; and the transition to export-parity gas pricing in Australia, which has seen an approximate doubling in domestic gas prices to AUD 6.00 per gigajoule and a consequent significant uplift in Santos' domestic margins, with little new investment.
Despite the near-doubling of oil prices in the past decade, Santos struggled. In the 10 years to fiscal 2011, diluted earnings per share fell 25% to AUD 0.50. Production declined 15% to 48 million barrels of oil equivalent, or mmboe, with the higher value liquids fraction falling fastest, down 37% to just 21% of total, on an energy-equivalent basis. Domestic gas prices didn't rise as strongly as oil prices, yet operating costs increased 120% to more than AUD 15.00 per boe at the EBITDA level. The group operating margin fell from 73% to 68%, while capital intensity rose sharply from about AUD 12.00 per boe in fiscal 2001 to more than AUD 60.00 per boe in fiscal 2011. Myriad smaller projects offset declining Cooper Basin output but complicated the production profile, adding management and operational cost relative to the far simpler Cooper legacy asset. In short, Santos' asset attractiveness diminished materially, leading to substantial profitability headwinds.
However, coal seam gas purchases increased reserves, and partial sell-downs generated cash profits, putting Santos on solid ground to improve performance. Group proven and probable, or 2P, reserves doubled to 1,400 mmboe, primarily East Australian coal seam gas. Coal seam gas has grown to represent more than 40% of group 2P reserves, despite partial equity sell-downs. An initial USD 2 billion 40% sell-down of Gladstone LNG to Malaysia's Petronas in 2008 crystallised some profit, and well-timed asset sales preserved shareholder value in the face of deteriorating operating margins and production per share. But Gladstone LNG-associated capital expenditure and a weakening in the AUD/USD exchange rate on U.S.-dollar-denominated borrowings caused net debt to balloon. More recently, value recognition has facilitated large rights issues, which have reduced net debt back to comfortable levels.
A degree of confidence can be drawn from project partners. U.S. energy supermajor ExxonMobil, the world's largest publicly traded oil and gas company, is 42% owner and the operator of the PNG LNG project. The Gladstone LNG project was built and is operated by GLNG Operations, a joint venture of owners Santos (30%), Petronas (27.5%), Total (27.5%), and Kogas (15%). Petronas is Malaysia's national oil and gas company and the world's second-largest LNG exporter. French energy major Total is the world's fifth-largest publicly traded oil and gas company, and Korea's Kogas is the world's largest buyer of LNG. Santos is in good company.
Overall, we see a happier future for Santos now that excess debt levels are addressed, aided via improved margins and earnings driven by Gladstone and PNG LNG. The company will increasingly enjoy export pricing on its gas. Previously, costs rose with international vigour, but domestic gas prices did not. In addition to Santos' Gladstone LNG, several other new third-party east-coast LNG projects conspire to drive domestic gas prices higher. As the largest domestic gas supplier, Santos can expect significant bang for its buck, with limited additional capital or operating cost required to capture enhanced prices. The group production profile is simplified with increased certainty in project life. LNG projects are large, as are the supporting coal seam gas resources.
STO Price at posting:
$7.26 Sentiment: Buy Disclosure: Held
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