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Positive news flow from Santos chief executive Kevin Gallagher has earned the oil and gas producer a rapid re-rating of its shares. Ben Searcy
by Matthew Stevens
Kevin Gallagher's ability to fulfil promises has become so finely tuned that the Santos chief executive now finds himself delivering on those that have been made for him.
When Harbour Energy finally sailed away empty handed from its long bear hug of Santos, the US bidder's chief executive, Linda Cook, predicted that South Australia's house of gas would promptly revisit stalled plans to acquire Quadrant Energy.
Needless to say, Cook did not think much of Gallagher's plan to add a new base of Western Australian production and growth options given that the more enriching opportunities and challenges appeared to lie on Australia's east coast and to the north in rapidly growing regional gas demand.
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Gallagher's ability to fulfil promises has become so finely tuned that the Santos chief executive now finds himself delivering on those that have been made for him. David Rowe
But, given the numerical realities of the deal Gallagher has knitted together, Cook's departing dubiety is hard to understand. Maybe she was just excessively disappointed at having come so far so little.
Certainly fulfilment of a deal that was interrupted by Harbour's emergence as a Santos takeover aspirant late last year has landed with plenty enough strategic and numerical affirmation.
The $US2.1 billion ($2.9 billion) price is modest given the quality of the recovery in oil prices and Santos is buying a business that trims $US4 a barrel from its average production costs while also reducing its risk to the pricing cycle because so much of its gas output is sold on fixed price, CPI-adjusted supply contracts.
Quadrant will arrive debt free and so its balance sheet will secure the $US1.2 billion of additional term and bridge financing that Santos has assembled to pay for the all-cash deal. The balance of payments to owners that include Brookfield, Macquarie and Wesfarmers will be covered by Santos' rich existing cash pool.
Growth options
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Linda Cook predicted that South Australia's house of gas would promptly revisit stalled plans to acquire Quadrant Energy. daniel.gray
Santos says the deal will be cash flow and earnings accretive and that it will be left with liquidity and free cash flow enough to contemplate the weight of growth options ahead, that range from buying a necessary stake in a gas field in Papua New Guinea to driving an offshore gas development off Northern Australia, and sustaining and expanding already resurgent onshore oil and gas production in the Copper Basin and Queensland.
The Quadrant deal adds 26 per cent or 220 million barrels oil equivalent (boe) to the driller's proved and probable reserves and at an inferred price that is about $US4 a barrel lower than the standing circa $US14 a barrel multiple that Santos shares have been trading at.
It also arrives with the potential of $US30 to $US50 million of synergies given a volume of overlapping asset ownership and with a new and possibly sizeable offshore oil discovery called Dorado.
The current Quadrant owners will earn future contingent payments of $US50 million should future appraisal affirm anticipation that the field is a 100 million barrels resource and then $US2 a barrel (bbl) for the next 25 million barrels confirmed after that and $US2.50/bbl for anything above that 125 million barrel threshold.
The synergies, on the other hand, appear to land pretty much for free.
The one other quirk in the deal is that Quadrant has pre-sold $600 million of gas to Alcoa as part of a long-term supply arrangement.
Given Quadrant will arrive with no cash, just as it will land with no debt, there are some who want to add this prepayment to the total deal price. But Santos insists that the $2.1 billion is based on revenue flow adjusted to reflect the effect of the prepayment on average received gas prices.
The results that Gallagher presented in the wake of his Quadrant coup severed to announce the quality of the recovery he has engineered and the breadth of the blue-sky that has opened up.
Stunning reduction in costs
The highlights that attracted our attention include, but are not limited to, the stunning reduction in drilling costs in the Cooper Basin and across the Queensland coal seams, the flow through of recovering oil prices to free cash flow, the schedule of growth options that only two years ago looked unaffordable and the crystalline simplicity of the business model.
"We have never deviated from the strategy we announced in December 2016," Gallagher told The Australian Financial Review on Thursday. "I think in the early days of execution that strategy was misinterpreted as a cost out story. But it was really a more rounded value story. It was selling non-core assets, it was shutting down non-value-adding activities, it was improving work streams.
"Honestly, I could not say that I expected the sustained rate of improvement that we have achieved. They did it in year one, but that would be the expectation of the first phase of a turnaround strategy. But they have kept doing it and now we have oil price rising and bringing inflationary pressures but we still have drilling costs falling."
Drilling costs in the Cooper Basin have fallen by 50 per cent since 2015 and will average $US2.4 million a well this year. To the north at Roma, drilling costs have fallen by 84 per cent over that same period. And many of the wells that Santos is now completing are more productive than the ones that cost more than twice as much three years ago.
By doing more with less Santos is able to maximise cash flows and open new horizons of development that might not have cut the economic mustard in times past.
"I was not a big fan of the Cooper [Basin] when I arrived here," Gallagher recalled on Thursday.
"I looked at the cost structure and the declining production profile and I thought 'what the hell have I done'," he said,
Production target
Step forward just two years and both gas and oil production are on the rise and just recently Santos deployed a fourth drill rig to give it the capability of drilling 100 wells annually in programs that will see Santos increase production while attempting to extend the horizon and life of its foundation province.
Santos has every reason to push the Cooper's boundaries. It remains the producer most exposed to the federal government's powers to contain liquid natural gas exports in the name of forcing liquidity on the domestic markets. And the more Cooper gas it can sustainably squeeze into the east coast markets, the more gas it can release to a two-train Gladstone LNG plant that is country kilometres from running at capacity.
The GLNG project is operating at a run-rate that leaves it about 1 million tonnes a year shy of its standing production target of 6mtpa. But that target sits a further 2.4mtpa below the known capacity of the thing.
The upside, then, is obvious. But to fill the machine Santos and its peers need to ensure that east coast gas demands are fully sated. And the simple fact that there are live plans to establish regasification thermals in NSW, Victoria and South Australia says that domestic gas markets are far from firmed.
The immediate reward for swinging what will be the richest acquisition in Santos' history and then, 14 hours later, delivering a thoroughly affirming interim profit result was as fitting as the timing of the Quadrant announcement was serendipitous. Through an active day's trading the Santos share price quietly slipped beyond the Australian dollar value ascribed to the Harbour bid before its rejection in May.
The price the Santos board rejected was equivalent to $6.91 a share. That rejection triggered a 10 per cent reset of the Santos price, which closed at $5.88 on that fateful Tuesday. And that gap was perceived as announcing the size of Gallagher's task in proofing the pudding of that decision.
Energy policy
Well, the market now assesses that is pretty much a job done.
Gallagher's positive news flow has earned a rapid-fire re-rating of Santos. The shares closed at $6.98 on Thursday and that leaves Santos within reach of even the currency-adjusted valuation of the US dollar-based Harbour bid.
For the record, Harbour offered $US5.21 a share and the exchange rate movements since then make that presently equivalent to $7.15 a share. But, for once, I reckon close enough is good enough to pass over the cigar.
Now, we couldn't let Gallagher go without reflecting on the gruesome events in Canberra and the unwinding of the energy policy that precipitated them.
"To be honest, I haven't thought through what it may or may not mean," he reflected.
"But generally, when it comes to energy policy in Australia, what we want is stability, a clear vision, a clear policy so we can all get in with planning our investments and growing our businesses. Anything that leads to stability in policy and in government is going to help everybody in the longer term."
STO Price at posting:
$6.98 Sentiment: Hold Disclosure: Held
(20min delay)
