MS report today...rerate Santos Gallagher's Action Plan: The...

MS report today...rerate

Santos Gallagher's Action Plan: The Scorecard
Stock Rating: Overweight
Industry View : In-Line

Until recently Santos was underperforming peers. Sentiment has improved significantly over the last couple of months given cost-out progress combined with stabilising oil prices. We examine cost trends, progress and key catalysts for the next 12 months. We remain Overweight. Santos WHAT'S CHANGED Price Target We upgraded Santos in Gallagher's Action Plan on a cost-out and drilling efficiency turnaround strategy. Equity performance was initially poor given sentiment around the equity raise, which was further compounded by concerns on domestic gas reservation policy and lower oil prices. Since that time, oil prices have stabilised and it's become clear that Gallagher is making progress on the action plan. Free cash flow breakeven has been lowered (from US$47/bbl to US$33/bbl) making the business much more defensive to lower oil prices, while retaining significant upside should oil prices continue to move higher. In this report we investigate the cost-out progress and demonstrate the sustainable nature of well cost reductions (from >US$6m in 2014 to
Prive target: $4.50
Set at an approximate 0% discount to DCF (rounded down slightly).The discount is similar to the discount we use for other largerAustralian E&P companies.DCFDCFBrent price = base case + US$10/bbl: We do not make any other changes fromthe base case.DCFDCFBrent price = US$48/bbl in 2017, US$50/bbl in 2018, US$58/bbl in 2019 andUS$65/bbl long term: A$/US$ exchange rate of 0.75. Static assets andexploration have some value, but NSW CSG worthless.DCFDCFBase case oil less US$10/bbl: We do not make any other changes from the basecase.

Investment Thesis: The investment thesis for Santos is that it has more cost-out and turnaround potential than other E&Ps in Australia. Santos has relatively high cost assets driven by GLNG and the Cooper Basin. By reducing cost, this increases free cash, improves balance sheet and has the potential to increase reserves over time. We think there will be consensus asset valuation upgrades over next 12 months in places like the Cooper Basin. The cost-out is driven by two factors – opex and capex reduction. The opex reduction is driven primarily by personnel cuts but also a focus on service rates and efficiency. The capex reduction primarily centres around drilling efficiency. Santos is the most active driller in Australia and needs to drill a large number of wells each year in the Cooper Basin and GLNG to produce booked reserves. Santos has managed to reduce well costs significantly due to faster drilling times, less mobilisation, better well planning and more efficient operations. We think Santos will incrementally continue on the cost-out journey, albeit most of the heavy lifting is probably done. Where the value creation lies is whether Santos can use the "new cost" structure to incrementally develop new gas resources in places like the Cooper Basin, which should mean reserve upgrades. We also think sentiment is likely to continue to improve on this company and given its upside to an improving oil price outlook, will be a company investors choose to play this theme. Changes to Price Target, Valuation and Earnings Our earnings forecasts have increased due to updated assumptions around production costs and other income in relation to 1H17 actuals. Our DCF valuation is higher based on increased asset values for the Cooper Basin plus modest incremental additions for Darwin LNG backfill plus some value for Muruk as discussed in more detail at the back of this report. We continue to run the forward curve oil price assumptions which we update in collaboration with the global team. Our current forecasts assume US$48/bbl in 2017, US$50/bbl in 2018, US$58/bbl in 2019 and US$65/bbl long-term. There is upside to our valuation based on oil prices at spot levels.