A gas giant in the making

Oil Search is quickly evolving into a major resources company, which could soon overtake Santos.

Summary: A major stake in a liquefied natural gas project in Papua New Guinea, and an interest in a promising oil discovery in Iraq, have positioned Oil Search as a force to be reckoned with in the Australian resources sector. If all goes well, the company could overtake Santos as the second-biggest ASX-listed oil and gas stock.
Key take-out: Listed investment company Australian Foundation Investment Company is keen on Oil Search, having taken a strategic holding, and a number of major stockbrokers are pitching the oil and gas company as a buy based of revenue and profit forecasts.
Key beneficiaries: General investors. Category: Shares.
Recommendation: Outperform (under review).

It’s not often that a game-changing event really does change the game. But, in the case of Oil Search, that is precisely what will happen next year when it joins the hottest game in the oil and gas industry as a co-owner of a big liquefied natural gas (LNG) project.

From the status of being a largely overlooked resource company with its roots in Papua New Guinea, Oil Search is set to rocket up, with its annual profit expected to move closer to that of Australia’s second-biggest and much better known oil and gas producer, Santos.

In theory that should mean that Oil Search’s stockmarket value will also match that of Santos, with Oil Search having the potential to eventually catch the sector leader, Woodside Petroleum, as it expands in PNG and has a promising recent oil discovery in Iraq. But also keep in mind that both PNG and Iraq carry substantial risk discounts.

A lot of oil and gas will need to pass through the pipes before Oil Search rivals Woodside, though a simple comparison of share price graphs shows what might happen – Oil Search has headed strongly upward over the past two years, while Woodside has performed erratically.

Overtaking Santos looks to be an easier assignment, which is one of the reasons why Oil Search is a buy for investors with either a short or long-term outlook.

In the short term a fresh share-price uplift to match what has happened over the past 12 months can be expected as PNG’s first LNG project switches from construction to production, a change scheduled for the first half (and perhaps the first quarter) of next year.

Oil Search has a 29% stake in PNG/LNG, which means it will be entitled to 1.94 million tonnes of LNG a year out of an initial production target of 6.7 million tonnes from the project that has the world’s biggest oil company, ExxonMobil, as its major shareholder and operator.

Converted to an oil equivalent basis, Oil Search’s share of LNG is equal to approximately 19 million barrels of oil a year, which is three-times the company’s current rate of oil production from its PNG projects.

Work on the PNG/LNG project, which will gather gas from a variety of fields in PNG and pipe it to a processing centre near Port Moresby, is more than 90% complete, with on-site work switching from construction to commissioning.

While prudent investors might have been holding back on adding Oil Search to their list of essential resource companies  – no doubt due to the obvious political and regulatory risk surrounding PNG-based projects – there is growing confidence that the PNG/LNG project will be completed on time, albeit somewhat over budget.

Tapping into Oil Search

One local institution that has not been holding back with its interest in Oil Search is the cautious fund manager and listed investment company, Australian Foundation Investment Company (AFIC).

AFIC ranks as the ninth-biggest shareholder in Oil Search, with a stake of 14.9 million shares (1.12% of the stock), which is dominated by its top 20 shareholders and their 85.4% stake. The PNG Government holds 14.7%.

More interesting than AFIC’s position on the Oil Search share register is that Oil Search represents AFIC’s 10th biggest overall investment holding. This standing is significantly higher that Oil Search’s position as the 24th biggest ASX-listed stock, and noticeably out of kilter with the AFIC investment list that otherwise largely follows the ASX market-capitalisation pecking order.

AFIC’s exposure to Oil Search is a sign of the rising confidence that PNG/LNG will do what Queensland’s controversial LNG projects might not do; deliver strong profits from the production of LNG from conventional sources of gas rather than struggle with slow rates of flow from coal-seam gas while also battling environmental protests.

ExxonMobil, as PNG/LNG operator, is sufficiently confident that it is on track to finalise the $US19 billion development that it is already planning to expand production by adding one, and possibly two, more production units (or trains as they are called in the LNG industry).

Gas for the additional trains could be sourced from a number of fields, with Oil Search a possible contributor as its exploration effort accelerates in the PNG Highlands and offshore in the Gulf of Papua, though the most likely supplier is InterOil from its Antelope and Elk gasfields.

Negotiations between ExxonMobil and InterOil have reached an advanced stage, with InterOil’s position being negotiated by the company’s recently appointed chief executive, and former senior Woodside employee, Michael Hession.

Whether Oil Search retains a 29% stake in stage two of PNG/LNG will depend on the current talks, with the company’s chief executive, Peter Botten, only saying that Oil Search “will have an opportunity to participate in this expansion”.

Electrifying growth

Before PNG/LNG is expanded the effect of stage one on Oil Search’s financial performance has the potential to be electrifying.

Revenue, which has been steady in recent years at around $724 million, should rise to around $1.1 billion next calendar year as first LNG sales are generated, and more than double in 2015 to around $2.6 billon.

Earnings before interest tax and other charges (EBITDA) – and this is where the Santos comparison becomes interesting – should rise from $380 million last year to a forecast $446 million this year, and to $735 million next year and $2.1 billion in 2015.

Santos, which has a 13.5% stake in PNG/LNG, is also expected to post higher profits over the next two years. But the growth rate will not match that of Oil Search, with EBITDA expected to rise from $1.7 billion this year, to $2.1 billion next year and $2.9 billion in 2015.

On the stockmarket Oil Search has moved to within overtaking distance of Santos, with their respective market values standing at $10.8 billion and $13.3 billion. Woodside is well ahead at $31.1 billion.

LNG will be important to Santos, but it will be a genuine game-changer for Oil Search as could be  the Taza oil discovery in Iraq. Taza has yielded encouraging early flows from exploration drilling and has been rated as containing between 250 million and 500 million barrels of oil.

Apart from routine drilling results from a variety of exploration projects in PNG and the Kurdistan area of Iraq, the next major news event for Oil Search will be its half-year profit statement scheduled for August 20.

Investment banks that follow Oil Search are expecting a strong profit result thanks to steady rates of oil production (1.63 million barrels) in the June quarter, which was reported last week.

The big event in the life of Oil Search, which has been in the PNG oil game since 1929, will be confirmation that PNG/LNG has started production (first quarter of next year), followed by first cash flow sometime near the middle of next year.

Bullish forecasts

It’s the promise of a big cash injection from LNG sales, and the potential for higher dividends and some form of bonus such as that made by Woodside earlier this year, which has Oil Search on the buy list of most big brokers.

Macquarie rates the stock a buy, with a 12-month price target of $9.50 (up 18% on recent trades at $8.05). BA Merrill Lynch also has a buy tip on Oil Search and sees $10 as the price target. Deutsche Bank and UBS are also in the buy camp, with price forecasts of $8.60 and $9.20 respectively. Goldman Sachs, normally the most conservative of the investment banks, has the highest price tip of $10.20, and a buy recommendation.

Three big brokers have a cautious view of Oil Search. Citi, JP Morgan and Credit Suisse like the stock but see it as having risen a long way from its 12-month low of $6.81 last November.

The next six to 12 months will determine whether caution is the best way to treat Oil Search given the potential for high rates of cash flow, which are expected to result in a sharp increase in dividends from the current 4 cents a share to at least the 17c in 2015 forecast by Goldman Sachs.

Interestingly, if that Goldman Sachs 17c dividend prediction for 2015 is correct, it will represent a very low payout ratio of 19.7%, far less than Santos’s forecast 32% payout ratio and a fraction of Woodside’s 70%.

In other words, Oil Search, if it delivers on its promise, has the potential to treat its shareholders far more generously.

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