Oil Search pips Santos

The PNG producer has passed out arch-rival Santos in terms of market capitalisation. It could signal a new era in our oil sector.

Summary: Oil Search is now the second-biggest oil producer on the ASX, after passing Santos in terms of market capitalisation. The producer’s interest in the Papua New Guinea LNG project gives it an advantage, given the conventional gas from onshore fields in the project is easier to extract than some of its rivals’ assets. The company plans to expand the project to meet rising energy demand in the Asia Pacific region.

Key take-out: The PNG/LNG project has the second lowest break-even cost of 11 LNG projects in the Australasian region. If Oil Search’s price predictions are right, the project will be handsomely profitable.

Key beneficiaries: General investors. Category: Shares.

Low commodity prices continue to dog Australia’s oil and gas sector but a mid-year change in the pecking order is becoming a permanent feature, with Oil Search last week outlining growth plans which should cement its status as the second-biggest ASX-listed oil producer.

Woodside Petroleum remains the biggest of the local oil stocks, for now, but the speed at which Oil Search has slipped past Santos to snatch the No. 2 spot is a sign that a change at the top sometime in the next few years is possible.

For management at Oil Search, the rising status of their company has special significance after an attempt earlier this month by advisers to the Australian National University to “name and shame” the business as one allegedly causing “social harm”.

What particularly hurt people familiar with Oil Search is that while it does profit from the production of fossil fuels it also ranks as the second-biggest provider of healthcare services in Papua New Guinea where it has been successfully operating for 85 years.

Investment bank analysts who attended the company’s annual strategy day last week were disinterested in the proposed divestment by ANU of its small stake in Oil Search but were certainly interested in the plans to expand production of liquefied natural gas (LNG) and to boost annual dividend payments.

The rise of Oil Search was first noted in a mid-year Eureka Report story (see The new energy pecking order, June 6) with the driver being the company’s 29% stake in the Papua New Guinea LNG project (PNG/LNG).

Since then the oil price, which is a yardstick for LNG prices, has sagged from around $US108 a barrel to $US86/bbl (Brent crude), taking down the share prices of most oil and gas producers, including Australia’s top three.

But what separates Oil Search from Woodside and Santos is its exposure to PNG, a position which is both a blessing and a curse.

On the negative side of the ledger, PNG is a difficult place to do business with a poor record of corruption and weak government. This is best measured in the country’s standing with Moody’s Investors Service, which has assigned the country a B1 or speculative grade rating which means it has a high credit risk.

In its latest report on PNG, Moody’s warned that while it would benefit from the potentially “transformative” production of LNG, the growing level of government debt could see a further downgrade of the country’s sovereign debt.

Set against the governance and debt issues is the country’s rich endowment of minerals and petroleum which are providing Oil Search with a number of advantages over its ASX-listed rivals, Santos and Woodside.

The biggest benefit can be found in the fact that PNG/LNG is based on the supply of conventional natural gas from onshore fields, and even though those fields are located in difficult terrain, onshore gas is easier and cheaper to extract than offshore gas, which is what Woodside produces.

The advantage over Santos, which has a broader mix of oil and gas assets and a small interest in PNG/LNG, is that Santos’ next big project is the Gladstone LNG development. This project is based on unconventional (coal-seam) gas which is both expensive to produce and less reliable than conventional gas.

But the primary reason Oil Search has become a star in the ASX oil and gas sector is that it has a clear growth strategy that is based on expanding its existing assets rather than hunting for growth options, which is Woodside’s challenge.

Peter Botten, the long-serving chief executive of Oil Search, used the company’s strategy day to explain how the company would leverage off the first PNG/LNG production unit (or train, as they are called in the LNG industry) to build at least two more trains, and possibly three more.

He also revealed a progressive dividend policy that would see between 35% and 50% of underlying net profit after tax paid as dividends.

Oil Search’s plan to expand the PNG/LNG project at a time when some companies are having second thoughts about future developments is explained by the project’s status as a low-cost producer, and confidence that demand for energy in the Asia Pacific region is stronger than most people realise.

Macquarie Bank, in a major report published earlier this month on energy demand in Asia, added to Botten’s confidence because it described Asia’s energy sector as “short and getting shorter”.

“Asia will see its primary energy demand rise by 37% by 2015,” Macquarie said, “and its energy imports rise by 53%, the equivalent of 436 nuclear power plants.

“Asia will be increasingly tight energy and we expect regional energy prices to thus rise over the next decade.”

In comparing his project with rivals in the region Botten did not “name names” at his strategy day but one graph demonstrated the cost advantage, with PNG/LNG enjoying the second lowest break-even cost of 11 LNG projects in the Australasian region.

At around $US7.80 per million British Thermal Units the PNG/LNG project is marginally more costly than the cheapest (at around $US7/mbtu), comfortably below the next highest (more than $US9/mbtu) and close to half the cost of the most expensive LNG project in the region (almost $US15/mbtu).

In his presentation Botten predicted that the price for LNG in the Asia Pacific region was expected to settle at between $US12 and $US14/mbtu in the period from 2020 to 2025.

If he’s right then PNG/LNG will be handsomely profitable – a benefit to both Oil Search and Santos.