Risky business for Oil Search in PNG?

Oil politics, PNG sovereign risk and a rebalancing of ‘who’s who’ among Australia’s top producers are all on the agenda after a surprise deal at Oil Search Ltd.

Summary: Oil Search has positioned itself for LNG expansion, striking a deal with the PNG Government that could see gas reserves developed at a faster pace. But history suggests much could go wrong in becoming over-exposed to our northern neighbour.
Key take-out: The oil and gas explorer's deal with the PNG government could be beneficial for shareholders, but not everyone's a winner... and the geopolitical risks can't be ignored.
Key beneficiaries: General investors. Category: Mining stocks.

It sounds rather grand to be named Papua New Guinea’s national oil champion, but it’s questionable whether that title will prove to be a boon for Oil Search investors. It also raises a wider question of Australia’s commercial relationship with PNG and its very mixed history with international resources companies.

Yesterday’s deal with Oil Search sees the PNG Government elbow itself onto the company’s share register at a discounted price of $8.20 a share.

By paying this price, when the last Oil Search sale before the deal was $8.57, the PNG Government has acquired a discounted 10% stake in a business it wants to see take the lead in developing the country’s oil and gas reserves.

It also provides some insight into the government’s belief that it is somehow entitled to special treatment in natural resources.

PNG may provide some ‘too-good-to-miss’ opportunities for the big oil and gas players, but there’s no doubting the risks involved. Certainly the PNG Government’s recent history of backtracking on long-term agreements is cause for concern.

Investors need only look to BHP Billiton and last year’s developments at the Ok Tedi copper and gold mine to see the potential risks for Oil Search.

In the 1980s and 90s, tailings from the Ok Tedi mine caused extensive damage to the Fly river system in PNG’s Western Province. In 2001, in exchange for legal immunity for the damage caused, BHP struck a deal with the PNG government to divest its majority share of the mine to the PNG Sustainable Development Program, a trust set up for those affected.

However, last September the PNG Government quickly pushed through legislation that gave it total ownership of the Ok Tedi mine and repealled laws that had previously protected BHP from legal action over the pollution caused. This was a blow for BHP and is an indicator of what could be in store for Oil Search further down the line.

The deal between Oil Search and the PNG Government has been described by some as a pragmatic and common sense transaction, in reality it’s just another version of resource nationalism as seen in many third-world countries.

Over time, it could become difficult to spot the difference between Oil Search as PNG’s national oil champion and Oil Search as an arm of government and that really ought to ring the alarm bells.

Still, as can be seen from the chart below, early market reaction to the deal has been positive, with Oil Search shares adding 12c (1.4%) in early trade today, to be priced at around $8.69.

Graph for Risky business for Oil Search in PNG?

Most of the $1.22 billion being raised by Oil Search from the share sale to the PNG Government will be used to pay $900 million for a 22.84% stake in oil and gas fields close to those being developed by the PNG liquefied natural gas consortium which also includes ExxonMobil and Santos.

Previously seen as the basis for a second LNG project in PNG, it now seems likely that the Elk and Antelope gas fields will become suppliers of raw gas to PNG LNG. (To read more on the PNG LNG project, see PNG a mining danger zone.)

The deal suits Oil Search and the PNG Government in terms of achieving a faster development of gas reserves, but it doesn’t appear to be in the long-term interests of other shareholders in the Elk and Antelope fields, who had been planning the own LNG project but now look like becoming minority participants in a substantially bigger PNG LNG project.

Clearly, not everyone’s a winner from the agreement. Without doubt, one of the biggest losers is the International Petroleum Investment Company, a sovereign wealth arm of the government of the Middle East emirate, Abu Dhabi.

In 2009, Abu Dhabi paid $1.68 billion for bonds which could be converted into Oil Search shares. Those bonds mature this year and would, theoretically, have become a 13.2% stake in Oil Search.

The PNG Government, claiming it was fearful of a foreign takeover of Oil Search, offered to buy back the bonds but was rebuffed by Abu Dhabi.

That rejection was a factor in the issue of new shares in Oil Search to the PNG Government which means the Abu Dhabi bonds, when converted, will represent a reduced shareholding in Oil Search, with the original 13.2% stake being cut to around 10%.

From a PNG Government perspective the re-acquisition of a stake in Oil Search is certainly a pragmatic solution to a problem it created by selling the bonds to Abu Dhabi five years ago.

But fixing the problem by simply cutting a deal with Oil Search for more shares to be issued after the Abu Dhabi sovereign wealth fund refused to sell is quite an underhanded solution. It leaves no doubt that what the PNG Government wants, it gets.

Oil Search, which is keen to closely align itself with the government, seems happy see Abu Dhabi ‘s stake watered down – though, at the risk of spelling it out,  the principle of watering down shareholders other than a favoured few is never good.

Abu Dhabi isn’t even the only outside investor wondering what games are being played in PNG.

French oil company, Total, also appears to have been shoved aside in favour of Oil Search under its new title of national oil champion.

Total has been negotiating a shareholding in the company behind the Elk/Antelope LNG proposal, a Texas-based company called InterOil.

Oil Search was not happy that gas reserves close to its operations and gas pipeline which runs from its fields to the 95% complete PNG LNG processing facility near Port Moresby were likely to be directed into a rival project.

Suggestions from Oil Search that Total join the Elk/Antelope party appear to have been rebuffed just as Abu Dhabi said it would not sell back the bonds it holds in Oil search.

This second rejection became a factor behind the share issue to the PNG Government, which provided the funds to buy a 22.8% stake in the Elk/Antelope fields.

Whether Total proceeds with its proposal to buy into Elk/Antelope and whether the PNG Government will “encourage” other shareholders in those gasfields to sign up to a deal with PNG/LNG is not yet known.

The question for minority shareholders in Oil Search - and more widely every investor in PNG - is whether their interests are aligned with those of the PNG Government? Or even whether that’s a good idea?

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