Santos belongs on the front-burner

The story of Santos is one of the most remarkable in Australian business folklore, and it has a clear message for investors. Santos is a company that all long-term energy investors need to seriously consider.

But to fully understand how the company finds itself in such a strong position we have to go back in history. In the 1990s the Santos board believed that they should run the Cooper Basin gas and oil producing company like a conventional mining or industrial group.

They maximised (and distributed) the profits by not spending vast amounts of money replacing the gas and oil that Santos took from its reservoirs. That is simply not the way you run an oil/gas company. (Interestingly, the difference between oil/gas and conventional mining companies is why Rio Tinto keeps referring to the different culture that must exist in BHP Oil to the rest of the company). Woodside, Australia's largest oil and gas company, has a market capitalisation of $38.8 billion; Santos is capitalised at $10.4 billion

Santos would have been taken over during this period but for the South Australian legislation that which limited any one shareholder to 15% of the company. The legislation had been designed to prevent Alan Bond in gaining control in the 1970s. The Santos board knew that to survive longer term they had to start taking exploration and oil/gas purchase risks, so they appointed John Ellice-Flint as chief executive, with a mandate to go out there and find oil and gas. I know one non-executive Santos director who gulped at the exploration risks Ellice-Flint took but this shareholder stayed on the board and must be very happy he did.

What Ellice-Flint did for Santos in the next decade is truly remarkable. His successful Australian and global hunt for hydrocarbons assembled an amazing array of reserves. Santos emerged with a stake in an LNG projects in Darwin and Papua New Guinea; gas in the Otway Basin, which will fuel a power station; and oil and gas assets in WA, Indonesia and Vietnam. Santos is also exploring in the Bay of Bengal. At the same time it found more oil and gas in the Cooper Basin.

Most importantly, Ellice-Flint also recognised ahead of the pack that coal gas had the potential of being one of the great fuels in the 21st century and assembled large reserves in Queensland.

But during this period of reserve and project assembly the analysts had no idea of the worth that Ellice-Flint was adding to Santos, and the stock was languishing at $10–12. Most analysts, who should have known better, were giving it a value of not much more than market and suggesting there were better energy plays around. Ellice-Flint and the board knew that their company was substantially undervalued.

As 2008 dawned, Santos entered a dangerous period because in November 2007 the South Australian government had voted to lift the 15% ownership restriction on its stock. Suddenly, Santos was a sitting duck and another Australian asset was open to be sold for a fraction of its worth, as happened with MIM (to Xstrata) and WMC (to BHP).

So in March the board, led by chairman Stephen Gerlach, decided that the man who had built this wonderful base was not the person to lead the company into the new era and he was encouraged to resign, to be replaced as chief executive by David Knox, previously a Santos executive vice-president.

Knox had a much better idea how to sell the company’s potential but, more importantly, he sold 40% of the coal/gas LNG operation to the Malaysian oil group Petronas for $US 2.5 billion. Ellice-Flint probably could have done that deal but his approach was different. He would ask the question why should we sell when we can keep all the value for Santos. However that sale suddenly alerted the analysts to Santos’s real worth. Some of the analysts then discovered that Santos was selling Cooper Basin gas to NSW and Queensland for a very low price, about $4 a gigajoule.

Average Australian gas prices are about twice that level and the international price is more than three times the Cooper level. With greater emphasis now being placed on carbon, the NSW and Queensland gas prices are likely to rise sharply in the early part of the next decade. (To read more on the future of gas prices, see today's feature by Charlie Aitken, Gas sees a bright future.)

Once the Santos/Petronas LNG plant is operating at Gladstone (about 2014) Santos will be able to divert Cooper gas to Gladstone and export it, so inevitably the domestic price of gas in NSW and Queensland will rise closer to export parity over the next decade. (In fairness, Citi last year alerted the market to long-term price potential of the Santos Cooper Basin gas.)

Meanwhile, analysts also discovered the worth of the other Santos projects. So what happened to Santos shares was truly amazing. Without any basic change in the asset situation, Santos shares skyrocketed rising at one point, to about $20, and the analysts came out with figures that were much higher. Deutsche Bank announced a target of $25.40; Merrill Lynch’s target was $27.22; while Citi is going for $29.40.

We now have valuations that are substantially higher than the market price, even when it was at its peak. Now I should add that these estimates were made when the oil price and the overall Australian market was higher.

However, longer term, what makes Australian gas and particularly coal gas so valuable is that the vast bulk of the world’s gas and oil are held by Russia, the Middle East and Western Africa. These are all political hotspots and Asian countries are looking around for gas in politically stable areas to lessen their risk exposure. So Australian LNG is highly sought after and that is one reason Petronas was prepared to pay such a high price in the Santos deal.

The Santos share price ($17.53 today) fluctuates with the oil price, but because it is so deeply involved in gas development the biggest long-term risks for Santos are in construction. And so all investors in Santos should understand that the analysts are placing a high value on the coal seam gas/LNG project, which will not come on stream until 2014. But they are also assuming that as Australia places greater curbs on carbon emissions, so gas will begin to replace coal as a power source.

However, there are still carbon emissions from natural gas. Coal seam gas is more carbon-efficient than natural gas. At last count, John Ellice-Flint was headed towards the Kokoda Track. He richly deserves his rest and Santos shareholders should not begrudge him one cent of the $85 million he received as a parting payment .

My guess is that he will bob up somewhere else and the shares in that company will be worth a punt. But the Santos he has left is headed towards being an energy leader. If somebody wants to take it over post November we now have valuation of $29 a share, which means they are going to have to pay $35–40 unless there is a big fall on the overall market and/or oil price

New chief executive David Knox is dedicated in ensuring that Santos will not be a rerun of MIM or WMC.