Santos fires up on LNG

A well-earned reputation for disappointing continues to dog Australia’s second-biggest oil and gas producer, Santos.

And this means some investors are missing what looks to be a substantial and sustainable period of strong growth.

The first clue that something is stirring inside a business that once behaved like an arm of the South Australian government can be seen in the share price, which has outperformed the local sector leader, Woodside Petroleum, since the start of the year.

The fact that Santos shares have risen by 13.5% since early January, and Woodside is up by 4.4%, is important because Woodside was the first of the oil producers to play the higher-dividend card, which gave it a price boost in April.

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Some of that rise could be attributed to speculation that Santos has once again become a takeover target, with a potential bid this time from the global oil giant, Chevron, which is partnering Beach Energy in a central Australian search for unconventional (shale) gas with some of the areas of interest overlapping tenements partly owned by Santos.

The theory is that as Chevron, which is mainly active in offshore WA through its Gorgon and Wheatstone LNG projects, builds a greater internal understanding of central Australia, and if it enjoys success in the search for shale gas, it might seek to make a substantial investment – with the easiest route in being an offer for Santos.

Another indication that investors are starting to take a fresh look at both Santos and Woodside is that they have both been rising while the oil price has been falling, perhaps a pointer to oil and gas replacing iron ore as the preferred exposure to Australian resources.

Since the start of the year, crude oil as measured by the Brent yardstick has fallen by $US10 (9%) a barrel to around $US102/bbl today, a drop which is negated by currency changes – though even after allowing for an 8.6% fall in the Australian dollar, the oil price is steady at $A107/bbl.

So, if Santos is not being helped along by the oil price or by a higher dividend, but is outperforming its great local rival, Woodside, there must be something else driving the stock. And that seems to be something as basic as increased oil and gas production, rising profits and the promise of a higher dividend to replicate what Woodside did in April.

Before considering the detail of what’s stirring inside Santos, it is worth looking at how investors reacted to Woodside’s April 23 announcement of a special (one-off) US63c dividend, and a promise to lift the annual payout ratio to 80% of underlying net profit.

It was that announcement which delivered a 15% upward jolt to the Woodside share price, lifting it from around $33 to $38, and while the benefit of that special payout has faded after it was paid to shareholders on the register at the time, the prospect of oil stocks becoming yield plays has caught the imagination of investors.

From an investment perspective, Santos and Woodside show similarities to the other two great resource rivals, Rio Tinto and BHP Billiton. While professional investors might sometimes see value gaps between the two energy groups, the best approach for average investors is to own both, leaving the challenge of picking marginal differences to traders.

With Woodside, there is the cash flow from its interest in the long-running North West Shelf joint venture, other oil assets, strong cash flows from the majority-owned Pluto LNG project, and a promise from management to focus on shareholder returns and to adopt less risky, and lower-cost, investment strategies.

Incremental growth

Santos, on the other hand, already has in place a policy of incremental growth rather than the “big bang” style once followed by Woodside, and it is that steady increase of exposure to the hot fuel of the future, LNG, which could deliver a dividend surprise as early as next year.

Urged on by investors keen to receive a higher payout, Santos managing director, David Knox, and recently retired chairman, Peter Coates, have promised to reward shareholders when cash flow permits.

“At the moment Santos is a growth stock,” Coates said after the Santos annual meeting last month. “But we are fast approaching the time when that is going to change.”

Like Woodside, Santos is expecting a flood of cash from its exposure to multiple LNG developments with an 11.5% stake in the existing Darwin LNG project, 13.5% in the emerging Papua New Guinea (PNG/LNG) project, 30% in the emerging Gladstone (GLNG) project, and 40% in the potential Bonaparte LNG project, off northern WA.

Even negative publicity directed at the Gladstone LNG project, and other Queensland LNG projects based on the use of coal-seam methane, is not distracting from the long-term appeal of the sector.

A similar situation swirled around Woodside’s Pluto project, with naysayers having a field day – until it started production and cash started flowing in rather than out.

In terms of incremental growth, Santos’ steady rise from a toe-in-the-water 11.5% in the Darwin project to 30% in GLNG, and then possibly up to 40% in the next generation of floating LNG-barge technology, is a guide to the way the new-look Santos is emerging.

In his presentations to investors, Knox has focussed on emerging LNG production, while not overlooking existing oil and gas output from projects scattered around Australia, including the company’s traditional (and re-awakening) engine room in the Cooper Basin of central Australia.

It is in the Cooper, site of one of Australia’s original oil and gas discoveries, that the revitalisation of Santos can be most clearly seen.

Rather than allow the oil and gas fields of the region to continue a long-term decline that has seen gas production collapse by 50% over the past decade, Santos is busy reviving its foundation project, targeting a 30% increase in gas output over the next two years.

Higher east-coast gas prices, a political hot button issue, are a factor in Santos re-discovering the financial firepower of the Cooper. Other factors include changing interpretations of geological structures, a drilling blitz to access smaller pools of gas, and the start of Australia’s version of the shale-gas revolution that has changed the face of the US energy industry, as well as that country’s economy.

First gas from rock units once regarded as too tightly-packed to flow commercially (so called shale gas) is already finding its way into the pipeline systems flowing out of the central Moomba processing centre.

Much more shale gas will come from the Cooper and other Australian shale-trapped gas deposits, but only after years of careful drilling and the inevitable process of trial and error.

To see where Australia’s adventure in shale gas started, and to see its future, I visited Moomba last week as part of an industry-sponsored tour of South Australia’s resources sector. My primary target was the Moomba 191 well, which started flowing gas from deeply-buried shales last August.

Drilled as an experiment, Moomba 191 is a vertical well driven directly into the Roseneath and other beds of shale without any directional turns to follow the rock units. This process dramatically increases exposure to gas in the rocks, and therefore rates of production.

Moomba 191

In its early days Moomba 191 flowed at a stabilised 2.7 million cubic feet of gas a day. It is still flowing at 2.3 million cubic feet a day, a remarkably modest decline for a vertical test well and a sign that the once unproductive shales, some more than a kilometre thick, will play a big role in the future of Santos and east-coast gas supplies.

From an investment perspective Santos has a compelling story to tell, though it is one to watch carefully because of that historic track record of disappointing – snatching defeat from the jaws of victory.

The key points from Knox, when he talks up the company, include:

• A forecast of 6% annual compound production growth over the next seven years.
• Rising Australian domestic gas prices to underpin work (and earnings) from the legacy Cooper assets.
• Two new part-owned LNG projects moving towards production in 2014 and 2015 respectively.
• A busy exploration schedule that is yielding a steady rate of discovery such as the recent Crown and Basset West gas and liquids finds in the Browse Basin off the north-west coast.
• The promise of being the first and biggest beneficiary of a shale gas rush in the making.
• The prospect of higher dividends as cash flows from the new LNG projects, in much the same way as Woodside delivered a bonus from its Pluto cash.

Analyst forecasts

Broker opinions of Santos are almost universally positive. BA-Merrill Lynch this week retained its 12-month share price target for the stock at $16.56, 31% higher than its most recent sale at $12.64.

Of particular interest to Merrill Lynch analysts was the relatively modest success of the Basset West discovery (just 7.5 metres of gas-bearing sands), but which can be seen “as proof of a working hydrocarbon system” that will help de-risk the project.

Other investment opinions of Santos include buy ratings from UBS, Macquarie, Citi, Deutsche and Goldman Sachs.

Macquarie has a 12-month price target of $16.50, and Goldman sees a 12-month future peak price of $16.25 as risk from the developing LNG projects is reduced.

Goldman told clients last week that it believed the LNG potential of Santos was not yet priced into the stock.

“We expect approaching LNG start-ups (PNG in 2014, GLNG in 2015), and a dividend policy review to act as catalysts,” Goldman said.