Santos's surprising recovery

Australia's big three oil stocks, Woodside, Oil Search and Santos are emerging from the oil-price shock which sent the price of crude below $US45 a barrel earlier this year with Santos the surprise leader of the recovery.

One reason for Santos heading the resurgence is that it fell further than its rivals. Another is that the Adelaide-based company has shrugged off alarmist predictions about its future to start planning expansionary moves.

All three are benefiting from the steadier, albeit still low oil price, which has been sitting above $US60 a barrel since mid-April.

Woodside, the biggest local oil and gas company, is up 12 per cent to $36 since dropping to a 12-month low of $31.97 in late January. Oil Search is up 9 per cent from its 12-month low of $6.87 in early December, and Santos is up 20 per cent since reaching its low of $6.92 in mid-March.

The oil price, more than anything else, will dictate the future direction of all three because of its direct effect on profits from oil production and also because it forms the base for pricing liquefied natural gas (LNG).

But, even though Woodside, Oil Search and Santos share a common source of cash flow a clear difference is emerging in the way investment banks see the future performance of the local oil-sector leaders which, with BHP Billiton's oil division and the global majors such as Shell and Chevron, account for the lion's share of Australian oil and gas output.

Santos, a company which Credit Suisse wrote off in January as having shares which could be “worthless” under a particular price and exchange rate scenario, is seen as most likely to succeed over the next 12 months.

Oil Search is rated second most likely to succeed as it ramps up LNG production in Papua New Guinea, while Woodside is third, thanks largely to doubts about its ability to maintain its extremely generous dividend policy with the consensus view being that Woodside's share price is  more likely to fall than rise in the months ahead.

That infamous Credit Suisse research report, which was partially retracted after a strident defence by Santos's chief executive, David Knox, was based on two key assumptions: that the oil price and the Australian dollar exchange rate (around $US55 a barrel and US80 cents at the time) would remain in place indefinitely.

“Clearly things have got out of control, and that statement (about Santos shares being worthless) is clearly nonsensical,” Knox said.

“Our projects here in Australia and in Papua New Guinea and Asia have lifespans of 20 to 30 years, and that gives Santos a very solid base.”

The recovery in Santos's share price justifies what Knox said, but it is worth looking back at the alarm in the oil sector as a flood of production from the Middle East and the US drove the oil price over a cliff and credit-rating agencies panicked about the outlook for oil and LNG.

Santos was a prime target for a rush of downgrades, led by Standard & Poor's which lowered its credit assessment of the company from BBB to BBB, and hinted that a further cut to BBB- was possible.

What particularly alarmed investment banks and ratings agencies was the potential glut of LNG as new projects in Australia, including Santos's partly-owned Gladstone project (GLNG) started production and new projects in the US were developed.

Those concerns remain but it now looks like a number of people over-reacted to the threat of long-term low oil prices, and a market-damaging glut of LNG.

Woodside, for example, is pressing ahead with plans to enter the US LNG sector as well as making progress on work designing a floating LNG production barge for its Browse project off the coast of WA. Oil Search is leading a plan to expand the PNG LNG project, and Santos is considering a deal to acquire a direct stake in the gasfields which would feed a third stage of the PNG project.

It is the possible purchase of equity in a gas field in PNG called P'nyang which sparked the latest revival of interest in Santos, together with news that the Gladstone LNG project has passed the 95 per cent completion mark with first LNG scheduled for late September.

Taken together the latest events indicate that Santos suffered a “Mark Twain” moment earlier this year, an experience similar to that of the author who famously quipped after a story about his death appeared in a US newspaper that: “reports of my death have been greatly exaggerated”.

Challenges remain for all oil companies given the capacity for oil production to remain high, keeping prices low. There is also concern about there being too many LNG projects producing more gas than the market can readily absorb, prompting comments about new projects having to “wait for customers”.

While conditions are far more challenging than at this time last year when the oil price was sitting comfortably above $US100 a barrel (and had been for the previous two years) there is increasing confidence that $US60 a barrel is the new floor for oil, not the ceiling.

The steadier view of the oil price has helped the three oil leaders, and most smaller producers such as Beach, Drillsearch and Senex, regain ground during the oil crash which induced panic selling.

Looking ahead the consensus view of leading investment banks is that the worst is over with better times ahead for two of the three top stocks.

Santos, according to the compilation of views from eight investment banks, is currently undervalued by around 23 per cent with the latest bank report, from Citi, well ahead of its rivals with a 12-month price target for the stock of $12.99, around 55 per cent above its latest price – roughly double the consensus view.

Whether Citi's optimism is as misguided as Credit Suisse's pessimism of just six months ago will be interesting to watch.

However, it is also interesting to note that the banks, having written Santos off as a stock with no future, are now dusting off their numbers to paint a picture of a future which is noticeably brighter than Oil Search or Woodside.

Of the eight banks which rate Santos, seven have it as a buy and one (Credit Suisse, naturally) has it as a sell.

The score for Oil Search is six buys and two holds. Woodside's score is four holds, three sells and one buy.

Interesting as those ratings are the more important issue is that oil, after last year's spectacular drop, is clawing its way back up. While it is likely to be a bumpy ride and a price of $US100 a barrel might be a long way off, the future direction is more likely to be up than down.