The oil plunge has Santos in a financial bind

A cut to the energy group’s credit rating has rubbed further salt into its wounds, but a debt issue may be needed to shore up the company’s balance sheet.

A slipping credit rating and a share price that seems to be trapped within a downward spiral ought to have Santos’ David Knox and his chief financial officer Andrew Seaton hastily drawing up contingency plans.

By itself, the one-notch downgrading by Standard & Poor’s, from BBB to BBB, isn’t overly damaging. The share price decline -- it was down more than 7 per cent today and has almost halved in three months -- is, however, a more destabilising and options-limiting development.

Knox and Seaton will be cursing the fact that they didn’t move a little earlier to add some insurance to their finances. Only last week they were forced to pull a planned $700 million-plus issue of hybrid debt in Europe that would have helped shore up Santos’ balance sheet after the latest downward lurch in the oil price.

The timing for the accelerating plunge in the oil price couldn’t have been worse for Santos. While the PNG LNG project in which Santos has a 13.5 per cent interest started shipping LNG earlier this year, the $US18.5 billion Gladstone LNG facility Santos is building in Queensland has the best part of a year -- and very substantial capital expenditures -- before it begins generating cash.

What appeared to be a reasonable margin for error as the GLNG project came within sight of completion isn’t looking so comfortable at a $US66 a barrel oil price, even though Santos says it has cash and undrawn facilities (mainly the latter) of $2.1 billion.

When it abandoned/deferred its hybrid issue last week Santos said it would review its spending plans for 2015 and expected to significantly reduce capital and operating expenditures. Previously it had provided guidance for $2.7 billion of capital expenditures.

The further its share price falls the greater the pressure on Santos to cut spending and cash outflows -- including cash dividends -- further to try to ensure it gets through to the start-up of the GLNG project regardless of what might happen to the oil price. It can’t assume oil prices are at or near their bottom, or that they will bounce back soon.

Apart from rationing cash and capital -- it could hack into its “growth” capex, apart from the GLNG commitments, while stopping exploration spending -- Santos will presumably be looking for any window into the debt markets that would enable it to revisit the hybrid issue. It probably needs a stable, and somewhat higher, oil price for that to make sense.

It has said it has no present intention of raising equity, which is understandable when its share price, which was over $15 three months ago, is heading towards $7.

The market is, however, betting on some form of equity issue, perhaps a dividend reinvestment plan underwriting, to try to shore up a credit rating that is still, albeit barely, investment grade. Santos has been marked a lot harder by the market than Woodside or Oil Search because of the perceived need for a stress-driven capital raising.

Knox isn’t going to put Santos at risk by hanging on and hoping for the oil price to rebound, but neither will he be all that keen on announcing a dilutive equity raising while his share price is so deeply depressed.

There are some in the market who believe Santos needs to raise several billion dollars of new equity to take itself out of the danger zone completely. With a decimated market capitalisation of only $7.5 billion, a raising of that magnitude wouldn’t be a pleasant prospect for Knox or his shareholders. It would be the option of last and desperate resort.

Knox and his board would also be acutely aware that, while nothing has come of the perennial speculation of a takeover in the past, its interests in PLNG, the Cooper Basin and GLNG (and to a lesser extent off Western Australia) are highly strategic and valuable in the longer term if industry consensus forecasts for a growing shortfall of gas supply into the Asia Pacific region from 2020 are borne out.

Santos is financially vulnerable at current oil prices and that generates another kind of vulnerability. The $2.1 billion of liquidity buys Knox and his board some time to review their options and hope that the oil price bottoms out. If it stays where it is or falls further, however, they will have to do something positive and significant to shore up confidence and the group’s balance sheet.