Why Santos was right to shelve its EU debt issue

A debt raising would be a prohibitively expensive exercise given a plunging oil price and spiking yields on existing issues from energy companies.

Santos' decision to defer its planned $700 million-plus hybrid debt issue in Europe is a pragmatic recognition of the obvious. For an energy company, trying to raise any kind of debt against the backdrop of sub-$US70 a barrel oil prices would be an extremely expensive and perhaps pointless exercise.

The abrupt and quite savage fall in oil prices in the back half of this year -- Brent crude prices have fallen nearly 40 per cent since July -- and the latest downward spike in the wake of last week’s OPEC decision not to cut production has sent shockwaves through debt markets.

Fears about exposures to energy companies in the US junk bond market, where the sector represents about 16 per cent of that market, have spilled into the wider market for energy companies’ debt.

With yields on existing issues from energy companies spiking, and growing concerns about the potential for wide-spread defaults in the junk bond market, even if Santos could get an issue away in the current market environment it would be prohibitively expensive.

It would also send the wrong and potentially destabilising message. A company would only persist with an issue in the current market circumstances if it were desperate and absolutely had to raise the funds.

Santos isn’t in that position. It has about $2.1 billion of cash and undrawn debt at September 30 and only modest amounts of debt maturing over the next couple of years.

The hybrid issue, however, was supposed to provide some balance sheet insurance and flexibility in the context of the volatile and tumbling oil price and Santos’ own capital expenditure profile. Its capital expenditures this year are about $3.5bn and only last week forecast reduced investment of $2.7bn in 2015.

Its 'problem' relates to the $US18.5bn LNG facility it is building at Gladstone, which is devouring capital but which won’t generate cash flow until the second half of next year at the earliest. That will see its gearing blow out towards 45 per cent before cash starts pouring out of the GLNG project (although, if current oil prices were sustained, far less cash than Santos had anticipated).

Today Santos -- only a week after its latest investor presentation -- said it would review its spending plans for 2015 and expected to significantly reduce capital and operating expenditures. Within the $2.7bn of capex guidance was $1.9bn of 'growth' investment, so there is significant scope to conserve cash and capital. Santos had already targeted a 9 per cent reduction in unit production costs next year.

The group also said that it had "no current intention" of undertaking an equity raising. Given that its share price has fallen 34 per cent in just over a week, wiping more than $4bn off its market capitalisation, it ought to have gone without saying that Santos wouldn’t be raising equity while the oil price is as depressed and volatile as it is -- unless it had to.

If, by battening down the hatches, Santos can get through to the start-up of the GLNG facility without being forced to raise debt or equity while oil prices are low, the current turmoil in energy markets could turn out to be a longer term blessing in disguise.

The junior end of the US shale gas market is under severe pressure. A sector that is dependent on access to debt because of the capital intensity of expansion in shale gas has lost access to debt markets, which is why the market is expecting a wave of defaults unless there is a sharp recovery in the oil price.

The severity and rapidity of the plunge in oil prices will also have a chilling effect on new oil and gas developments, truncating the queue of prospective US and Canadian LNG exporters that had been building and which loomed as some level of threat to the Australian LNG sector.

In the absence of a quick bounce-back in oil prices a big slab of potential competitive production to existing Australian LNG projects and those nearing completion will be taken off the board.

As discussed last week (Santos’ long-term opportunity is also its near-term threat, November 26) while the short-term effects of the lower oil prices on the Australian producers aren’t pleasant, the longer-term impact could be very strongly positive if they deter new capacity.

The current oil prices are a function of modest over-supply in an environment of relatively weak demand. By the end of the decade a gap between supply and demand begins to emerge and by the middle of next decade, even if US shale gas were being sold into the Asia Pacific markets as originally envisaged, there would still be a major shortfall. Without significant North American-sourced LNG, the shortfall will be far larger and the impact on LNG prices probably quite profound.

The advantage that the Australian projects, either existing or those within sight of completion, have over those still on the drawing boards is that almost all of them have customers as co-investors and are under-pinned by longterm contracts.

Given that these are projects whose success will be measured over decades, less relevant than what the oil and LNG prices (which are linked to the oil price) might be today is where prices might be in five or ten years’ time.

The market fundamentals appear to be very supportive over the medium to longer term and the impact of the slump in prices this year will be to strengthen those fundamentals. The same, incidentally, could be said of most of the major commodities we produce if marginal production is taken out of the market by depressed prices and new investment is deterred.

For Santos and its peers, of course, the key is to ensure that they are still around as independent entities in five years’ time so that their shareholders gain the benefit of the massive investments. Low oil and hard commodity prices create vulnerability and any signs of balance sheet stress would tend to exacerbate the risk of opportunistic action.

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