A safe Harbour for Santos

The latest takeover offer made by Harbour Energy is now the fourth made by the unlisted energy firm for Santos and the sixth takeover offer made since 2015 (perhaps we've missed one?).

The $6.50 offer comes in the form of a cash payment of US$4.70 and a fully franked dividend of US$0.28. Santos has announced it will engage with its suitor, in effect declaring that the price is right. The details, rather than the sum, now stand in the way of a successful transaction.

The market is clearly sceptical, with the shares trading at a 10% discount to the offer price. With a keen bidder, a willing target and frustrated shareholders, the persistent discount may surprise but it is justified. Regulators may yet kill any deal.

Santos owns key gas infrastructure in the Cooper Basin and has long been a fixture of the Adelaide corporate scene, so any change of control would have to satisfy both the Foreign Investment Review Board (FIRB) and the South Australian state government.

Santos's board has been reluctant a suitor but it would be crazy not to take the deal. It values the business at US$13.5bn, significantly higher than the $7bn-odd takeover from Sceptor (remember Santos has raised about $4bn in equity since then) three years earlier.

Buying LNG

As is evident from our Sell recommendation on the stock, we don't think the business is worth that much. To justify that price, Santos would have to successfully develop resources in the Cooper Basin, PNG and Northern Australia and see higher LNG prices. That may or may not happen but it would suck huge sums of cash into the business.

The jewel for Harbour appears to be the LNG business, mostly GLNG and PNG LNG. We've raved about PNG LNG in the past and named it the premier LNG project in the region. We are less enthused about GLNG.

The main difference is the capital expenditure profile. PNG LNG requires just a few wells to release gas while GLNG requires tens of thousands of wells. That constant drilling requires constant capital expenditure and means lower returns. Reserves have also stagnated and there doesn't appear to be enough gas to fulfill contracts. Santos relies on external gas purchases to fill its processing facilities which, again, eats into margin.

GLNG is a large, important piece of infrastructure but it is paired with poor economics and requires much higher prices to generate decent returns. Yet Harbour has been keen on it. Why?

We must confess ignorance. Harbour is backed by smart private equity and has been involved in LNG for decades. It has recently been buying energy resources around the world and has demonstrated patience and intelligence. It may be able to do more with the assets, or it may have a specific view on energy prices.

Will it work?

Regulators permitting, we think the deal is likely to go through, but we don't recommend getting cute with takeover arbitrage. Buying now for a 10% return if the bid is accepted is poor risk management. If the deal fell over, Santos would likely fall back towards $5 a share.

This offer comes right after a takeover for AWE and when industry insiders are buying up gas resources. Woodside has made several asset purchases, as have international peers. The confidence shown by the industry contrasts with the negligence shown by the market.  

The deal highlights that Woodside, our single Buy recommendation in the sector, remains cheap. Santos does not and, despite the corporate interest, ours isn't piqued. SELL.

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