Oil Search: changing the rules

PNG LNG is arguably the best new LNG project in the world. From a huge onshore gas resource that may ultimately host as many as five processing facilities, the ExxonMobil-led venture - in which Oil Search has a 29% stake - boasts low costs, long-life resources and has attracted some of the best technical talent in the industry. 

The project's flaw is that it happens to be located in Papua New Guinea, a jurisdiction long derided as a graveyard for miners and drillers. 

Risk is easily forgotten when everything is running smoothly and cash is flowing. Once again, investors have been reminded that a great resource in the wrong location doesn't always make a great resource. 

A change in the PNG Prime Minister - the previous one resigned in scandalous circumstances - has raised fears that fiscal terms for project expansions may change. 

Growing pains

Oil Search and its partners are currently exploring ways to increase production in PNG and two projects are being considered. One is to add another processing facility (or 'train') to the existing site in the Southern Highlands. Another option is to build a second project known as Papua LNG using newly acquired gas resources.

Oil Search has stakes in both projects and both now face the prospect of delays.

The new Prime Minister, James Marape, has wasted little time making his mark. Though he has pledged that existing terms will stand until renegotiation is due in 2025, beyond that they could be more onerous. 

Project expansion depends on tapping new gas sources and several ministers have argued for harsher fiscal terms.  

Some of the new features of policy may include: the joint venture loaning PNG cash to buy into new trains; a gas reservation policy that will force the joint venture to sell domestically; and a requirement to convert some revenues into local currency. 

These ideas - and they are only ideas at this stage - are far from disasters. The greater risk to Oil Search comes not from a worsening fiscal deal but from delays that could encourage its colossal allies - Exxon and Total are project partners - to prioritise other global projects over PNG expansion. We've seen many project delays fall into neglect and ultimate abandonment. That is the risk here.

Pricing the bad

Neither the PNG government nor the LNG joint venture has made any decisions. Officially, nothing has changed, but the possibility of an adverse outcome has increased a little.

That shouldn't change our valuation too much. For all its flaws, PNG LNG is already producing steadily from two trains and is generating excellent returns. 

We think the two existing trains alone are worth about $6 a share to Oil Search. To this we ought to count some value for PNG LNG expansion, production from Papua LNG and Oil Search's own promising Alaskan oil properties.

Adding these up, we come to a value of at least $9 a share and more likely closer to $14 a share, depending on how likely you believe expansions are to commence. 

With the share price hovering around $7, little growth is being counted. Yet that may be sensible.

Remembering risk

Oil Search will have to take on debt to fund growth. Sensational cash flows - the company can generate free cash flows (before growth expenditures) of about US$900m a year - should rule out a capital raising. Unless oil prices fall.

The requirement to reinvest in new project development leaves the business exposed to oil prices. It will need cash to expand and, if oil prices fall in the meantime, a capital raising, or more modest growth, is possible. 

That prospect, along with higher political risk, should be considered in the price we are prepared to pay. This is already a risky project; piling on more uncertainty doesn't merely raise risk, it compounds it.

We remain comfortable with our price guide, which suggests upgrading at around $6.50 a share. Those with a higher risk tolerance may consider starting a position now but, for most portfolios, patience is recommended. HOLD.