Oil Search: close to perfect

It's easy to dismiss Oil Search. The company's key asset is a 29% stake in PNG LNG, an LNG project operating in the Southern Highlands (the most lawless part) of PNG. That project is majority owned and operated by another producer and it counts the PNG government as a major partner. 

Many would be sceptical about a smallish Australian producer being sandwiched between powerful partners in a lawless jurisdiction.

Yet, time after time, Oil Search has confounded the sceptics. PNG LNG itself was once a pipe dream and is now one of the best LNG projects anywhere.

Gas is cheap and plentiful; onshore LNG generates stronger economics than peers. Best of all, there are plenty of options to expand both production and profits. 

Understated

The PNG LNG consortium currently operates two processing facilities (known as trains) that produce almost 9m tonnes of LNG per year (mtpa), far exceeding early expectations of 6.9mtpa. 

The project can be expanded to three and, over time, possibly four trains. This would be tremendous for margins because expensive infrastructure like roads, water access, electricity generators and ports don't have to be replicated to support additional output. As production grows, so do margins.

Oil Search's stake in PNG LNG already generates significant cash flows. Over the past three years, it has collected over US$2bn in operating cash flows and spent US$1.2bn on capital expenditure, much of that on new field development. 

If PNG LNG were left to run at current capacity without expansion costs, Oil Search could generate perhaps $US900m in free cash flow assuming steady state production at 30m barrels of oil equivalent (mmboe) and oil prices of US$60. That suggests a free cash flow yield of about 8%. Not bad for a capital-intensive LNG producer.

This is not, however, a business in run-off or liquidation. Oil Search is investing heavily in new production in PNG and elsewhere.

Discounted growth

In PNG, the joint venture aims to double LNG capacity over time, tapping newly found gas fields. That would add significantly to the value of the project.

The market has been cautious about expansion because there are several obstacles to overcome. The most basic, sourcing raw gas, doesn't appear to be a problem any longer. The company has outlined credible resources of up to 11 trillion cubic feet of gas, enough for at least two additional trains. 

With so many partners and competing interests, however, it's hard to reach consensus about who owns what, what fields are utilised and how costs are allocated. Expansion may take time, so investors appear to have heavily discounted growth. 

We don't have a better understanding of the exact structure of PNG LNG's growth path. Doubling LNG output is, for now, an objective rather than a firm plan. Yet there are plenty of gas molecules in PNG that would be profitable if processed into LNG and the venture already has the capital, the know-how and the licences to make it happen. We trust that the profit motive will ultimately ensure sense prevails among the participating partners.

A more interesting - and controversial - growth option is being pursued in the US, where Oil Search has bought a stake in a distant Alaskan oil field. 

Alaskan upside

Everyone was surprised when Oil Search announced it would buy large chunks of oil acreage in Alaska for US$400m. Early drill estimates, which are not yet advanced enough to earn reserve status, suggest resources of 500mmboe with potential for over 700mmboe. 

These are large oil fields with excellent supporting infrastructure and where new exploration techniques haven't been applied.

In particular, modern seismic and well-development technologies have not been used. In other parts of Alaska, these technologies have reduced costs by up to 50%. Considering the size of the prize, potentially low operating costs and the abundance of support services and infrastructure Oil Search appears to have bought well.

It is too early to know how much Alaska might add to production and profits - development is still several years away - but by comparing neighbouring projects, we estimate Oil Search should be able to generate free cash flow at under US$40 a barrel. 

The next step is to spend time and cash on additional development to shore up resources. The company will then seek to add an equity partner which would provide an insight into how other producers are valuing the asset.

The Alaskan option, for now, is not being valued by investors. That will change if Oil Search can attract a high-quality partner to the project and if the valuation shows a viable project exists. 

Is it cheap? 

On conventional metrics, Oil Search doesn't appear cheap. Trading on a price-earnings ratio of over 30 and an enterprise value to earnings before interest, tax, depreciation and amortisation (EBITDA) multiple of over 12, there are cheaper oil producers in better locations. And the company still carries US$4.5bn of debt which won't come down in a hurry.

Yet few producers can match Oil Search's combination of wonderful economics and impressive growth. 

A decade from now, the business could be producing almost 20mtpa of LNG and a few million barrels of oil, all at attractive margin.

That PNG LNG is a stunning project is no secret and that's why Oil Search has rarely appeared cheap. We think the company's share of the project could be worth $8bn-10bn, or $5-6.50 a share if associated gas fields are included.

That suggests the market is placing a modest value on PNG LNG growth and ignoring the potential of the Alaskan assets. In a conventional oil business, this would be a buy now.

Yet there is one factor that has always held us back from enthusiastically recommending Oil Search: PNG itself.

Bad neighbourhood

PNG is a graveyard for miners and drillers and, perhaps because your analyst has spent time working in PNG and confronted its frailties, it spooks us too. 

I've spent time with raskol gangs, heard the stories of heinous violence and lived in armored compounds with 24-hour security. This remains one of the least developed, most lawless countries in the world and its location demands a discount.

Exactly how much of a discount is contentious. On the one hand, Oil Search has operated here for about 80 years and knows how to work and get things done. History suggests a degree of comfort and expertise in the country that is rare.

Yet that can't disguise immense political risk. The government is weak and the licence to operate is fragile. 

We've previously suggested that, below $6.50 a share, Oil Search is worth buying. We will retain that price guide with a qualification. 

Those who have a higher risk appetite might consider purchasing at current prices but Oil Search, by nature of its higher political risk, should always be held in modest volume. We recommend no more than 3-4% of a risk-tolerant portfolio. 

If you can stomach the political risk, here lies a world-class energy asset with a colossal resource base and sensational economics. And it's starting to look attractively priced. While some investors may choose to start building a position at current prices, we demand a little more value before acting. Oil Search remains a HOLD.