Santos gets close

The theory is simple enough: have a price guide that reflects our estimate of intrinsic value and, when the share price gets below that number, pull the buy trigger. As Yogi Berra reminds us, though: 'In theory, there is no difference between theory and practice. In practice there is.'

A falling share price usually accompanies negative news. That means the decision to buy isn't merely a reaction to prices falling to a predetermined level; it is a judgment on whether problems recognised today will persist into the future, and whether they're sufficiently compensated by the new price.

In the case of Santos, the share price has fallen from almost $7.50 in October to below our $6 buy price. Yet we have not pulled the buy trigger because that fall is a rational response to a steep fall in oil prices. 

Oil prices are particularly important to Santos. They, along with several capital raisings and a few asset sales, have saved the business from excessive debt.

With the existential crisis over, the company has outlined an ambitious growth plan that aims to double production to 100m barrels of oil annually by 2025. That will require billions in additional capital expenditure at a time when debt is higher following a large (and excellent) acquisition. The balance sheet will, for a time, deteriorate.

Santos needs higher oil prices to generate the free cash flow to fulfil its pledges and to meet its obligations. So, when the oil price falls, it's rational to expect the share price to follow. 

A rational fall

So, even though the stock has fallen below our buy price, we don't see a mispricing and, unless you wish to take on excessive risk, we don't think the stock offers an obvious opportunity. 

That may sound odd because, on any sensible measure, Santos appears cheap. A sum of parts valuation using realistic return expectations suggests the business could be worth about $8 a share.

The largest chunk of value comes from Santos's 13.5% stake in PNG LNG and minority stakes in various PNG gas fields. This is immensely profitable and generates standout free cash flows. 

Over the past three years, Santos has generated about $1.2bn in aggregate operating cash flow from PNG LNG and has had to spend just $150m in capital expenditure. 

Compare that to its eastern Australian production (GLNG and the Cooper Basin) which have generated $550m in operating cash flow but sucked in almost $900m in capital expenditure.

That comparison is a little unfair as GLNG is still in ramp-up phase and will produce more income over time. Yet it highlights an unchanging truth: GLNG and Copper Basin assets will always demand more capital expenditure and generate less free cash flow. PNG LNG is easily the best asset in Santos's suite. Better yet, it is riddled with growth options.

Trophy asset

Santos has stakes in various PNG gas fields and should be a participant in project expansion. We estimate that Santos's stake in PNG LNG, along with its PNG gas holdings, are worth around $3 a share.

Next comes GLNG which we are less enthusiastic about. Here is a project that cost over $20bn to build (Santos has a 30% share), but which has already attracted multiple writedowns.

GLNG is now operating reasonably well, recently reporting lower drilling intensity and better than expected production. Yet the project remains plagued with risk. Reserves have long been suspected of being too low and the economics remain questionable.   

Yet its sheer size and strategic importance - LNG trains are valuable pieces of infrastructure - mean it does retain considerable value. We think it's worth about $2 a share.  

These two projects alone come close to the current share price. Count in some decent gas assets in WA, the ageing but still prolific Cooper Basin fields along with some growth and development options and it's possible to get to $8 a share in value.

If that is on offer for less than $6 today, why not buy?

Remember risk

A simple sum of parts valuation captures the company's potential but fails to capture risk. Every valuation is a guess but, for Santos, that is doubly so because valuation involves so much variability.

It's not just that oil prices swing around. If that were our sole gripe, we would never have recommended Woodside.

Santos uniquely combines a capital-hungry balance sheet with a mediocre asset base. If things work as expected, we should expect to do well, but each asset includes a high degree of risk and is vulnerable to negative surprises. 

In particular, GLNG suffers from fragile economics. A large, expensive fixed asset sits atop of gas-bearing coal seams of variable quality and yield. 

The value of GLNG is highly sensitive to gas volumes and Santos knows it. That's why the company has diversified gas sources and is piping expensive gas from elsewhere in its portfolio. 

If gas gets scarce or too expensive, margins generated from GLNG will evaporate, risking billions of dollars in value.

At high oil prices - say, over US$70 a barrel - Santos should generate decent cash flow and many of those risks can be faced and conquered. At today's oil price, free cash flows are less copious, debt will remain higher for longer and negative surprises will hurt.

Stronger peers

There is a final reason we hesitate to upgrade. Woodside and Oil Search - each previous Buy recommendations - boast stronger project economics and, in the case of Woodside, far lower risk. We would rather be investors in those producers ahead of Santos at current prices.

Santos's sensitivity to oil prices makes price guides difficult and confusing to maintain. Had oil prices remained above US$70 a barrel, we would have upgraded at these prices. However, the combination of a lower oil prices and a lower share price isn't enough to tempt us just yet.

Those who hold the view that oil's current weakness is an opportunity - and there is a sensible case to make - should consider Woodside which is a whisper from an upgrade or perhaps Oil Search, which commands far better economics.

Santos, although much improved and less imperiled, remains too risky for most portfolios while oil prices remain low. We're raising our risk ratings from Medium to High and we're removing the price guide, which is more of a hindrance than a help due to such a heavy reliance on an extraneous and volatile factor. HOLD.