Santos: Interim result 2013

The investment case for Santos is working out as expected. Although production fell 4% to 24.5m barrels of oil equivalent (mmboe), higher prices more than offset this decline and the company posted net profit of $271m for the half year, a rise of 3%. From earnings per share of 28.1 cents, up 2%, a 15 cent interim dividend was declared (est ex date 22 Aug), suggesting an annual yield of 2.1%

Operating cash flow was disappointing, falling 13% to $629m, due to higher taxes and the maiden payment of the carbon tax. This year is the peak for capital expenditure, which rose 30% to $1.9bn and is expected to reach $4bn for the full year. Net debt rose to $3.3bn.

Although oil prices fell for the period, gas prices are starting to march higher: Santos received an average gas price of $5.52 per gigajoule, a rise of 11%. Over the next few years, we expect gas prices to rise dramatically as Queensland’s LNG projects start to suck up gas resources from the east coast.

More LNG

Two large LNG projects will soon start producing cash; PNG LNG in 2014 and Gladstone LNG in 2015. PNG LNG should be immensely profitable, although we remain concerned that GLNG will produce low returns on capital. Yet Santos has already received billions from a part sale of the asset and the project will contribute to higher gas prices elsewhere in the empire, so the project is not entirely a disaster.

Management, no doubt watching peers being rewarded for paying hefty dividends, have indicated that higher dividends will be a top priority as those projects are completed; Santos’s long held 2% yield will most likely rise in the years ahead.

Local gas firing

While LNG captures the headlines, the Western Australian and Cooper Basin gas businesses have performed splendidly. The WA gas camp has grown to become the largest profit engine, generating almost half of the company’s earnings before interest, tax, depreciation, amortisation and exploration. Recent exploration success – four new discoveries have been made offshore WA – and high west coast gas prices should sustain that performance.

In the Cooper Basin, Santos is slowly proving an enormous shale resource can be unlocked. The only shale production well in the country is operated by Santos and it's currently producing gas from the Cooper.

Santos’s share price has increased 18% since 25 Feb 13 (Long Term Buy - $12.34) and, although the business is progressing pleasingly, higher prices have reduced our margin of safety. We’re downgrading to HOLD.