Santos: Result 2015

Before announcing its full-year results, Santos acknowledged it had not anticipated the depths of the oil price slump. There is no shame in that; neither did any other producer in the world or, for that matter, did we. Yet other oil producers, although pained, haven't been as crippled as Santos.

Origin Energy, for example, appears in far better shape. So why has Santos been hit so hard? In our view, it isn't the crisis itself that has hurt most, it is the reaction of management.

Santos had an opportunity to sell assets in a carefully considered asset sale program and to raise enough cash to safeguard the business. On both fronts, its efforts have been timid and, as a result, the company today is more imperiled that it has ever been.

We will not mince words: there is a risk that this company will fall.

Instead of shrinking in size or accepting pain from a capital raising, management stubbornly sold just a single asset and raised just $2.5bn, barely half the minimum that was needed. Even after those measures, debt towers at $6.5bn. Even worse, it is denominated in US dollars. Currency movements alone raised debt by $900m in 2015.

Santos will report in US dollars starting this current year, which will stabilise debt for reporting purposes but nothing can change the fact that a USD debt is being paid largely from AUD revenues. Management's actions are a red flag rather than a solution. The structure of the debt, however, does offer some relief. About $2.6bn is non-recourse PNG LNG debt and a further $1.1bn are notes that are due in 2070.

Profits and debt

In that context, the results were meaningless save for one measure: the business generated $1.1bn in operating cash flow, down 40% from last year despite the highest production in almost a decade. From that cash flow, Santos must meet capital expenditure – forecast to be be $1bn next year – and interest costs of $1m a day. It can probably do that but it's hard to see how debt will fall in the absence of higher oil prices. Unless something changes, there is no clear path back to security.

Santos booked impairments of $3.9bn, mostly from GLNG and Cooper Basin assets. In the Cooper, lower capital expenditure was mostly responsible for the impairment. Asset values have fallen because Santos cannot afford to develop new reserves although, at some point, they are likely to see production. At GLNG, the impairment was just $600m, a fraction of what we expected. There are likely to be higher impairment charges from this asset. At current oil prices, it likely generates a zero total return.  

Santos assumes oil prices of US$40 a barrel this year, rising to US$75 by 2019, assumptions which are fair. Cost have been ripped from the business with $230m slashed from operating costs and $180m savings from fewer staff. Capital expenditure has been particularly savage, falling 54% to $1.7bn. Just two years ago, Santos spent more than $4bn in capex, a sign of how times have changed.

Another of those signs is the end of progressive dividends. Santos will now pay a proportion of underlying profits to shareholders, which saw the final dividend cut from 15cps to 5cps.

Risks rise

There is a real risk that Santos will not survive in its current form; a low ball takeover offer or a forced break-up is now more likely than not in our view. So what should shareholders do now?

Selling is an option, especially for those conservative investors who cannot stomach further losses. That is the conservative call but, perhaps, the wrong one. There is some hope because break-up value likely exceeds market value. Santos's stake in PNG LNG, in particular, is probably worth $5bn–6bn. Disposal of this asset would revitalise the company and remains an option.

Santos also carries tremendous leverage to oil prices. Should prices rise from here – although we don't expect them to in the short term – no producer would benefit more. With those factors in mind, there is enough upside to HOLD.