Will Santos raise equity?

For a business renowned as a producer of gas, lower oil prices have had a calamitous impact on Santos: for the first time in more than two decades, the company reported a full-year loss recently (see Santos: Result 2014 on 24 Feb 15 (Buy – $8.15)) as lower oil prices forced asset writedowns; the share price is down about 40% since we upgraded the stock in Get your claws into Santos on 2 Oct 14 (Buy – $13.48); and expectations of a cut-price capital raising persist. Even as oil grudgingly recovers, the woes of Santos, in the eyes of many investors, haven't been relieved.

It's true things look grim today. We've long said that the flagship Gladstone LNG (GLNG) project, a key reason why the business is loaded with $7.5bn in debt, will achieve average to below average rates of return. Lower expected cash flows mean previously anticipated higher dividends won't now appear and the business is scrambling to assemble the cash to meet its expenditure needs.

Despite these difficulties and the risks they present, Santos is cheap enough to remain on our buy list although it remains highly leveraged to oil prices.

As we noted in Santos: under fire or under water on 18 Dec 14 (Buy – $7.58), Santos will generate outstanding profits at $100 oil; decent profits at $80 oil and disastrous results at $50 oil. No amount of cost cutting or management nous can change that. This is a recommendation only suitable to oil price bulls.

Hi, capex

The share price has recovered 17% from its lows but it remains about 20% below net asset value, an indication that asset writedowns are already priced in or that the market expects Santos to have to raise more money.

There are good reasons to be nervous about the company's capital expenditure. Coal seam gas requires far more drilling than conventional projects. The first phase of PNG LNG, for example, will require just 8 onshore wells to be drilled; GLNG will require between 700 and 800 wells.

Even after GLNG is commissioned later this year, cash needs to be spent on drilling to generate required gas volumes, pipelines, dewatering facilities and compressor stations (CSG is only lightly pressurised). All this will require about $900m a year for the first four years – a cumulative cost of $3.6bn. That's on top of the US$18.5bn spent developing the project.

Following the initial flurry of costs, expenditures should fall to around $500m a year after 2020. These high costs and the lower energy content of CSG are key reasons why GLNG economics pale against a conventional project like PNG LNG.

Asset sales likely

Low oil prices not only ruin project economics, they limit the amount of cash available to Santos for funding. The business had expected more than $1bn a year from existing assets to complete funding for GLNG; that sum will be lower now – which is why there are concerns about a capital raising.

A capital raising at these prices would undoubtedly hurt but we think Santos can scrape through without one. The business has immediately cut cash outflows by 40%, there is still room to increase debt slightly and the business is rich with non-production assets it can sell.

At least $2bn could be reaped from asset sales. Pipelines are a prime candidate and are particularly attractive as investors seek reliable, high-yielding assets. A sale of GLNG's transmission pipeline would alone yield $1bn to Santos.

The business could also consider selling the Moomba to Port Bonython pipeline and liquids terminal. In total, $2–3bn of asset sales are easy to identify.

Best of all, Santos can exert control over the prices by tweaking the embedded rent in any sale. To increase the price of the asset, Santos could agree to pay higher rents to the buyer. That would increase operating costs in the future but bring in valuable cash today.

No raising needed

When combined with cuts to expenditure, tapping more debt and asset sales, Santos should comfortably have access to over $5bn in additional cash, enough to cover remaining capital expenditure and avoid a dilutive raising.

Those measures do come with costs. Cutting capital expenditure now means deferring projects that could threaten future output; more debt means more risk and higher interest costs and asset sales will increase operating costs as the business must pay rent. Those measures, however distasteful, look better than the alternative.

Santos will be laden with debt until both GLNG trains are operational and generating cash. Once that happens in late 2016, we expect cash to be deployed to lower debt. GLNG generates free cash flow at US$40 a barrel so debt should fall rapidly.  

Santos isn't irrationally priced and this isn't the time to load up but it does offer the best leverage to higher oil prices. Management is responding to low oil prices and debt,  which looks scary today, should be repaid quickly. This one isn't for the faint of heart but Santos remains cheap enough to BUY.