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Analysis

Can Santos weather the perfect storm?

Analysis

It has been a tumultuous year for oil and gas producer Santos. Baillieu Holst chief economist and financial advisor Darryl Gobbett asks what he would do if he was in the eye of the storm?

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Santos has faced the perfect storm throughout 2015 as the favourable energy price climate in which they made their Gladstone LNG (GLNG) investment decisions rapidly changed and caused those decisions to look less wise in hindsight.

For those that want to understand the reason for Santos share price movements it is perhaps worth a change of perspective.

Shareholders often spend time looking from the outside in but perhaps it is worth looking from the inside out and looking back through Santos long and successful history.

Imagine if you and I started a business.

It was in the oil and gas sector and we had some assets that we had developed over time.

The assets, mainly from exploration tenements grew over time and required further investment.

You and I had this asset for over 60 years which contributed significantly to the energy supply of our economy and generated substantial export income.

Over that time there had been substantial assets that had been generated from the initial investment but also and crucially, from the cash flows that those assets had generated over time.

Darryl-Gobbett---Baillieu-Holst-21

What would you do if you ran an oil and gas producer, asks Darryl Gobbett.

Along with contributions from the shareholders these assets had been able to continue to grow as the world economy relied on the energy for their cars, to heat their homes and run factories.

In the early days you and I contributed capital to start these projects.

Most recently our GLNG asset has required a significant amount of capital to get it to production and required 5 years to develop.

The course of our business changed when coal seam gas was discovered and made profitable with new technology.

For our business and other competitors in the Southern Queensland region it became apparent that we were sitting on a vast untapped resource and we had exploration tenements in the region.

The rush was on to develop these assets.

GLNG became the one of three competitors that would each build a LNG train and a part of this was committing significant capital to that process and to do it while the oil price was high.

Accordingly the high oil price made us assume that the oil price would remain high for a longer period of time.

The largest risks that the asset has is the price that its output can be sold for and can the asset be developed with few delays?

The largest risk for an oil business is the oil price.

We could have the best asset in the market but if the price that we sell the output is highly variable and we are just a small player in a much larger global business selling a product that many others produce, we are unable to influence the price.

We have always been price takers and reliant on the oil price for our future income.

As owners of the business you and I were highly aware of this when we founded and contributed more equity.

We had to make some longer term assumptions of our own.

Is it worth continuing to own an asset that just requested us to put even more of our capital back into the business? Where will the oil price head? Are there any other risks that need to be assessed?

Thankfully some of the price risk is reduced as the largest future asset of the business has partners that are willing to take the asset at a fixed price albeit with some oil price linkage.

We have been getting very excited in as recently as 2 years ago conditions looked to be excellent for the future profitability of our company changing asset.

Then the storm hit. Oil prices dropped dramatically from mid-2014. With much of our income derived from oil price related sources, it became clear that oil would be sub $US100 per barrel for a long period of time particularly with larger suppliers in the Middle East looking to maintain production in the face of a world adjusting its use of fossil fuels and slowing economic growth.

All of this while our main asset GLNG was still a year from production.

This looked to not be such an issue if the company could just get to production.

The cash flow would then increase substantially and allow payments to fund some of the debt that we had issued to fund the GLNG project. We had not expected to put more cash into the project and had thought that it was fully funded based on our oil price assumptions.

Unfortunately these assumptions needed to change in the new much lower priced environment.

Our attempts to reduce the impact of cash flow reduction from other assets had been to cut support and expansion plans to our other assets so that we did not need a capital raising.

However this was not enough and we were required to raise capital and implement a transition to a new CEO.

Before the capital raising, all the capital that we had put into the business through our initial contribution, capital raisings and retained profits had equated to approximately $10 per share.

The recent capital raising was for $3.85 per share. Compared to our efforts over the last 60 years, this would seem to be a very low price and reflects the predicament that we are in to fund the remainder of the project and ensure repayments of debt.

If you own Santos it wasn’t hard to buy shares in a company that has accumulated $10 book value over the years.

However, there is an expectation that book value will be written off as many of the assets will have had values based on the now much lower oil price.

Book value post capital raising is $6.66 per share. So even if book value is worth around $5 per share the new shareholders have bought that $5 book value for $3.85 with a future that contains a new income streams from GNLG.

Santos is trading around $4.24, well below the diluted book value and reflecting the lower current income.

For people that continue to invest in Santos, they need to ask themselves can the new CEO implement a strategy that will offset the declining oil price? Either way, I bet the oil price wins but I see the current share price as well below the intrinsic and longer term value of the business.

Darryl Gobbett owns shares in Santos.

Please note: This is not personal advice and should not be construed as such. If you require advice on this stock or any other you should contact your financial adviser.

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