STO Second Quarter Production Has Modest Rise

Santos’s second-quarter production rose 2% to 12.4 million barrels of oil equivalent (mmboe), marginally below expectations, and full-year 2013 production guidance has been reduced by 3% to between 52 and 55 mmboe. The decline reflects deferred oil and gas production from Chim Sao in Vietnam due to power system constraints, steeper than- expected natural field decline at Sangu, and deferred Carnarvon production due to poor weather and maintenance.

Despite softer-than-expected production, second-quarter revenue was higher than anticipated, up 8% to AUD 797 million, reflecting a record quarterly average gas price of AUD 5.61 per gigajoule (/Gj) and higher oil production. The record gas price reflects stronger average gas prices in the Cooper Basin, in accord with the thesis for Santos that the fast-approaching promise of East Australian liquefied natural gas (LNG) exports will pressure domestic gas prices higher. Santos in particular is a potential key beneficiary of such an outcome, given its substantial domestic infrastructure footprint.

However, some of the higher second-quarter gas price also reflects higher sales from Darwin LNG and higher Indonesian prices. Higher oil production reflects first output from Fletcher Finucane off the West Australian coast, ahead of schedule and on budget. The second-quarter result has no implication forthe AUD 14 per share fair value estimate. The fact that major growth projects PNG LNG and Gladstone LNG remain on track, and that domestic gas prices continue to rise, is supportive of our growth thesis for the company.

PNG LNG is 90% complete and on schedule for first production in 2014. Gladstone LNG is 60% complete and on schedule for first production in 2015. Combined, these projects could increase group equity production by 60% to 85 million barrels of oil equivalent (mmboe) by 2017. At AUD 13.85 per share, the market is already crediting Santos near full value.

Recent promising gas discoveries off the Western Australian coast, including 112 metres of net gas pay at 25%-owned Bianchi-1, have fired market interest. No change to our no-moat stance on Santos. We don’t see the sustainable competitive advantages necessary to prescribe such.

Infrastructure is an advantage, but Santos must still compete on cost, and it is up against capable competition in the oil and gas space. Fair value uncertainty remains high due to the high proportion, 50%-plus of fair value, ascribed to projects yet to achieve first production. The risk of LNG project-specific issues dictates some caution. Teething issues are a risk with Gladstone’s unconventional coal seam gas and PNG LNG’s sovereign and geotechnical peculiarities. Our fair value estimate incorporates a 9% cost of equity, reflective of low systematic risk with a 1% country risk premium.

That drives a 7.8% weighted average cost of capital, assuming a long-term 25%:75% debt:equity split and 6% cost of debt. Our fair value estimate equates to an enterprise value of five times EBITDA (EV/EBITDA) in 2017. We assume a long-term oil price of USD 100 per barrel (2016 real, inflated a 2.5% per annum) and steady group production excluding LNG expansions.

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