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Morningstar | Exploration Success Reduces Effective Cost of Alaskan Equity Increase; No Change to AUD 7.00 FVE

Oil Search bought its 25.5% Pikka Unit and 37.5% Horseshoe Block interests on Alaska’s North Slope approximately 18 months ago for USD 400 million or AUD 0.38 per share. Our fair value estimate had until recently carried the Alaska stakes at cost, before Oil Search flagged material though still unquantified exploration success, and we conservatively upgraded to USD 600 million or AUD 0.56 per share, equivalent to 8.0% of fair value overall. This equates to a value of USD 4.70 per barrel based on the current 500 million-barrel contingent of 2C Nanushuk oil resources at the Pikka Unit, still pending an upgrade.

But Oil Search has now exercised an option, and agreed to a subsequent part sell-down to partner Repsol, that will increase its Pikka Unit and Horeseshoe Block stakes to 51% for a net additional USD 385 million. This equates to a considerably lower USD 3.00 per barrel of Nanushuk 2C resource, before impending resource upgrades, than the original acquisition. Did Oil Search pay too much for the original buy-in, or is it just getting a better deal this time around? While not straight-forward the answer is regardless clearly the latter.

Joint venture partner Repsol is buying additional Horseshoe equity from Oil Search to align ownership interests across their shared Alaskan assets. It is paying more for the privilege because of the successful drilling and testing undertaken by Oil Search during the option period. This work has confirmed that Horseshoe and east Pikka are highly prospective for tie-ins to any Pikka Nanushuk development, or even as a potential secondary Horseshoe standalone development. The increased resource potential recognised is already being partially monetised in the sell-down to Repsol.

We increase Alaska Slope’s fair value contribution by 60% to AUD 0.90 per share given Oil Search’s increased equity. But the group fair value overall is unchanged given the largely offsetting increase to net debt.

Although we haven't increased our Oil Search fair value yet, pending an update of Alaska Slope resources, we at least take comfort that the Repsol transaction validates our views underpinning our prior upgrade to Alaska Slope.

Oil Search says a material resource upgrade for Pikka Nanushuk and its satellites is anticipated prior to a front-end engineering and design, or FEED, decision later in 2019. Together with Repsol, it now plans a phased development to ensure it generates an early income stream. The idea is to initially produce 30,000 barrels of oil per day, or bopd, from 2022 using existing third-party infrastructure, followed by 120,000 bopd via dedicated facilities from 2024. Oil Search’s 51% or 22 million-barrel eventual annual production share would amount to a substantial 75% increment on current 29 mmboe group production rates, or 50% on forecast 47 mmboe production rates, including by then doubled PNG LNG output. Proven and probable reserves would not need to exceed the existing 2C resource to support this production, although this is likely. The value from such an outsized group production contribution is however curtailed by the time to first full production and associated capital expenditure, phased development notwithstanding. We think Pikka Nanushuk could ultimately be worth up to AUD 2.00 per share if the plan is successful.

We haven't included potential Alaskan cash flows into our earnings forecasts yet, still crediting a lump sum fair value. Our AUD 7.00 fair value estimate instead assumes 6.8% 10-year group EBITDA CAGR to USD 1.9 billion by 2028, assuming a midcycle Brent crude price of USD 60 per barrel in 2021, and an AUD/USD exchange rate of 0.70. It equates to a 2028 EV/EBITDA multiple of 4.9, excluding AUD 2.05 for Other PNG gas resources and Alaska Slope. We assume above-average risk to equity, incorporating a 3.0% sovereign risk premium for PNG. Removing the premium would increase our fair value by 43% to AUD 10.00 from AUD 7.00, considerably above the share price, and within 4-star territory. At AUD 7.05, Oil Search shares trade at close to fair value.