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Morningstar | No-Moat Oil Search Approaching FEED for PNG LNG Expansion. No Change to AUD 7.00 FVE.

Oil Search shares are down approximately 20% from this time a year ago and now trade close to our unchanged AUD 7.00 fair value. PNG LNG comprises the lion's AUD 4.90 or 70% share of that fair value contributing 26 million barrels of oil equivalent, or mmboe, or 90% of Oil Search's current 29.5 mmboe in group annual production. But PNG LNG expansion plans are afoot, 100% risked in our base case, and could increase group equity production, by approximately 60% to 47mmboe.

Considerable associated capital costs limit the NPV impact to approximately AUD 1.00 per share, still material, and every lever needs to be pulled to maximise value. This hasn't been straightforward with a complex ownership structure of new gas resources to comprise the feed gas for the new trains. While the infrastructure ownership versus tolling interplay is yet to be fully bedded-down between interested parties including operator ExxonMobil, the laudable solution has essentially been to split ownership of the downstream plant to marry with the upstream field equity. This structure most simply facilitates project advancement despite differences in ownership, while still allowing equitable distribution of capital efficiency gains, leveraging off existing infrastructure. Return on invested capital is the winner, to the creditable benefit of shareholders.

Our AUD 7.00 fair value estimate equates to a 2028 EV/EBITDA multiple of 5.2, excluding AUD 1.73 for Other PNG gas resources and Alaska Slope oil. Our fair value estimate 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 dollars, and an AUD/USD exchange rate of 0.70. 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 to within 4-star territory.

The existing approximately 8.6Mtpa 2 Train PNG LNG plant near Port Moresby pipes gas from the Hides, Angore and Juha gas fields in PNG’s Southern Highlands via 700 kilometres of on- and off-shore pipelines. PNG LNG has a dedicated 7.6 trillion cubic feet, or Tcf, in remaining gas reserves, with the rule-of-thumb being each 1.0Tcf notionally supports 1.0 million tonnes per year, or Mtpa, of LNG production for just over 20 years. Debottlenecking has seen capacity increase by 25% from the initial rated 6.9Mtpa; and remaining project life based upon dedicated resources has declined, to just under 20 years, as a result of the expansion and the production to-date. Field life is still healthy and ignores other gas that could be applied, even discounting future discoveries. The PNG exploration portfolio also still has multi-Tcf gas potential.

Expansion plans call for construction of three new 2.7Mtpa capacity LNG trains on the existing PNG LNG plant site. But a multi-level ownership structure of new gas resources to comprise the feed for the new trains complicates matters. The first of the three new trains, T3 will be rolled into the existing PNG LNG structure, given that ownership of the required new P’nyang feed gas resource is essentially the same as for PNG LNG. But trains 4 and 5 and associated infrastructure (Papua LNG) will be built and funded separately by the equity owners of the dedicated Elk-Antelope gas resources feeding them. Any sensible co-use of existing infrastructure, for example, loading and export facilities, is to be handled via an agreed toll.

Outside of PNG LNG’s 7.6Tcf in proven & probable, or 2P, gas reserves, P’nyang contains 4.4Tcf in contingent 2C resource while Elk-Antelope has 6.7Tcf in 2C, all on a 100% basis. We expect the vast majority to be converted to 2P upon project sanctions. Bringing P’nyang gas into an expanded three train PNG LNG with 11.3Mtpa capacity effectively increases life to 23 years. Elk-Antelope’s gas resources represent over 26 years life, assuming a combined 5.4Mtpa capacity from Papua LNG’s trains 4 and 5.

The Papua LNG and PNG LNG/P’nyang joint ventures are both targeting first LNG deliveries commencing in 2024. The conclusion of Gas Agreements, together with commercial agreements supporting integration, including PNG LNG site and facilities access, will clear the way for an aligned FEED entry in 2019 and final investment decision, or FID, in 2020. A benefit from the PNG LNG side is that existing developed gas fields will be able to support expanded production to at least 2029, before development of P’nyang might be required. This defers upstream spending and is value accretive.

Despite anticipated reduced capital intensity and improved returns on new invested capital, we still don’t ascribe Oil Search a moat. We expect ROICs to improve from current mid-single-digit levels towards 10% in the long-run, though still below our assessed 11.6% WACC. The 14% cost of equity in that WACC calculation includes a 3% sovereign risk premium for PNG.

Further details can be viewed in our associated detailed report “Oil Search Limited: Approaching FEED for PNG LNG Expansion.”, published 20 June 2019.