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Morningstar | No-Moat Oil Search Meets 2018 Profit Expectations, Talks Debt-Funded Expansion. No Change to FVE.

We make no change to our AUD 6.60 per share fair value estimate. Oil Search reported 2018 NPAT up 13% to USD 341 million, in line with our expectations. We marginally reduce our 2019 EPS forecast to AUD 0.30 from AUD 0.31, following updated guidance for exploration and evaluation expenditure of USD 235-285 million, higher than we’d previously anticipated. Our 2019 production forecast is unchanged at 29.6 million barrels of oil equivalent, or mmboe, near the midpoint of 28.0-31.5 mmboe guidance. This is a 20% increase on 2018’s earthquake-impacted performance, and back to prior years’ levels. Our USD 13.20/boe unit operating cost assumption is also at the midpoint of guidance for 2019, excluding administration expense.

Our unchanged AUD 6.60 fair value estimate equates to a 2023 EV/EBITDA multiple of 7.8, excluding AUD 1.40 for Elk/Antelope resources and AUD 0.35 for Alaska Slope. Existing producing PNG assets comprise AUD 3.25 or approximately half our fair value estimate after allocating the full AUD 2.60 in group net debt. Our assumption for expansion at PNG LNG contributes AUD 1.60 or 25% of fair value. We credit full value for Oil Search’s 8.0Mtpa expansion aspirations via three new 2.7Mtpa trains at PNG LNG. These will double PNG LNG’s capacity by 2023 and increase group production by 80% from a non-earthquake-impacted 29.5 mmboe base to more than 53 mmboe. We consequently forecast 15.5% five-year EBITDA CAGR to USD 2.1 billion by 2023. This is marginally ahead of Oil Search’s 2024 target, assuming they will do better. We assume an unchanged midcycle Brent crude price of USD 60 per barrel and an AUD/USD exchange rate of 0.72.

At just over AUD 8.00, we think no-moat Oil Search shares remain materially overvalued, the market still insufficiently accounting for risks. Our fair value ascribes above-average risk to equity and incorporates a 3.0% sovereign risk premium for PNG.

Removing the premium would increase our fair value by 35% to AUD 8.90 from AUD 6.60, somewhat above the share price, though only to 3-star or Hold territory. Also apparently not considered by the market is net debt, or if considered, then chiefly the positive side of the ledger. Oil Search finished 2018 with a comparatively hefty USD 2.8 billion in net debt. That was down 12% from USD 3.2 billion levels at end June 2018, but net debt/EBITDA is still high at 2.8 and the company heading into capital expenditures for PNG LNG expansion. We currently factor USD 9.4 billion or USD 1,175 per tonne of capacity. If correct, and it may prove too light, Oil Search’s 29% equity share would be USD 2.8 billion or USD 1.85 per share. Consequently, we don’t anticipate net debt/EBITDA falling below 1.0 until 2025, after peaking at 3.5 in 2021.

Aside from sovereign risk, this is a key differentiator for Oil Search versus peers who sit on more attractive net debt/EBITDA ratios of sub-1.0 for Woodside and 1.3 for Santos even including the Quadrant acquisition. Asset sales could help of course, and might include Alaska slope at the right price, or a sell-down in PNG LNG equity from 29%, or sale of the PNG oil assets. We value Oil Search’s 25.5% Alaska Slope interest at the USD 400 million acquisition cost, its 29% PNG LNG equity stake at USD 8.6 billion, and the oil assets at USD 940 million. At higher market prices, potential sales could even be accretive to our fair value estimate.

But as discussed before, Oil Search has long shown comfort in operating at high debt levels, a key value driver if you can get away with it. Average group net debt/EBITDA for the last eight years was 4.0, a factor in our determination of high fair value uncertainty. It may prefer to continue to operate with high leverage, comforted in the knowledge there would likely always be a buyer for PNG LNG equity if push came to shove. Net operating cash flow fell 20% to USD 555 million in 2018, burdened by the earthquake and despite 28% higher average pricing of USD 62.50 per boe. We project annual net operating cash flows to exceed USD 650 million from 2020.

Oil Search declared a final USD 0.085 dividend, bringing the full year to USD 0.105, close to our expectations. It translates to a modest 1.8% unfranked yield at the current share price. You don’t buy Oil Search for income, at least not at this stage, and unlikely for the medium term either given capital expenditure requirements.