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Morningstar | Oil Search Navigates Impactful 1H2018 Earthquake with Earnings to Recover in 2H

We make no change to our AUD 6.00 fair value estimate for no-moat Oil Search. The company reported a 39% decline in first-half fiscal 2018 NPAT to USD 79 million, close to expectations, featuring earnings impacts from the PNG earthquake. At AUD 9.00, no-moat Oil Search shares remain materially overvalued, but we think the market is insufficiently accounting for risks. A lower than expected USD 2 cent interim dividend was a surprise, a payout of just 38% of already quake-impacted earnings, the board presumably watching the balance sheet. Net debt is USD 3.18 billion, following first-quarter acquisition of Alaska Slope for USD 416 million, and Oil Search must prepare for intended expansionary expenditure at PNG LNG.

Annualised first-half net debt/EBITDA is a hefty 4.5. We expect this to improve to 3.0 by year's end, though that's still high for a company potentially heading into expenditure. We consequently assume just one additional 3.7Mtpa LNG train, rather than taking-on Oil Search's more aggressive 8.0Mtpa expansion aspirations via three new 2.7Mtpa trains. However, we don't think the fair value is materially different under either scenario. We expect greater capital efficiency under our lesser capacity increase, leveraging off existing tankage and wharfage, with more infrastructure needing to be duplicated under a larger expansion. Material synergies decline under the three train scenario, and that before potential for application of a more punitive discount rate due to excessive debt. We admit Oil Search seems wedded to the three train LNG concept with joint venture alignment being achieved in first-quarter 2018.

First-half group sales volumes fell 30% to 9.8 million barrels of oil equivalent, or mmboe, following the magnitude 7.5 quake. Higher realised average pricing, up 20% to USD 58 per boe, was a useful partial offset. Unit costs increased 65% to USD 18.70 per boe, reflecting remediation work, make-up LNG cargo purchases, and reprioritised maintenance.

Our assumed midcycle unit cost assumption remains USD 12.75 per boe in 2022 dollars at our unchanged USD 60 per barrel Brent crude forecast.

Our AUD 6.00 fair value estimate equates to an unchanged fiscal 2022 EV/EBITDA multiple of 7.0, excluding AUD 1.35 for Elk/Antelope resources and AUD 0.35 for Alaska Slope. Existing producing PNG assets comprise AUD 3.10 or just over half our fair value estimate, after allocating the full AUD 2.70 in group net debt. Our assumption for a third PNG LNG train contributes AUD 1.20 or 20% of fair value. For the less risk averse, removing the 3% PNG sovereign risk premium from our cost of equity would increase fair value by 37% to AUD 8.20, or 9% shy of the current share price.

Our 2018 and 2019 EPS forecasts are little changed at AUD 0.31 and AUD 0.47, respectively. Oil Search guides for 24-26 mmboe of production and USD 435-530 million in capital and exploration expenditure in 2018. We sit at the approximate midpoint in each case. Creditably, second-half output is anticipated to have rapidly recovered to at/above pre-earthquake levels. We rein-in our 2018 full-year DPS forecast to AUD 0.15 for a modest unfranked 1.7% yield at the current share price. That would equate to a 47% payout, still toward the high end of the 35%-50% guidance range.

First-half net operating cash flow, after exploration and evaluation expenditure of USD 98 million, halved to USD 117 million, close to our USD 126 million expectations. Oil Search expects cash balances to begin rebuilding from second-half 2018, despite capital expenditures.