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Morningstar | Oil Search’s 2Q Tracks to Expectations, Though Earthquake Costs a Near-Term Impost.

Our AUD 7.00 per share fair value estimate for no-moat Oil Search Limited stands. There has been no change to the status of major projects since a number of recent announcements already reported by us. These include the Papua LNG Project continuing to advance towards front end engineering and design, or FEED, entry with the associated gas agreement signed in April and the access agreement to the PNG LNG site and infrastructure ready for execution. Additionally, the Alaska Slope interests are being increased via options exercise. As previously discussed, PNG LNG expansion is already 100% risked in our base case, and should increase group equity production by approximately 60% to 47 million barrels of oil equivalent, or mmboe, though the fair value impact is limited to AUD 1.00 per share due to the considerable associated capital costs. In Alaska, exploration confirming that Horseshoe and east Pikka are highly prospective for tie-in to any Pikka Nanushuk development bolstered our confidence in AUD 0.90 per share assessed fair value for Oil Search’s increased equity there.

Otherwise Oil Search’s second quarter was largely as expected, other than the key element of cost. Second-quarter production fell 5% to 6.9 mmboe. This was largely as expected given 13 days scheduled maintenance at PNG LNG. Further, oil and liquids production was softer with outages involving reinstatement from earthquake-impacted levels. Our full-year group production forecast remains 29 mmboe, still toward the lower end of now marginally downgraded 28-31 mmboe company guidance. But full-year production costs are expected to be higher due to more earthquake recovery work than previously anticipated, and delayed booking of insurance recovery. We see no implication for the longer term and at AUD 7.18 Oil Search shares trade at close to fair value.

Our 2019 and 2020 EPS forecasts are little changed at AUD 0.34 and AUD 0.33, respectively. Oil Search lifted 2019 production cost guidance to USD 11-12 per boe from AUD 9-10 per boe. But other operating cost guidance fell by approximately 10% to USD 135-145 million, and second quarter exploration write-down came in at a lower than anticipated USD 12 million. Further, cash levels are aided by reduced 2019 capital expenditure guidance of USD 500-600 million, down from USD 545-655 million due to later timing for PNG LNG expansion FEED, and development at Angore. Net debt of USD 2.6 billion at end June is consequently better than anticipated assisting full year net interest of guidance of USD 117-121 million. Annualised net debt/EBITDA is 2.7.

Our AUD 7.00 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 2022 dollars, 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 to within 4-star territory.

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 mmboe in group annual production. Impending 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 in 2020. A benefit from the PNG LNG side is 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 NPV valuable. 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, remaining below our assessed 11.6% WACC.