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Morningstar | Prices and Creeping Capacity Boost Oil Search FVE by 9% to AUD 6.00 per Share. See Updated Analyst Note from 17 Jul 2018

We increase our Oil Search fair value estimate by 9% to AUD 6.00 per share from AUD 5.50, reflecting a softer Australian dollar, higher near-term energy price expectations, and the time value of money. At AUD 8.80, no-moat Oil Search shares remain materially overvalued, we think the market insufficiently accounting for risks.

Since our last note, the Australian dollar has fallen from 0.78 to 0.74 against the U.S. dollar, and our forecast average Brent crude price for the four years from fiscal 2018 to fiscal 2021 has increased by 12% to USD 72.50 per barrel. The currency and pricing in combination account for approximately 70% or AUD 0.35 of the AUD 0.50 fair value increase. Time value of money at our assessed 11.6% weighted average cost of capital, including a 3% sovereign risk premium for PNG, accounts substantially for the balance. We have marginally increased our long run PNG LNG capacity expectations to 12 million tonnes per annum, or Mtpa, versus 11.5Mtpa prior, but to only modest fair value impact. Midcycle assumptions including USD 60 Brent crude (2021 dollars) are unchanged.

Our 12 Mtpa PNG LNG capacity forecast pitches Oil Search producing a marginally higher 40 million barrels of oil equivalent, or mmboe, by fiscal 2023, up 38% from 29 mmboe fiscal 2017 levels. This still anticipates just one additional LNG train being built, though at slightly higher 3.7Mtpa capacity versus our prior 3.5Mtpa estimate. The decision to increase follows capacity creep reported on the existing around 8.0Mtpa two-train configuration, and intensified LNG expansion efforts. Oil Search reports PNG LNG operated at 8.5Mtpa in May and June, following post-earthquake modifications. We credit 8.3Mtpa being the sustainable rate. We choose to assume 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 impact materially different under either scenario.

We credit 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 risk to equity weighting due to excessive debt. Oil Search is highly leveraged, net debt/EBITDA nearing 5.0, and we currently ascribe an 11% cost of equity, before the 3% sovereign risk premium. Adding still more debt to fund additional trains could warrant an even greater discount. While an equity raise or asset sell-downs at prices above fair value could null concerns, the same in a less favourable weaker oil price scenario could be expected to exacerbate them.

Our fiscal 2018 EPS forecast declines 8% to AUD 0.30, despite improved oil prices and our higher fair value estimate. Fiscal 2018 production guidance of 23.0-26.0mmboe is unchanged, but we reduce expectations by 1.0mmboe to a mid-range 24.6mmboe. Fields closest to the earthquake's epicentre remain offline and pre-quake oil production levels are now not anticipated until the March 2019 quarter. Higher LNG capacity is only a partial offset. Our fiscal 2019 EPS forecast increases 30% to AUD 0.48 on stronger pricing.
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 would increase fair value by 37% to AUD 8.20, or just 7% shy of the current share price.