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Morningstar | Strong 3Q from PNG LNG. Higher Pricing Increases our Oil Search FVE to AUD 6.60.

We increase our Oil Search fair value estimate by 10% to AUD 6.60 per share from AUD 6.00, and up our 2018 and 2019 EPS forecasts by 3% and 23% to AUD 0.32 and AUD 0.57, respectively. Very strong third-quarter output from PNG LNG contributes to the higher 2018 earnings forecast, while higher near-term energy prices and a weaker Australian dollar drive the improved 2019 EPS and fair value estimates. We now assume a 2019 Brent crude price of USD 82 per barrel and an AUD/USD exchange rate of 0.71. Time-value-of-money also creeps into the fair value change. Longer-term assumptions including a USD 60 per barrel midcycle Brent crude price are substantially unchanged. At AUD 8.25, no-moat Oil Search shares remain materially overvalued, we think the market still insufficiently accounts for risks.

Third-quarter production rose 39% to 7.5 million barrels of oil equivalent, or mmboe, beating our 7.3 mmboe forecast. The PNG LNG project achieved record output following modifications and maintenance undertaken in March after the earthquake. The plant averaged 8.9 Mtpa versus our long-run 8.3 Mtpa assumption, ignoring expansion potential. No more significant maintenance is scheduled for the rest of the year and Oil Search has upped 2018 production guidance to 25.0-26.0 mmboe from 24-26.0 mmboe prior. We upgrade a touch to 25.0 mmboe. Despite the higher production, stronger third-quarter pricing including 18% higher LNG at USD 10.45/mmBtu and 5% higher oil at USD 76.17 per barrel was regardless marginally softer than anticipated.

Our AUD 6.60 fair value estimate equates to a little changed 2022 EV/EBITDA multiple of 7.2, excluding AUD 1.43 for Elk/Antelope resources and AUD 0.37 for Alaska Slope. Existing producing PNG assets comprise AUD 3.35 or approximately half our fair value estimate, after allocating the full AUD 2.95 in group net debt. Our assumption for a third PNG LNG train contributes AUD 1.45 or 22% 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 36% to AUD 8.85, or 7% ahead of the current share price.

Our assumption for just one additional 3.7 Mtpa LNG train, rather than taking-on Oil Search’s more aggressive 8.0 Mtpa expansion aspirations via three new 2.7 Mtpa trains stands for now. We admit the three train LNG concept seems the more likely, with joint venture alignment achieved in the March quarter, and Oil Search reporting discussions continuing between the PNG LNG project and the P’nyang and Papua LNG joint venturers around the three-train concept in the September quarter. However, we still don’t think the fair value impact is materially different under either scenario given greater assumed capital efficiency under our lesser capacity increase, leveraging off existing tankage and wharfage. More infrastructure needs to be duplicated under a larger expansion scenario.

Oil Search reported quarter’s end net debt improving to USD 2.87 billion from USD 3.05 billion at end June, thanks to strong third-quarter cash flows and lower than anticipated capital expenditure. Third-quarter expenditure including exploration was USD 136 million, and Oil Search has reduced full-year guidance by around 7% to USD 425-475 million from USD 435-530 million. Still net debt/annualised EBITDA remains hefty at 3.6. We expect this to improve to 3.0 by year’s end, though that’s still high for a company potentially heading into more expenditure. Even assuming our cheaper one train option, we don’t anticipate net debt/EBITDA to hit more palatable sub-1.5 levels before fiscal 2022. 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 including the Quadrant acquisition.