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Morningstar | Strong Finish to 2018 Though our Oil Search AUD 6.60 FVE Is Unchanged.

We make no change to our AUD 6.60 per share fair value estimate, with weaker near-term oil prices substantially offset by time value of money considerations and a strong fourth quarter. Oil Search reported stronger than expected revenue, up 6% to USD 503 million thanks to inventory drawdown and a 5% increase in LNG price to USD 10.96 per mmBtu. Our 2018 EPS estimate consequently increases by 3% to AUD 0.32. But a softer spot crude price, down 20% to USD 62.50 per barrel since our October 2018 note, weighs on the fair value and reduces our 2019 EPS forecast by more than 40% to AUD 0.31. Longer-term assumptions, including a midcycle USD 60 Brent price and AUD/USD exchange rate of 0.72, are intact.

A solid final quarter’s production of 7.4 million barrels of oil equivalent, or mmboe, brought the full-year total to 25.2 mmboe, as expected and within guidance. But unit production and depreciation costs are now favourably expected to be at the lower end of previously advised ranges of USD 11.50-12.50 per boe and USD 12.00-13.00 per boe, respectively. The costs creditably include approximately half of the USD 65 million in earth quake expenses not already offset by insurance recoveries. Positive for cash flow, the performance leaves Oil Search with lower than anticipated net debt of USD 2.7 billion at end December, though net debt/EBITDA is still elevated at 3.0. The PNG LNG project produced at an average annualised rate of 8.8Mtpa during second-half 2018, the highest half yearly rate ever achieved and an underpinner of the lower unit costs.

Although down from plus AUD 9.00 October 2018 highs, at AUD 7.60 no-moat Oil Search shares remain materially overvalued, we think the market is 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, above the share price.

Our AUD 6.60 fair value estimate equates to a 2022 EV/EBITDA multiple of 8.0, 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 2.50 in group net debt. Our assumption for expansion to PNG LNG contributes AUD 1.60 or 25% of fair value. We now take-on Oil Search’s more aggressive 8.0Mtpa expansion aspirations via three new 2.7Mtpa trains at PNG LNG. Previously we had assumed just on additional approximately 4.0Mtpa train would be added. But as flagged, the change impacts little our fair value estimate because we anticipate the capital intensity will be higher. A lessor expansion would have better leveraged off existing tankage and wharfage. More infrastructure needs to be duplicated under the larger expansion scenario, though future cash flows will naturally benefit.

Net debt/EBITDA of 3.0 is high for a company potentially heading into more expenditure. With Oil Search’s 8.0Mtpa expansion plans factored, we don’t anticipate net debt/EBITDA falling below 1.0 before 2026, after peaking at 4.4 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 the Alaska slope might represent a prime contender for Oil Search at the right time. Our fair value carries Oil Search’s 25.5% Alaska Slope interest at the USD 400 million acquisition cost. But the Pikka B well encountered encouraging hydrocarbons this month, highlighting potential for value accretion. That, and/or part PNG asset sell-downs or equity raisings. At the current share price, we’d view the latter as being value accretive. That said, 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.