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Morningstar | Barossa Enters Into Exclusive Negotiations with Darwin LNG. No Change to AUD 8.15 FVE.

Santos’ announcement that the Barossa joint venture has entered into exclusive negotiations with Darwin LNG increases our confidence that we are right to forecast about an 80% increase in group production to over 100 million barrels of oil equivalent, or mmboe, by 2025. We maintain our AUD 8.15 fair value estimate, and despite trading at AUD 7.20, the shares remain undervalued.

In September 2018 no-moat Santos outlined plans to grow production by two thirds to more than 100 mmboe by 2025 from 2018’s 59 mmboe base. This included immediately base-additive production of about 19 mmboe via the Quadrant acquisition, growth in PNG LNG capacity, development of the Dorado oil discovery also coming via Quadrant, and increments from elsewhere across Santos’ portfolio, including the Cooper Basin.

We recently fleshed out PNG expansion plans in a June 20, 2019, special report on Oil Search Limited, “Approaching FEED for PNG LNG Expansion.” Santos’ 13.5% share in the PNG LNG portion accounts for 4.3 mmboe of incremental production growth toward its 100 mmboe-plus production aspirations. We also published a Santos note on the Dorado oil project on June 6, 2019, “Dorado-2 Seals the Deal for Santos’ 100 mmboe Group Production Target.” As a likely 50,000 barrels of oil per day project supported by stellar drilling results on the North West Shelf, Santos’ 80% Dorado equity accounts for an outsized 14 mmboe production increment to the 100 mmboe target, though will likely persist for a shorter life than for gas projects given more rapid production and field decline. The final piece of the puzzle is Barossa, which could account for a 4-5 mmboe production increment via increased gas contribution through the 57% ConocoPhillips owned and operated Darwin LNG.

Santos has a minority 11.5% stake in Darwin LNG, fed via gas piped over 500 kilometers from the equally owned offshore Bayu-Undan field in the Australia/Timor Leste Joint Petroleum Development Area. Darwin currently accounts for about 4.0 mmboe, or roughly 7% of Santos group production. But Bayu-Undan is going into decline, and new gas feed is required to ensure Darwin’s 3.5 million tons per year of LNG output (100% basis) persists. Barossa is the near certain solution now that its joint venture partners, including ConocoPhillips at 37.5%, have entered into exclusive negotiations for the supply of backfill gas. Agreement on a tariff with Darwin LNG still outstanding would allow a final investment decision for Barossa’s development by early next year.

Somewhat nearer than Bayu-Undan, Barossa is located 300 km north of Darwin, and its resources are sufficient to extend LNG plant life for a further 20 years from 2022 when Bayu-Undan exhausts. At 25%, Santos’ equity in Barossa is more than double that for Bayu-Undan, and we expect it will consequently more than double the existing Northern Australian production share to about 9 mmboe. Santos has previously flagged its net capital expenditure share at AUD 1.0 billion-AUD 1.2 billion phased over four years. This calls for a development using subsea wells tied back to an FPSO for gas processing and condensate export, and a 260 km export pipeline to transport gas to the existing Bayu-Undan pipeline, requiring less pipe to be laid to Darwin. In this way Santos’ plus 100 mmboe production aspirations are sensibly rounded out via an efficient existing infrastructure-leveraged growth path in Barossa. This still isn’t sufficient to change the no-moat rating, with group returns on invested capital to grow to modestly exceed 9.7% its weighted average cost of capital, but by an insufficient margin.

Our Santos fair value estimate equates to an unchanged 2028 enterprise value/EBITDA of 6.7, crediting 10-year non-third-party group revenue CAGR of 6.2 % to USD 4.7 billion. This supports 10-year EPS CAGR of 6.8% to AUD 0.92 by 2028 for a nominal PE of 7.8 at the current AUD 7.20 share price. Our comfort to credit these earnings levels is supported by quality growth projects above and favourable activity on Santos’ part. We assume a midcycle Brent crude price of USD 60 per barrel in 2022 dollars.