EUR 850.00 For Business Accounts Only

Morningstar | Santos Plans to Grow Production Two Thirds to More Than 100 mmboe by 2025. FVE Increased to AUD 7.85

We increase our fair value estimate for no-moat Santos by 12% to AUD 7.85 per share. The company has set out the path by which it intends to grow group production by 40 million barrels of oil equivalent, or mmboe, or around 65% to over 100 mmboe by 2025. This includes base additive Quadrant production of around 19 mmboe, still subject to regulatory approval but unlikely to run into road-blocks in our opinion. The USD 2.15 billion Quadrant acquisition was already factored into our fair value estimate, though we’d assumed depletion would leave group production at a midcycle 80 mmboe or one third above current production levels, all else equal.

At its annual investor day this week, Santos pointed to the growth being achieved substantially from its existing portfolio including Quadrant. Consequently, we increase our midcycle production forecast to around 90 mmboe, still short of the targeted 100 mmboe, but 13% above our prior 80 mmboe forecast. In addition to growth in capacity at PNG LNG, some of which we’d already assumed, Santos points to a tie-back of Barossa gas to more than double its equity share of Darwin LNG production to 9.0 mmboe, development of the Dorado oil prospect which comes with Quadrant but is not included in base production, and from increments elsewhere across Santos’ existing production portfolio. The latter includes the Cooper Basin, where well costs are down 50% since 2015, and Queensland’s world-class coal seams where drilling activity is increased to 300 wells in 2018 with a fourth rig added, among others.

We now include the growth from Barossa, slow our assumed rate of depletion across Santos’ existing onshore gas assets, and credit 5% capacity creep to 8.4 million tonnes per year at Gladstone LNG by 2023. However, we still don’t yet factor-in Dorado’s oil, and we still credit just one additional 3.7Mtpa PNG LNG train, rather than partner Oil Search’s more aggressive 8.0 Mtpa expansion aspirations via three new 2.7 Mtpa trains.

Each 2.7 Mtpa train would add 2.8 mmboe net to Santos. These largely account for our 90 mmboe production target versus Santos’ 100 mmboe. We think waiting for greater clarity on these projects prudent before crediting full value, though CEO Kevin Gallagher is proving a leader not to be under-estimated.

Our upgraded fair value estimate equates to a 2023 EV/EBITDA of 6.7, crediting five-year non-third-party group revenue CAGR of 7.8% to USD 4.1 billion. This supports annual EPS of 12% to AUD 0.76 by 2023 for a nominal PE of 10 at the current AUD 7.35 share price, or 15 when discounted at WACC. We think the shares are marginally under-valued at the current price. Our midcycle Brent crude price forecast is unchanged at USD 60 per barrel, or bbl (2021 real) versus spot of around USD 80 bbl.

Santos says it will be able to fund the growth from free cash flows at a USD 65 per barrel oil price and is targeting gearing levels of less than 25% through the cycle, down from 34% levels expected at end 2018, immediately post the Quadrant purchase. Group 2018 forecast free cash flow breakeven is around USD 35/bbl, and with Quadrant will go to USD 32/bbl. From our forecast for 2.2 at end 2018, we project net debt/EBITDA to hit sub-1.0 levels by as soon as 2020, including projected growth capital expenditure.

Santos’ simplified portfolio of five long-life natural gas assets generating free cash flow at less than USD 40 per barrel represents a much stronger foundation than a few short years ago. Growth can now be leveraged off all five areas. At Gladstone LNG we’ve included nothing beyond abovementioned capacity creep, but here there may also be more potential. Room to expand beyond the initial two trains, brought increasingly into focus with a looming global LNG supply gap from 2022, brought even more sharply into focus given Chinese retaliatory trade tariffs capturing U.S. LNG exports.