“Harbour Energy has commenced confirmatory due diligence as part of an engagement process to determine if a proposal can be developed that is capable of being recommended by the Santos Board to shareholders.” – Santos 2018 Q1 Activities Report
The move from Santos (ASX: STO) in agreeing to granting Harbour Energy access for due diligence on their non-binding takeover bid at $6.5/sh gives the proposed transaction some serious assurance. No past bids to acquire Santos by Harbour or otherwise have been accepted to due diligence, indicating the new board is indeed favourable to the transaction.
The only prominent risks we see to the transaction are Foreign Investment Board (FIRB) approval (downside risk to holding Santos shares) and the possible emergence of counter-bids (upside potential to holding Santos shares at current price). With the stock trading, at the time of writing, around 5% below the bid price one may think that its too late to seize a trading opportunity from these news.
Whether buying Santos is a compelling move entirely depends on the likelihood of FIRB approval. We find the process of gauging probabilities of FIRB approval too difficult for our skills but this article will nonetheless address some issues to approval and possible positives. The transaction may, however, be a reason to look into a particular small cap, Senex (ASX: SXY), especially in light of comments in Harbour’s release.
Uncertainty to regulatory approval
The biggest risk to this deal falling through in absence of counter bids is FIRB approval. Harbour Energy is a highly capable and well funded organisation backed by the reputable EIG Global Energy Partners (EIG). Harbour would likely be effective in utilising Santos’ assets, increasing their returns and unlocking value. Harbour is a foreign company, however, seeking to purchase energy assets in an increasingly protectionist world and a country with an active interventionist government policy of safeguarding gas supply for forecast domestic consumer demand through the Australian Domestic Gas Security Mechanism (ADGSM). Such a political stance is representative of the gas markets precarious situation with issues surrounding adequate supply to Australia’s population-heavy east coast and a lack of import terminals (which likely means the problems will only get worse until imports begin). A ruling government which allows FIRB to grant approval to the foreign ownership of a major player in this market, Santos being the operator of Cooper Basin and Gladstone LNG (both crucial to the east coast gas market), is providing an easy target for its political opponents should the gas market situation continue to deteriorate. Further, concerns will arise to FIRB regarding Harbour’s high leverage and whether they would be able to allocate sufficient capital to asset growth should oil and gas prices reduce to not-so-old lows again.
We are of the opinion that regulatory approval is mostly an issue due to political liability to the government in allowing it to pass with the current precarious state of the gas market. We do not envy those making the decision given that other wise the deal presents strong policy reasons for supporting it. Harbour is likely to make good use of of Santos’ assets and unlock value, not to mention increased taxes the highly leveraged transaction, and resulting activity, would garner.
Having considered all this we note it is doubtful an entity of Harbour/EIG´s credentials has not considered the political factors of a transaction on this scale prior to committing to a bid. They must have a high degree of confidence that FIRB approval will pass. Harbour has commented that the transaction will contribute to domestic energy security, clearly aware of the political implications of this transaction and seeking to position itself outside of ADGSM sanctioned intervention. There may be other solutions to political hesitance at play such as expected divestment of certain Santos assets given Harbour’s focus is likely confined to LNG assets. Good arguments may also be made that even these assets will be much less essential once the infrastructure is established to see imports to the east coast gas market.
Bid guides us to other prospects
The price of Santos will be completely driven by how the bid proceeds and whether another one arises. The market is clearly sceptical of regulatory approval with still no premium to the bid price seen in the market pricing. We find this situation to be beyond us to understand in order to have sufficient conviction in a play. Further, any upside is likely to be limited in effect. We would note to those who have held a position in Santos and seen its doubling price in the past seven months there is a logic to cashing in at least part if not all of their position given the little upside left.
With uncertainty as to the transactions approval we have considered whether Harbour’s interest in acquiring Australian assets presents an additional reason to consider other potential targets in Australia above the otherwise increasing aggregation within this industry.
Whether the Santos bid is successful or not there will be increased consolidation in this industry and Harbour is liable to make another play. Great emphasis ought to be placed in Harbour’s release on the mention that they expect to “pursue the acquisition of additional natural gas and LNG focused assets in Australia.” With EIG Partners influence on Harbour being a major shareholder/founder, it seems sensical that Senex (ASX:SXY), currently trading at around $0.41 at the time of writing, would be a prominent target for Harbour given the large stake EIG has in Senex.
Senex has operations related to Cooper Basin whose acquisition would be aligned with a regional aggregation strategy. It presents a compelling opportunity for Harbour even should the Santos bid fall through.
Senex has acute reasons to give it serious consideration compelling us to commit to further inquiry.