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Why Santos (ASX: STO) is an Oil and Gas Stock to Buy

This article was originally published at MF & Co. Asset Management.

An Australian energy pioneer since 1954, Santos Limited (ASX STO) is one of the leading independent oil and gas producers in the Asia Pacific region, providing the energy needs of homes, businesses and major industries across Australia and Asia.

However, since the average realised oil price dropped by half to US$53.8/barrel in 2015, Santos shares have experienced shrinking revenue and continuous 3-yr negative profits with the EBIT reaching -7 billion in 2015.

About Santos Shares (ASX STO)

Founded in 1954 and headquartered in Adelaide, Santos Limited (ASX STO) is an Australian energy company with the largest exploration and production area as well as key infrastructure in Australia.

The company mainly focuses on exploration, production, transportation, and support of fossil oil and natural gas in Australia and Asia, and products include natural gas, such as liquefied petroleum gas, ethane, methane, coal seam gas, liquefied natural gas, shale gas, and condensate, as well as oil. Probable petroleum reserves for Santos include 848 million barrels of oil equivalent.

Santos Performs Low-Cost Onshore Operation and Focuses On High-Margin GLNG

Due to the unexpected low oil price in 2015, Santos started transforming and leveraging their capabilities to achieve high-margin assets. In 2015, Santos signed with Ophir Energy (LSE: OPHR) and sold its non-core Asian assets for US$ 221 million to reduce the company’s net debt. The disposed of assets were late-life and were not a priority for capital in the Santos portfolio. In the same year, Santos exchanged 11.72% of holding shares with ENN (SH: 600803), a high-quality Asian buyer, to further reduce its net debt and clean up the business balance sheet.

Debt repayment continues to be a key priority for the company and Santos decided not to declare dividends in 2016 and 2017 and used the cash to repay debt, and has a target to clear $2 billion in net debt by the end of 2019.

Santos shares (ASX STO) debtSince 2017, Santos has achieved cost leadership in Australia as an onshore operator, which is a significant point of differentiation.

In early 2015, Santos kicked off GLNG, the largest LNG project Santos has ever undertaken by using technology to drive down costs and increase productivity. As shown in the pie chart, it is obvious that after two years of investment, production of LNG in 2017 accounts for 22% of Santos’ total production and 70% of sales revenue in 2017. GLNG’s high potential via upgrades and incoming technology developments are set to be a point of difference for Santos in the long run.

Santos Shares (ASX STO) revenue

Santos Shares (ASX STO) production

 

 

(Source: STO Shareholder Review, 2017)

Santos Turns Around Performance and Reduces Breakeven Point

The company’s 2017 full-year performance demonstrated a significant turnaround thanks to operational transformation, a more disciplined operating model and a reliable, affordable, and sustainable energy supply.

In 2017, Santos achieved sales volumes of 83.4 million barrels of oil equivalent from core assets, which generated $618 million of free cash flow and reduced the free cash flow breakeven point to US$32 per barrel, well below the average realised oil price.

Santos Shares (ASX STO) oil price

Santos Rejects a Takeover Bid by Harbour Energy

Another noticeable acquisition offer came from energy provider Harbour Energy Australia Pty Ltd (Harbour). Harbour proposed the acquisition of 100% of Santos shares by the way of a scheme of arrangement for US$4.98 (AU$6.63) per share. The settle price offered was AU$0.4 higher than the then price of AU$6.2 per share.

Before the final offer, there were a number of shareholders who didn’t feel that the deal was good enough. Firstly, one of the advisors at Argo Investments felt the move was high risk. Secondly, there was concern that the government might raise issues that a takeover could affect gas supply on Australia’s east coast and could raise questions about foreign companies not paying enough tax in Australia.

According to the ABC, the independent directors and chief executive of Santos unanimously resolved to reject the $14.4 billion takeover offer on 22 May 2018. They said that the offer was  “too low” and high risk. In addition, the final proposal was stated to be subject to various conditions, including FIRB (Foreign Investment Review Board), which contributed to the termination of all discussions.

Santos Shares Has Growth Potential

Overall, Santos has high potential growth opportunities in the market supported by increasing demand for natural gas and oil from Asian countries. Santos’ cost-efficient operational model and reliable oil field and LNG projects will support growth for the company into the future. As Santos CEO Kevin Gallagher said in the chairman report, in the second half of the financial year the company was planning the investment in P’nyang gas field to expand LNG business and progressively open LNG projects in northern Barossa, Adelaide to provide LNG in Darwin.

However, since Santos is a price taker in the oil and gas industry, the key risk for Santos will be continual volatility in the price of their products.

Henry Fung is a Partner Managing Director and co-founder of MF & Co. Asset Management. He is a highly experienced equities, derivatives and financial markets professional with over 12 years of experience. Henry specialises in building trading algorithms & systems, quantitative & qualitative analytics across macroeconomic, fundamental and technical disciplines and currently runs the MFAM VPAC AU/US models portfolios. The management Partners and Adviser team have decades of experience between them, with experience from major Investment Banks and Brokers. Their Advisers are highly experienced, having dealt with some of the wealthiest clients in Australia.



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