Just as the world is blundering its way to more hydro and less carbon, distracted by the emissions epiphany, a sensible and timely merger of two Australian oil and gas companies will create real value for its shareholders.
Along with the Oil Search Board of Directors' approval and recommendation, the Independent Expert (IE) has concluded the merger with Santos is in the best interests of OSH shareholders, in the absence of a superior proposal. The IE report was not without its criticism, but on balance has reached the 'right' decision, in our view.
The IE report essentially came to the same conclusions as the OSH Board as to why the merger makes sense for OSH shareholders. The merger is being conducted against a backdrop of accelerating change in global energy markets and the strategic logic behind it is compelling. The IE report noted that:
- OSH faces a number of real challenges on a standalone basis including funding constraints to develop its growth assets.
- Free cash flow is severely constrained until after 2026 when PNG LNG will have fully repaid its project debt and will begin distributing its operating cash flows.
- OSH is unlikely to be able to secure an investment grade credit rating given its asset concentration in PNG.
In the view of the IE, OSH shareholders are contributing around 43-44% of the total underlying value of the merged group compared to the 38.5% that they will receive under the terms of the merger. Even after taking into account the value of the synergies expected to be realised (approximately $60 million pa), the IE said there would be a reduction in value to OSH shareholders.
But back in the real world, OSH shareholders are already receiving a 16% premium to the share price at the time the merger was announced, and have not received a superior proposal from any other source.
So the choice was either to languish as a standalone business with good assets but big funding issues, or to jump aboard the good ship Santos and look forward to a more promising combined future.
Based on 2020 sales volumes, the combined business has a base of 135mmboe pa split between gas (35%), LNG (47%) and liquids (18%).
But that description greatly understates the potential of the STO-OSH asset base together with a credible balance sheet to fund its development plans.
Our primary thought on the new strategy of the merged company would be to realign the portfolio to de-risk growth projects and to crystallise some value of others. The obvious starting point for the latter is the combined 42.5% of PNG LNG that would have a ready buyer in the form of TotalEnergies which owns 31.5% of the yet to be built Papua LNG project but none of the mature and very valuable PNG LNG. Such a deal, subject to price, would allow TotalEnergies to align its PNG investments whilst realising a substantial war-chest for STO-OSH to reallocate to funding growth projects. Such a deal would also likely help Papua LNG towards being built, which again would benefit STO-OSH as it will own 22.8% of the project.
A second agenda item for STO-OSH would be the awkward situation OSH was facing with regard to its Alaskan investment. On its own, OSH did not have the financial firepower to fund the development of its Pikka unit and was seeking a buyer for part of the asset to help fund the project. But the market knew OSH was in a difficult position and would have been a weak seller. With the benefit of a much stronger balance sheet, STO-OSH can address the problem more favourably, perhaps by selling operatorship to its partner Conoco which has far more experience in the region.
On the STO side of the equation, there are growth options aplenty at Dorado, Barossa, Beetaloo, Moomba, Narrabri and other east coast gas opportunities.
There is also the matter of a more capable Board and management under the STO-OSH purview which we contend to be a major upgrade from OSH shareholders' perspective.
Investment view
With the OSH Board and the Independent Expert now in furious agreement that the merger is a good idea, the process should be completed by 17 December with the new STO shares trading from Monday 20 December 2021.
The STO-OSH merger will still have the same earnings risks from changes to the oil price, development and financial risk as well as normal operational risks on existing assets.
The STO-OSH merger will inevitably be compared against the other big merger now underway between Woodside Petroleum and BHP Petroleum. Our preliminary view of that choice is straightforward – the STO-OSH merger will be a much better outfit than the LNG-heavy WPL that has just lost its CFO and is about to FID a giant new LNG project (Scarborough and Pluto Train 2) with many questions overhanging its robustness as an investment.
At the big end of town in Australian oil and gas, we continue to recommend STO as a Buy.
