Santos has a problem. Sturdy production together with historically high commodity prices are generating so much cash flow that the balance sheet is undergeared. Even with a buffet of attractive projects in development, Santos has too much cash. Shareholders should prepare for a meaningful increase in capital management.
Third quarter production of 26.1 mmboe has enabled STO to narrow its full year production guidance to 103-106 mmboe (was 102-107). While production was fairly unremarkable, the average realised prices for the range of commodities produced continued to push higher taking quarterly revenue through the $2 billion mark for the first time. LNG is STO’s largest product by revenue at approximately 61% of total revenue in the quarter (Figure 2). The average realised LNG price achieved in the period of US$16.76/mmbtu was 14% ahead of 2Q22 and 62% above the same period last year. Of the 59 cargoes shipped during the quarter, 5 were sold on a JKM-linked basis where the index price averaged US$36/mmbtu in the quarter.
The domestic gas business performed just as impressively given high demand for product. Domestic sales gas and ethane revenue increased 40% compared to 2Q22 and 19% compared to the same period past year. The East Coast domestic gas price achieved of US$8.96/GJ was 63% higher than 3Q21.
Not everything went swimmingly for the company during the quarter. The Barossa gas and condensate project to backfill the Darwin LNG plant is currently 46% complete. Drilling was halted on 21 September due to a Federal Court decision concerning the associated environmental plan. A review of the decision is to be expedited but there remains some uncertainty on when activity can resume. For more positive reasons, the FID on Dorado has been delayed while further exploration on the new Pavo discovery is scoped.
Free cash flow flood. The modest free cash flow of recent years has turned into a surge (Figure 1) as prices leapt and volume effectively doubled from pre FY19 levels. Third quarter FCF of >US$1 billion has STO effectively on a FCF yield of ~26% which says two things about the stock: (1) Gearing is heading for unsustainably low levels around 13% by the end of CY22 post the proceeds from selling 5% of PNG LNG and (2) the share price is implying an oil price of US$54/bbl assuming an AUD:USD at 70c. This compares to the US$105/bbl implied in the WDS share price.
Investment View
The Annual General Meeting on 8 November will be closely watched as the likely date for any capital management announcement.
In addition to the current US$350 million share buyback, STO will need to repurchase an incremental US$500 million just to get to the lower end of its 15-25% gearing target range. If investors are oblivious to the value on offer in the share price, the Board should step up and light the fuse on a much more substantial buyback.
As a reminder, STO’s capital management framework is to maintain a strong balance sheet (gearing <25%) and provide a base return to shareholders of 10-30% of FCF at average Brent oil prices up US$65/bbl. Above that oil price, STO will make additional returns of at least 40% of FCF.
Factoring in all of the known projects (US$7bn capex), including Pikka Phase 1 in Alaska, at US$65/bbl oil, STO will generate excess FCF of approximately US$16 billion between FY22-30f. At US$100/bbl oil, an additional US$11 billion of FCF would be generated (Figure 6).
Risks To Investment View
Oil prices remain subject to volatility and operational risks are always present for oil and gas companies. If STO cannot execute on its strategy to optimise the merged portfolio and develop its major growth projects, then earnings and value could be lost.
Recommendation
We have retained our Buy recommendation.
Figure 1: FREE CASH FLOW
Figure 2: REVENUE BY PRODUCT
Figure 3: AVERAGE REALISED PRICES
Figure 4: PRODUCTION BY PRODUCT
Figure 5: PRODUCTION BY ASSET
Figure 6: ~US$16-27BN FORECAST CASH SURPLUS OUT TO 2030
