Santos has announced a new capital management framework that aims to achieve a balance between growth and returns to shareholders. The initial step under the new framework is an onmarket share buyback but there will be much more to come, regardless of the macro environment.
The two stage structure consists firstly of a dividend policy of 10-30% payout of free cash flow at an average Brent oil price up to US$65/bbl. The second stage adds returns of at least 40% of the incremental free cash flow in the form of additional dividends and/or share buybacks at Brent oil prices above US$65/bbl.
It is important to understand STO’s definition of free cash flow which is operating cash flows less investing cash flows net of acquisitions, disposals, and major growth capex.
In practice, if we assume a payout at the top end of the base dividend, then that would represent a yield of 2.6%. The additional dividend would add approximately 0.9% yield for every US$10/bbl higher oil price at the (minimum) 40% of incremental free cash flow. At current oil prices, that would equate to a yield around 6.5%.
STO released its first quarter production result for 2022 which featured free cash flow of US$865 million. This very big number was boosted by 7 spot LNG cargoes and 6 contracted GLNG cargoes sold at JKM prices which were higher than the 3-month lagged JCC average price of US$80/bbl. The average realised LNG price received during the quarter od US$13.77/mmBtu compared to the US$6.12/mmBtu in the same period last year. Crude oil prices received were also much higher at US$113.09/bbl compared to US$86.32/bbl in 4Q21 and US$60.41/bbl in 1Q21.
Production for the quarter was modestly soft at 26mmboe but FY22 guidance is unchanged at 100-110mmboe. 1Q22 production in WA was about 1.5mmboe light due an outage at a major customer. Adding this volume back across the year leads to production heading towards the upper half of guidance.
We note that FID on Dorado has been shifted from mid-2022 to 2H22 to incorporate the recent major discovery at Pavo-1 and the subsequent exploration around the field.
Also notable is that Barossa is now one-third complete, on schedule and on budget.
STO said initial synergies of US$54 million from the Oil Search merger had been achieved within the first 3 months. The integration is ontrack to deliver guidance of US$90-110 million per annum of synergies.
Investment view
STO is doing everything right as evidenced by the rapidly accumulating free cash flow. The company has a broad base of producing assets, and an attractive portfolio of development assets in various stages of completion. Following the merger with Oil Search, it also has options to sell down some positions such as the world class PNG LNG and it has room to manoeuvre on the Alaskan assets.
This is all happening at a time when global oil and gas prices are geopolitically (Russia/Ukraine) and economically (demand exceeding supply) pushing higher.
The corollary to this ideal situation is the formation of an attractive capital management framework that will enable the company to balance its allocation of capital between investment and growth in the business while also delivering sustainable and attractive returns to shareholders. This can all be achieved within a sensible gearing target range on the balance sheet.
A crucial ingredient for a sound investment requires an excellent Board and Management and, in our view, STO certainly has this factor.
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.
