Stock Spotlight (Santos)

We have received substantial interest in the energy sector over the past year following high profile mergers such as the creation of Woodside Energy Group (WDS) from the merger of Woodside and BHP’s energy business as well as a larger Santos (STO) following the takeover of Oil Search in 2021. Here we are highlighting the Santos business, its current performance and our view on the medium-term outlook.

Santos is a large-scale, predominantly gas producer with operations centred on Australia and Papua New Guinea. The firm both explores for and produces a mix of natural gas, crude oil, condensate and other related energy products.

Its existing projects are long-life and low cost with a free cash flow breakeven oil price of ~$18 per barrel achieved before hedging in 2022. The business has shifted to a sustainable capital return model over time with a 40 per cent of free cash flow target for capital returns in the form of dividends and buybacks. The current period of higher energy prices following the Russian invasion of Ukraine in Feb-22 has seen deleveraging occur with gearing falling to 18.9% by Dec-22 (at the lower end of its target range of 15-25%). Its portfolio is predominantly geared towards gas production with crude oil only accounting for 15% of overall sales.

In its first quarter reporting for FY23 the business saw a drop off in first quarter production with 22.2 mmboe (million barrels of oil equivalent) which was 13% lower than the prior quarter due to reduced gas volumes from its Western Australian operations. Its US$700m buyback remains on track with US$464m purchased as of the end of March.

The business maintained its 2023 guidance for production of 89-96 mmboe with a unit cost of $7.25-7.75/boe (barrel of oil equivalent), down from the unit product cost of $7.82/boe achieved in FY22.

STO earnings are expected to decline over the next three years until troughing at $0.82 per share in FY25. Key drivers of this are:

• expectations of weaker energy prices due to a mix of transitioning away from fossil fuels and reduced impact of the war in Ukraine, and

• limited new production coming online during this period so negligible volume growth to offset weaker prices.

Consequently, dividends are also expected to be flat over this period. Earnings are expected to pick up in FY26 but there is only a minute handful willing to forecast on this kind of horizon with the variability in energy prices to that point making accurate forecasts highly unlikely.

Source: Bloomberg as of 24 May 2023

As Table 1 illustrates the firm has overwhelmingly positive coverage across sell-side analysts with only one analyst of the current 19 captured on Bloomberg having a lower conviction (hold) call. The average price target is ~$9.00 still suggesting upside from current prices. We caution though that the ultimate profitability will hinge upon energy prices given the limited impact of growth projects coming online in the next two years.

Table 1: Consensus price targets and recommendation snapshot

Source: Bloomberg as of 24 May 2023

At the current price STO shares appear cheap on an adjusted forward price-to-earnings ratio (see Figure 3) with the stock trading at the lower end of its long-term average. However, a similar consideration but on a cashflow basis (see Figure 4 below) suggests the stock is trading in line with its recent average valuation. For the share price to trade materially higher in our view requires either:

• another shock in the form of reduced market supply for a prolonged period; or

• a change in existing energy requirements (Paris Accord etc) that reduces the long-term risk for energy stocks.

Neither option can reasonably be part of a “base case” view. Energy shocks are notoriously difficult to predict given their geopolitical dimensions. Energy stocks are very much anti-consensus for policymakers given the focus on net zero greenhouse gas emission targets. This is likely, in our view, to continue seeing these stocks trade at a discount to what their fundamental earnings or dividend yields might otherwise suggest.

The fact that Santos has much higher exposure to natural gas, a fossil fuel with lower emissions, should be helpful in the sustainability of earnings over the longer term. Natural gas is seen as an important “bridging” energy source given issues with reliability for renewable energy sources for which energy storage has not adequately solved for e.g. reduced wind power generation in periods of calm weather. It is still a source of emissions however and is being treated as such by the market through subdued valuations both domestically and overseas, the latter arguably more so. While there is some attention about its Energy Solutions segment targeting decarbonisation and clean fuel production, this is still a rounding error for the business (4% of EBITDAX in 2022) so remains unlikely to materially shift the valuation higher.

In addition, near term market and economist consensus forecasts suggest pricing headwinds over the next three years continue to be expected. On a consensus view, prices are expected to be gradually declining from the end of this year and approach current spot prices by the end of 2026. Market pricing is more subdued and suggests we approach the 10-year average price for Brent crude by the end of 2026. Either path does not portray an overly bullish outlook for STO earnings. The economic outlook is not especially supportive either with subdued global growth conditions anticipated over 2023 and 2024 which typically bodes poorly for energy commodity demand due to weaker economic activity.

Over the medium term the business still retains attractive fundamentals with its exposure to natural gas as an “energy transition” fossil fuel. Expansion of its Energy Solutions segment would help de-risk the fossil fuel exposure to an extent but needs to grow materially higher from current levels to shift the dial on its valuation. In the meantime, the company is likely to retain profitability thanks to its low-cost operations and return capital to shareholders through dividends and buybacks over the medium term.

We would caution though that as a more mature business there is limited scope for increased production in the short run. For new investments to increase production requires much larger scale projects that take time and are also subject to cost-overruns. In the interim this means that there is less scope for increased volumes to offset price weakness which makes STO earnings even more sensitive to changes in energy prices. Given the mixed outlook for energy prices there is less scope for a material rerating than there was during periods such as Mar-20 after the initial COVID-19 selloff in the broader market. We would also expect these shares to be more volatile than the broader market given the sensitivity to oil prices as commodity stocks tend to reflect the volatility of their underlying products if not more so due to gearing and operating leverage.

If a client has a notable overweight to a business such as STO we would suggest that it is prudent to consider trimming the position on risk management considerations given higher volatility than the broader market. That being said, we think the business fundamentals remain intact in the near term and the valuation is not particularly egregious based on current consensus figures (these might surprise on either the upside or downside depending on how energy prices perform).

Key for below charts

STO: Santos

WDS: Woodside

BPT: Beach Energy

Figure 3: STO Forward Price-Earnings multiple versus ASX-listed peers (Mar-05 to May-23)