No-moat Santos (ASX: STO) reported a robust first-quarter 2024 operating result, with production and revenue down 7% and 6% to 21.8 million barrels of oil equivalent, or mmboe, and USD 1.4 billion, respectively, in line with our expectations.

We have made no change to our $12.30 fair value estimate. The production decline reflects the anticipated depletion of the Bayu-Undan gas field and planned maintenance, as well as unplanned shutdowns due to cyclone activity in Western Australia. It was creditable that expectations were still met despite the weather.

Average price achievement improved by 5% to USD 61.50 per boe, with stronger LNG and West Coast domestic gas prices more than countering weaker Brent crude and East Coast domestic gas prices.

Santos maintained all 2024 guidance, including production of 84-90 mmboe and capital expenditure of USD 2.85 billion. We hold to higher-end production of 88.5 mmboe and at guidance for capital expenditure. Despite this, our 2024 earnings per share and dividends per share forecasts increase 8% and 6% to $0.65 and $0.22, respectively, due to Brent crude prices having strengthened to nearer USD 90 per barrel, against about USD 80 per barrel at the time of our last note.

The forecast 2024 dividend equates to a moderate 4.5% part-franked yield at the current share price. However, Santos’ capital management program intends to supplement with on-market buybacks, which effectively enhance shareholder returns beyond just dividends, subject to market conditions.

At around $7.70, Santos shares are up 14% from December 2023 lows but remain materially undervalued in 4-star territory. Effective delivery of the Barossa and Pikka projects is the key potential catalyst for price appreciation toward fair value.

Business strategy

Santos is the second-largest Australian pure oil and gas exploration and production company (behind Woodside Petroleum, ASX:WPL), with interests in all Australian hydrocarbon provinces, Indonesia, and Papua New Guinea.

Well-timed East Australian coal seam gas purchases and subsequent partial sell-downs bolstered the balance sheet and set the scene for liquid natural gas, or LNG, exports. Santos is now one of Australia's largest coal seam gas producers and continues to prove additional reserves. It is the country's largest domestic gas supplier.

Coal seam gas purchases increased reserves, and partial sell-downs generated cash profits, putting Santos on solid ground to improve performance. Group proven and probable, or 2P, reserves doubled to 1,400 mmboe, primarily East Australian coal seam gas. Coal seam gas has grown to represent more than 40% of group 2P reserves, despite partial equity sell-downs.

A degree of confidence can be drawn from project partners. US energy supermajor ExxonMobil, the world's largest publicly traded oil and gas company, is 42% owner and the operator of the PNG LNG project. The Gladstone LNG project was built and is operated by GLNG Operations, a joint venture of owners Santos (30%), Petronas (27.5%), Total (27.5%), and Kogas (15%). Petronas is Malaysia's national oil and gas company and the world's second-largest LNG exporter. French energy major Total is the world's fifth-largest publicly traded oil and gas company, and Korea's Kogas is the world's largest buyer of LNG. Santos is in good company.

Overall, we see a happier future for Santos now that excess debt levels are addressed, aided via improved margins and earnings driven by Gladstone and PNG LNG. The company increasingly enjoys export pricing on its gas. In addition to Santos' Gladstone LNG, several other third-party east-coast LNG projects conspire to drive domestic gas prices higher. As the largest domestic gas supplier, Santos can expect significant bang for its buck, with limited additional capital or operating cost required to capture enhanced prices. The group production profile is simplified with increased certainty in project life.

Moat rating

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Given a lower energy price paradigm, we don't expect Santos to generate returns sufficiently in excess of its cost of capital, meaning that it has no moat. LNG projects in Papua New Guinea and Gladstone will see Santos generate improved returns based on our long-term oil price of USD 60 per barrel.

Santos has 20-year contracts that tie the gas price to the oil price--USD 60 per barrel equates to USD 8.40 per gigajoule. However, returns will now be insufficient to support a moat. Returns on invested capital, or ROICs, have been in the single digits and below the weighted average cost of capital, or WACC, since the mid-2000s.

Santos suffered industry cost inflation without the benefit of higher international pricing because of a heavy weight of domestic gas contracts. In addition, the construction phase of Gladstone and Papua New Guinea LNG projects further crimped returns precommissioning. We expect the trend to improve with ramp-up from Gladstone LNG and domestic gas contracts rolling off.

With the USD 60 per barrel midcycle Brent oil price, however, we expect ROICs to only marginally exceed the cost of capital. Less-than-stellar returns are driven by PNG LNG and Gladstone being constructed at Australian energy boom inflated capital cost, permanently bloating the invested capital base and detracting from returns.

If expansion LNG trains are built at Gladstone, returns could be expected to improve after 2024. Santos can expand its Gladstone LNG project from two trains to four, which would allow it to drive greater capital efficiency on the two-train startup configuration. Current infrastructure, such as pipelines and wharfage, is sufficient for the expansion, and no further expensive dredging would be required.

However, we don't credit expansion in the number of trains, given the likelihood that the LNG market will be in a state of excess supply for at least the near term. Furthermore, it is not clear that expansion would sufficiently correct for the inflated expenditure of the past, to drive returns sufficiently in excess of WACC. Deflating industry capital costs will also benefit competitors yet to enter the market.

Santos is Australia's largest domestic gas supplier, only cemented with the August 2018 USD 2.15 billion purchase of Quadrant Energy. Profitability will improve with the higher domestic gas price. With the advent of LNG exports in Eastern Australia, the domestic gas market has become more attractive, with contract prices being written near $8 per gigajoule, versus historical contracts near $4 per gigajoule. Group average domestic gas price achievement was $5.00 per gigajoule in 2018. Our long-term Australian domestic gas price assumption is $7.00 per gigajoule in 2022 dollars. In this space, Santos is largely owner-operator of assets, with little additional capital required to take advantage of the higher domestic gas prices. Competitive advantage is from efficient scale, particularly at the important Moomba hub, where it makes no sense for a competitor to replicate infrastructure. But again, Santos' domestic businesses comprises less than a third of our fair value estimate, which is insufficiently material to offset no-moat attributes in LNG.

We don’t expect Santos’ economic moat potential to be undermined by material shareholder value destruction from environmental, social and governance, or ESG, risks. ESG risks are based largely on industry risks that are already incorporated into our base-case analysis. And natural gas is the predominant value driver for Australian E&Ps like Santos. Natural gas is less carbon-intensive than coal or oil, and stands to benefit from efforts to minimize emissions, at least in the medium term. This is because renewables like wind and solar, while growing rapidly, can’t hope to entirely meet global energy requirements for decades, if ever.

Hydrocarbons’ share of primary energy consumption fell to 84% from 87% over the last decade, though in absolute terms consumption increased by 74 exajoules or 15% to 492 exajoules. Share was displaced by renewables which increased to 5% of total from 2%, or by 21 exajoules to 29 exajoules. Note in absolute terms, growth from hydrocarbons was more than triple that for renewables. And gas played the lead role, consumption increasing by 36 exajoules or 34%. We expect the trend for gas in particular to continue at least in the medium term, as the most effective way to quickly reduce emissions meaningfully. Gas’ share of primary energy consumption increased to 24% from 22% over the last 10 years.

Further, E&Ps are doing more to defray emissions from their extraction operations. Santos plans 26%-30% reduction by 2030 and net-zero emissions by 2040. It also has the Moomba CCS project that proposes to store 1.7 million metric tons of carbon dioxide annually.
Another element of ESG risk for E&Ps includes potential loss of field access due to poor community relations. Santos too has courted community unrest at Narrabri in New South Wales. The coal seam gas project was ultimately given the green light from the NSW Independent Planning Commission in 2020, but not before a large number of concerns from farmers around potential effects on groundwater were aired. Only time will tell as to what scale the project achieves. Regardless, we don’t view it as overly material for the company, its Queensland coal seam gas leases far more important and enjoying greater public and political support.