Credit Suisse on Santos versus Australia

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From the excellent crew at Credit Suisse today:

When political correctness is key…

Perspectives in the domestic gas market, certainly in terms of scrutiny and public perception, have changed beyond all recognition in the past few weeks. To quote APA CEO, Mick McCormack, every petshop parrot now was a view on it all. As of yet there doesn’t appear to be a clear solution adopted, however.

Sadly for the gas market, unlike electricity markets so it seems, there isn’t a 100PJa gas field that everyone had forgotten about that can be dusted off and brought to market. The challenges to fix the gas market are another level of difficulty.

In it all Santos is certainly encountering the ire of all and sundry. Mick McCormack proclaimed “there is no doubt that Santos has caused the whole issue to come to a head by buying all that domestic gas in volumes enough to force net-back pricing through the system” (as reported AFR, 19 Mar). Again, we think this belies an understanding of the situation – sure, Santos is operator of GLNG; sure, Santos has likely done plenty of questionable things in the past to contribute to the current predicament, but it is GLNG as a whole that has the problem and the power to agree to a fix.

We have to confess, we struggled with Mr McCormack’s other comments that it “just surprises me that people are as surprised as they seem to be”. It is after all APA, that as recently as a few months ago proclaimed that “we are all finally in agreement that there is sufficient gas forecast to be produced to satisfy both the LNG and domestic demand…so there was no gas crisis after all, which is what APA had said all along”.

This argument that price alone can fix the crisis (for those of us who do believe it is a crisis) also belies the true nature of the situation, on two fronts. Firstly, it doesn’t matter whether we had a A$50/GJ gas price, there is unlikely 150PJa or more of gas that could physically be brought to market over a 12- to 18-month period.

The more important second point is what scale of market actually exists at these higher prices that people believe will fix the market. Mrs S might be technically, factually correct when she says that the issue is not with the amount she spends on shopping, instead with the amount that I earn. Unfortunately, much like there is a (depressingly low) finite level of income I can expect to earn, there is a gas price at which large parts of the domestic market simply won’t exist.

Sure domestic buyers had it very easy for a long period of time, and A$3/GJ is an unrealistic relic of the past, but when a market effectively commits to export the next 40 years of its supply curve, the jump to where supply = demand for the next domestic contract from t-1 to t+41 is unfortunately large.

Bringing this all back to Santos, the political (both real politics and apparent political shenanigans of those with vested interests) spotlight is firmly on it. In many ways erroneously there appears an expectation that the burden of fixing the short term is upon it.

We continue to believe it is best resolved with that burden falling upon GLNG, but again that is not Santos. It is 30% of that JV and cannot make unilateral decisions – particularly when, if you are Total, Santos actually is potentially incentivised to reduce GLNG volumes if it helps in the Cooper Basin.

What has particularly dawned on us of late though is the potential disconnect between Santos’ explicit, but maybe more importantly implicit, new strategy and the political environment at present.

Absolutely none of what has gone on before is new management’s fault (some board members do still exist from the days of GLNG sanction, Cooper expansion sanction, etc.), but it is unfortunately their problem to navigate. With Santos itself seemingly being a large net provider of gas to export markets, we wonder whether strategy needs to change away from cash preservation and pocketing something like Narrabri as non-core.

Marrying corporate strategy with politics

The playing field in the east-coast gas market has changed beyond all recognition in the past few weeks. Now well and truly on the national agenda, with a largely accepted belief that the gas market is in a spot of bother, every move is being monitored closely by all and sundry.

Good rhetoric from Shell; does it bring more gas to market?

Whilst perhaps Shell should be commended for it, it is hard not to form a wry smile when reading its release yesterday which started with “Shell Australia is proud to invest in regional Queensland, where state and local government have had the vision to establish the rules for a gas industry that creates jobs and supports farmers.”

What Shell has done is approve the drilling of up to 161 more wells in the next 18 months or so. The headline grabbing number is that it will be net suppliers to the domestic market of >75PJa this year. The question that is unanswered is how much of that net 75PJa is already contracted and how many of the 161 incremental wells are to ensure QCLNG can honour existing contracts/export volumes and how much is going to be incremental, new uncontracted gas to the market. The lack of clarity on this might lead the cynic to believing that not much incremental, uncontracted gas is coming its way.

However, this is all probably a politically astute move. For Santos it is the kind of move that seems incompatible with its current strategy. Whilst some of our writing of late has veered away from specific stock implications, this is the point where the two converge again.

A need for Santos to marry strategy and politics

The most notable assets that stand out in the Santos strategy, from an east-coast gas market perspective, are GLNG, Narrabri and Cooper Basin. Whether these assets become larger headaches or potential pain relief will in part depend on what path Santos chooses to take strategically. Take no new path and the risks of someone else cutting a rather rough path for you can’t be ruled out.

Narrabri was written down to $0 and has been moved across to the non-core business being run by Bruce Clement. Did this make sense in the recently announced Santos strategy? Most likely. It is a challenged asset (perhaps more so politically than economically) and one that funds are clearly not readily available to deploy on.

At the Cooper Basin drilling has been well below the levels required to supply the Horizon contract without the help of other Santos portfolio gas. The focus has been on lowering breakeven across the whole business, with a high cost asset like the Cooper Basin clearly the obvious one to target. Indeed, FCF at the Cooper Basin has been artificially inflated by selling plenty of gas out of storage – perhaps the new person running the Cooper Basin owes the old chap a beer, the old one having carried all the development costs with no revenue, the new one benefitting from all the revenue with no development costs on those volumes in storage.

At GLNG, once again, these are not Santos’ decisions to make. However, certainly the strategy to date has been to reduce costs by drilling very few wells and instead look to continue to sign up more third-party gas to maximise FCF from partly redundant capacity at the plant.

When one considers the rhetoric coming out of government on the east-coast gas market, none of these options seem as viable as they were only a few months ago. So does Santos need to refresh its strategy for the new world (or domestic, more accurately) order? At face value it would appear so.

Time to accelerate or sell Narrabri

Putting aside funding capability (not something an equity analyst should do for too long), the promotion of Narrabri feels politically sensible. This could, to be fair, take two forms – bringing it back into the core business and accelerating it, or selling it to someone potentially with a gas supply agreement (GSA) back to Santos with a commitment for that gas to go to the domestic market.

Either way, for that asset at least, the onus gets put back on (state) politics rather than on Santos. Whilst more still needs to be learnt about Narrabri, at a A$7-9/GJ gas price, particularly if some rationality returns to the costs imposed by red tape, it seems likely it is an economically viable asset.

The largest impediment, balance sheet aside, is clearly state politics. To the extent this can be rationalised, the asset does take a different form. Perhaps there is scope for Santos to also push for some kind of concessional financing in this all.

Whilst our idea of a state oil company was labelled a “terrible idea” by Wood Mackenzie’s head of Australian oil and gas in Energynewsbulletin.net last week, we continue to believe that government has a role to play in funding (in one form or another) gas development.

Perhaps one thing we had already grasped, but was held out as a reason not to have a state oil company, was the scale of the financial loss received by the private sector through building these projects on the east coast. The good thing about spending your waking hours looking a very small collection of Australian companies is that you have a vague idea about their profitability.

Whilst everyone is entitled to their views on it all, couldn’t one argue that the complete failure of the private sector in developing these resources is exactly why government support is needed? With the financial impacts of those failures still weighing on many corporates, leaving the situation to market forces might not end up with the result that is best in totality for the country.

Cooper Basin true FCF breakeven might be tested

If there is a real, or perceived, political imperative for Santos to supply more gas to the east-coast gas market then, from a physical capability perspective, the Cooper Basin is the asset that could be ramped up most quickly.

Clearly there is a caveat to this that current 2P reserves at the Cooper Basin do not cover the Horizon contract and it is unclear how much contracted portfolio gas (largely third-party a la Kipper) Santos has.

However, warehousing gas from 10+ years away, that is going into an export project, would not appear eminently sensible. The question is, at what cost can incremental gas be developed?

At face value we were told that the Cooper Basin generated US$100mn of FCF for Santos in 2016, this with a realised oil price of ~US$45/bbl. On an 8x slope for new gas, this would be a <A$5/Gj gas price and at that price the Cooper Basin is seemingly breakeven. However, is this really the case and what are true development costs for incremental gas.

Whether the starting point of FCF breakeven is right or wrong, uncontracted gas can certainly get a lot more than A$5/GJ in the current market. How Santos chooses to operate the Cooper Basin in the current environment will be fascinating.

Clearly from a Santos perspective the best outcome is to see the Horizon contract nullified and it be allowed to generate a more ’normal’ price for that gas. What GLNG wants in return for this scenario is of course the big unanswered question.

Remember GLNG decisions are a GLNG JV decision

It seems to be somewhat stating the obvious to say that any decision by GLNG is a decision made by the four JV partners (Santos, Petronas, Total and Kogas). However the obvious seems to sometimes escape popular commentary on the east-coast gas market where the belief seems to be that Santos has contracted all the third-party gas and Santos has a decision to make on that third-party gas.

Left up to Santos alone, given its perverse self interest in repricing the Horizon contract, this might all be somewhat easier to fix. However, any decision for GLNG to voluntarily divert gas domestically (presumably with a complicated quid pro quo amongst all parties) has to be agreed upon by all four of those JV partners. As we have discussed at length before, the economic impact from reducing those third-party volumes is profoundly different across the partners. Reaching a palatable compromise might be needed ultimately, but it wouldn’t be easy.

If the reaction within GLNG is also to start drilling, and exploring aggressively then this once again is a higher cost impost on the Santos balance sheet. As we have discussed before, if all in cash costs for undeveloped GLNG gas really is <A$4.50/GJ(we categorically do not believe this is truly the case), then everyone should be developing and exploring like mad. They aren’t at present, which raises inevitable questions.

An interesting wire to walk for Santos

Whilst everyone man and his dog (or petshop parrot) have been keen to point the finger at Santos as the cause and solution of the problem, we remain of the view that this overly simplistic view of life does no one any favours. Could Santos come out the other side of the ultimate resolution to the gas market worse off? Absolutely, in our view.

Could it also come out neutral or even better off (if only from a risk profile perspective)? Absolutely yes, too, in our view.

If rhetoric is to be believed then Santos might not have all that long to present a new vision of the business to us. Again, none of this is the fault of New Santos. Indeed, brave decisions that might be painful to Old Santos are likely what is needed to best place Santos in this world. One can only hope that bruised pride over what has gone before does not impede the right decisions for what lies ahead.

A couple of points to add:

  • more gas in the domestic market is up to neither GLNG nor Santos. It’s up to the Australian people now;
  • price will rebalance the market only through demand destruction not via manufacturing paying more;
  • why hasn’t Do-nothing Malcolm hired CS yet?
About the author
David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geo-politics and economics portal. He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.