Time to get on board and cover those shorts. The worst could be...

Time to get on board and cover those shorts.

The worst could be over for Santos
At face value, the fall in Santos’ first quarter sales revenue might appear to confirm the pessimism that has enveloped the group since the oil price started plummeting last year. Its share price, however, rose.
In fact Santos’ share price has risen sharply over the past six weeks -- it is up more than 16 per cent. The anxiety about the impact of the low oil prices on a leveraged balance sheet, and calls for some form of balance sheet response, appear to be receding.
The first-quarter production report issued today shows production up 15 per cent on the same period of last year and sales up 10 per cent but sales revenue down 24 per cent, from $1 billion to $825 million.
Given that there was a 44 per cent fall in the average realised oil prices between the periods being compared, the fall-off in revenue despite increased sales volumes -- or, rather, because of the increased volumes, was reasonably well contained.
We’ve yet to see how the decisive action Santos took late last year to carve into its cost base and capital expenditures flows through to its earnings, but they ought to be a moderating factor on the impact of the near-halving of the oil price.
The larger influences on Santos’ share price, however, have little to do with its latest production statistics but relate to more macro factors.
The most obvious is that the oil price appears to have bottomed for the moment and, indeed, has come off its lows of around $US50 a barrel at the start of the year. Overnight it was trading at just under $US64 a barrel.
The monthly OPEC world oil market report provides some context and suggests that OPEC believes the Saudi-led strategy of maintaining (in fact actually increasing) production into a falling market would drive out non-OPEC (primarily US) production.
OPEC’s concern about the growth in US shale oil production was perhaps the major influence over its strategy and its tactics appear to be starting to have their desired effect, even if US production volumes and inventories are yet to reflect it.
The US and Canadian oil rig count, which peaked at 1575 in December, is now down to 813 -- it has almost halved. While that dramatic reduction in drilling has yet to show up in production volumes, which have kept growing, OPEC expects it to start biting in this quarter and be reflected in lower volumes in the second half of the year.
The oil price supports that thesis, given that there is a forward-looking element to any commodity market.
While there would still be a global surplus of about 1.2 million barrels a day of supply over demand this year, with underlying demand continuing to grow and a fall-off in production that will be exacerbated in the future by the massive cuts to spending and investment across the sector, the fundamentals for oil are looking more stable.
To sustain the strategy and justify the hit OPEC producers have taken from the lower prices, the Saudis would have to keep a significant proportion of the potential North American production on the sidelines, which should be a limiting factor on the price over the next few years.
Nevertheless, if the price has indeed bottomed, it puts a floor under the degree of risk associated with Santos and its balance sheet and reduces the pressure on David Knox and his board to do something short term and structural. The market had been imposing real pressure on Santos to raise equity.
An important moment for Santos will occur when the $US18.5bn GLNG coal seam gas-fed export LNG project it leads at Gladstone in Queensland finally begins producing product, and some cash, towards the end of the September quarter rather than consuming cash and capital.
The start of the partial recovery in the Santos share price (it’s still about 37 per cent off last year’s highs) coincided, with a fortnight’s lag, with the start of the modest recovery in the oil price last month. There is a very obvious and direct correlation there.
That provided about half the $1 a share ($1bn) uptick in Santos’ share price and value.
The other 50c a share came in an immediate response to the announcement of Shell’s $91bn bid for BG Group.
Apart from the general signal from one of the industry’s behemoths of confidence in future oil and gas prices provided by the announcement, there is an aspect of the bid that is of particular relevance to Santos.
The larger part of the appeal of BG to Shell might be its Brazilian oil resources, but it is impossible to ignore the significance of BG’s own $US20bn Gladstone LNG project to the value of the bid.
While there has been a lot of sceptical analysis of the economics of those projects, the Shell move signals its confidence in their long-term prospects. Shell, with PetroChina, has its own undeveloped coal seam gas resources in Queensland that can support the BG facility.
Santos has been cautious in saying too much about its expectations of GLNG. However, Origin Energy, which leads the third of the near-identical projects, has said that its plant will generate free cash flow for Origin shareholders at oil prices above a cash break-even price of about $US40 to $U45 a barrel once fully operational. It expects to get about $900m or more of distributable cash a year from its share of the project from 2017.
Generating free cashflows doesn’t necessarily, of course, equate to respectable risk-adjusted returns on capital. But the Shell move on BG could suggest that the market has notionally written down the value of those projects too far.
Origin, which had also experienced a steep decline in its share price (albeit not quite as steep as Santos’), has also seen a two-step pick-up in its price as the oil price improved and the news of the Shell bid was digested by the market.
With the other mega energy companies mulling the implications of Shell’s move and the dominance it would give Shell in LNG -- a sector of the energy market which, because of Asia’s continuing growth, has strong long-term fundamentals -- both Santos and Origin could come within someone’s sights.
Origin was, of course, BG’s initial preferred base from its expansion into coal seam gas-fed LNG, while Santos, with its GLNG equity, an interest in the PLNG project in Papua new Guinea, the Darwin LNG project, the Bayu Undan field and the Cooper Basin, would be a relatively clean and a predominantly upstream gas-focused play.