Latest research note from...

Latest research note from Macquarie

___________________________________________________________

Wednesday, 9 December 2009

Oil Search
Finally, it's definite

--------------------------------------------------------------------------------
Volatility Index: High
Recommendation: Outperform


Stock price $5.84

Event

A sigh of relief: The PNG LNG project was formally sanctioned yesterday.

Impact

No devil in the detail: As we expected, all development licences were awarded, Oil Search's (OSH) equity interest in the project was confirmed at 29% post government back-in, and the imminent award of the Engineering, Procurement and Construction (EPC) contracts is expected to confirm existing project cost estimates of U$15bn. We understand these contracts would contain provisions for the construction of a possible third train signalling Exxon's longer-term intent.

So, what's next? Some investors are concerned the OSH story may go quiet into 2010 as Exxon is likely to wait until 2011 to test the Hides field (the most likely source of gas for train 3). While this may be true against the backdrop of a transformational 2009, we think OSH continues to offer the sector's most attractive valuation and represents a safer investment than either Woodside (WPL) or Santos (STO) next year. OSH is due to drill 8 prospects in PNG over the next 18 months, essentially looking for gas for train 4. We estimate these wells target around 3 trillion cubic feet (tcf) net, which could add over $2.80 to our net asset value.

Well placed to face a tightening LNG environment: OSH is ahead of the pack with its LNG pricing terms agreed while the project's construction costs are set to be largely locked in upfront. Meanwhile there will be many losers in the LNG game over the next 5 years as project economics are squeezed by increasingly price-conscious LNG buyers and increasingly scarce contractors. Consequently, many projects are likely to be delayed and see their returns eroded, which would play into the hands of those with the potential for brown-field expansion trains (a third train at PNG LNG would break even at around $22/bbl, which rivals anything outside Qatar).

Earnings and target price revision

We raise our target price by 4% to $8.30 to reflect the full de-risking of the PNG LNG project and the growing likelihood of a third train. OSH is trading at a 30% discount to our net asset value, which is large, given that Final Investment Decision (FID) removes subjectivity from OSH's valuation, making assessment of what is largely a single asset company even more transparent.

Price catalyst

12-month price target: $8.30.

Catalyst: The completion of the sales and financing arrangements (both of which have been agreed in principle) should be finalised in coming weeks.

Action and recommendation

OSH remains our preferred exposure in the large-cap energy sector, given its attractive yet transparent valuation, the falling risk profile of the PNG LNG project, its fully funded status and the significant potential for additional trains in due course, which are likely to enjoy huge advantages over greenfield developments in a tightening LNG environment.

OSH's attractive valuation not only offers considerable headroom but will likely limit the downside, given the strategic nature of OSH's interests in PNG to a potential industry buyer with a lower cost of capital.