After an extended courtship with private equity-backed Harbour Energy, in May this year Adelaide-based oil and gas producer Santos (ASX: STO) abruptly rejected its suitor’s overtures.
Amongst other things, Santos argued that the bid – then valued at $6.86 per share – undervalued the company while also being too complex, resulted in the unequal treatment of shareholders and relied on too much leverage to boot.
Santos instead argued that more value could be created by it remaining independent.
Now, when private equity gets interested in a company, it is usually for good reason.
Why Harbour was interested
And there were – and remain – obvious reasons why Harbour wanted to get its hands on Santos.
First and foremost, with only 13% of Santos’ production hedged to the end of 2019, the company remains highly leveraged to a recovering oil price.
After crude oil prices crashed in calendar 2014 due to rising production from US shale, they were subsequently forced even lower as OPEC made the misguided decision to try to maintain its market share and thereby hopefully push the US frackers out of business.
Of course, OPEC ultimately relented and reduced production. Combined with steadily increasing demand on the back of improving economic growth and additional reductions in supply – ranging from Venezuela to Libya – oil prices have continued to march steadily upward.
For example, after falling from above US$100 per barrel in calendar 2014 to below US$30 per barrel in early calendar 2016, West Texas Intermediate has risen to just under US$70 per barrel today.
Add to that the fact that the world’s major oil and gas companies have only replaced one-third of their reserves since 2014 and the long lead times between commencing exploration and ultimately bringing a successful oil or gas discovery into production, I think the future for oil prices remains bright.
Even better, Santos CEO Kevin Gallagher has done a sterling job cutting costs and making the company more efficient: upstream production costs fell from US$10.35 boe in 2015 to US$8.07 in 2017, while increased cash flow (and a couple of capital raisings) allowed the company to reduce its net debt by 48% to less than US$2.5bn at 30 Apr 18.
A rising oil price and falling production costs are usually a good combination.
And rising LNG demand from Asia potentially leading to an undersupply of LNG sometime in the 2020s is an added bonus.
So if you agree with me that oil prices will likely keep rising, then it is easy to see why Harbour was interested in Santos.
And combined with the copious amounts of debt Harbour intended to foist on Santos, the potential returns to Harbour and other equity holders would likely have been what even Warren Buffett would label as “satisfactory”.
Correct to go it alone
But with the hard work of cost cutting and debt reduction nearly complete, in rejecting Harbour’s advances Santos’s Board evidently concluded current shareholders rather than private equity should be the ones to benefit from a (hopefully) rosier future.
In considering its decision, no doubt the Board acknowledged that either way, billions in growth investments – including potential additional investments in LNG projects in Papua New Guinea, the Barossa project in northern Australia (which will extend the life of Darwin LNG) or the company’s Narrabri Gas project – would have to be funded somehow.
Yet by doing such a good job of righting the ship – albeit helped by rising oil prices – Santos is now in a much better position to fund its growth investments itself rather than surrendering to a better-funded acquirer.
And Exhibit A is Santos’s recent acquisition of Western Australia-based gas and oil company Quadrant for US$2.15bn (plus potential contingent payments), funded using existing cash and committed debt facilities.
As well as further reducing the company’s free cash flow breakeven oil price – to US$32 boe from US$36 boe – the acquisition increases Santos’s pro forma 2P reserves by 26% and pro forma production by 32%, with material cost synergies of between US$30-50m per year also likely.
There’s additional potential from Quadrant’s development pipeline, and exploration and appraisal upside too.
This is just one example of how Santos intends to grow in coming years.
So while Santos shares are still hovering just below Harbour’s $6.86 takeover price, the company looks well placed to continue its great progress in recent years. Assuming of course that oil prices don’t experience material falls in the short to medium term.
