The Oil Search Buy Argument


By Andrew Nelson

The FNArena Database shows six Buy calls and two Hold calls and nearly 14% upside to the consensus price target for oil & gas explorer/developer Oil Search ((OSH)). According to the database, current year consensus full-year earnings growth is pegged at 78.9%, while dividend growth is pencilled in at nearly 48% (off a low yield). Looking at these numbers it almost seems the obvious question is why are two brokers at Hold, not why are six at Buy?

It all comes down to the valuation model employed by the broker. More specifically it comes down to how brokers value the optionality the stock offers.

JP Morgan, at Hold, sees a 75% chance of a third production train at PNG LNG, while Citi, who downgraded to Hold at the end of February, sees an 80% chance of a 5tcf third train and also cites many potential exploration catalysts. Still, the broker sees prospects like Mananda, Taza, and the Gulf of Papua as being relatively high risk and ascribes little value to them. Despite the lack of speculative valuation support, Citi calls Oil Search the best value, top pick in the sector, while JP Morgan's call is based on a sector-relative valuation.

That's the simple story of why there are two Hold calls. The six Buy calls will take a little more explaining.

Analysts from CIMB seem to hold one of the biggest crushes on the stock and believe there are nowhere near the amount of unanswered questions that brokers like Citi and JP Morgan see. CIMB calls Oil Search a simple but good story, citing a better than 15% free cash flow yield when, not if, Train-3 comes on line in 2018. What's more, with Exxon running the operation, the story is enhanced.

The broker points out that on many levels, the Oil Search investment case is also a fairly cheap play on Exxon Mobil and its ability to deliver and operate a major project. So even if PNG LNG T3 is risked at 80%, Exxon trades at current 10.9x, so it is cheap way to play the what is the biggest operator in the global game.

The real question to CIMB is whether Exxon will want to own Oil Search post start-up at PNG LNG?

One of the keys for the company going forward will be maintaining the sustainability of the currently strong levels of free cash flow on offer. If the company is able to remain disciplined, then there isn't really that much to tax the balance sheet other than PNG LNG. Most other projects, like Taza, are low cost, so even if they do fall over, the broker doesn't see much value destruction.

Another thing supporting the broker's appreciation of the Oil Search story is that the rest of the big caps in the sector either look a lot more expensive, or present much greater capital risks. On current numbers, Oil Search's FY18 PE ratio is less than 5x, free cash flow yield is in excess of 15% and the long-term earnings potential is impressive, says CIMB.

It may take a while for the market to appreciate all of this and share price appreciation may be slow in coming, but it will be a steady climb over the coming years until the stock begins to be priced more on earnings and more importantly, cash flows.

CIMB's view is pretty much the same story told by most other brokers, although with a few variations.

BA-Merrill Lynch is much more relaxed about risk profile, feeling increasingly confident about start-up timings and capex budgets. The broker notes the pipeline has now passed Kutubu, which is the source of commissioning gas. Komo is nearing completion and all of the heavy lifting has been completed at the LNG plant.

Operationally, FY production forecasts were maintained at the recent profit result release and what's more, all of the oil sold in 2012 has been replaced by increased reserves in 2013 after a 24% increase in contingent resources was posted with the result at the end of February. This has the broker thinking the company couldn't be in better shape prior to first LNG production. Again, cash flow is strong, which will support ongoing exploration and development.

There is one problem seen by the broker. Even though a resource increase has made, and the PNG LNG expansion almost a certainty, Merrills thinks Exxon probably won't green light the development until drilling at Hides is completed, so a final investment decision (FID) is unlikely in 2013.

Credit Suisse agrees on first LNG in 2014 and sees capex needed to get there as easily covered. Given the type of resource increases being booked at sites like P'nyang, the broker is very confident enough resource can be found to soon underwrite Train-3. The broker calls it "the best LNG project among Australian majors".

Goldman Sachs notes the stock trades at an unwarranted 18% discount to the broker's valuation. Goldman expects the project will enter front end engineering and design (FEED) on Train 3 in 2013, with more good news to come over the year ahead. Drilling at Hides, offshore Gulf of Papua and in Kurdistan are all likely to offer valuation upside, although this will put some strain on the capex budget.

This pretty much sums up Macquarie's opinion as well, the broker noting that with continued solid progress being made on a number of fronts and what seems to be a seemingly conservative budget for the PNG LNG development, all the market should get in the year ahead is positive drilling news and more support for the valuation case.

Analysts at Deutsche Bank are very upbeat on the increased resource estimates at Pn'yang, proving there are more than enough unallocated gas opportunities in PNG to support a third train. The broker, like the rest, sees a run of drilling catalysts in the Gulf of Papua and Middle East/North Africa, which should increase growth prospects. More than enough to keep an undervalued stock at Buy.

Lastly, UBS pretty much sees Train-3 as a done deal and thus believes other catalysts, of which there are quite a few, will drive the share price this year. Drilling at Taza in Kurdistan, Semda in Tunisia and in the Gulf of Papua all kicking off in the first half this year. Taza may well contain 250-500 mmbbl. Mananda oil resources in PNG have been upgraded from 12.5 to 30 mmbbl, with an appraisal likely to commence drilling next month.

Thus the existing oil business itself, plus Train 1 and 2 at PNG LNG underpin the share price, with a 50% risk weighting on Train-3 and 44c per share for the 2013 exploration drilling program is more than enough to support UBS' Buy call.

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