This energy producer just increased its profits by 300%

If you're a company exposed to the economy, you've watched energy prices take off with a deepening sense of dread and despair. 

If you're an oil and gas producer like Santos (ASX:STO), it's as if Christmas has come early. And the present has come in the form of a US$1,267 million underlying profit in the first half. That's a 300% increase. 

“Demand for our products has remained strong in both Australia and internationally, due to increased demand and shortages of supply from producing nations due to global underinvestment in new supply,” said Santos Managing Director and Chief Executive Officer Kevin Gallagher.

“We are seeing these issues play out in the significant shift in global energy policy towards energy security as a key priority."

So what do you do when you're flush with cash? You return it to shareholders in the form of a US$350 million share buyback. 

But these headline numbers distract from what Michael Slack from Martin Currie reckons is the main narrative out of today's result - namely, the asset sales and the final investment decision on a joint venture in Alaska.

In this wire, Slack shares some of the highlights from the Santos result, and gives us his take on the company and the oil and gas sector generally for the year ahead. 

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Martin Currie Select Opportunities Fund

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SANTOS (ASX: STO) KEY RESULTS:

• Underlying profit of US$1,267 million, up 300%
• Statutory net profit after tax US$1,167 million, up 230%
• EBITDAX of $2,731 million, up 122%
• Free cash flow of US$1,708 million, up 199%
• Annual merger integration synergies target increased to US$110-125 million
• 38% increase in the interim dividend to US7.6 cents per share unfranked. 
• An increase in the previously announced on-market share buyback from US$250 million to US$350 million.

Note: This interview took place on Wednesday 17 August 2022. Martin Currie currently holds Santos in its Australia Value Fund. 

What were the key takeaways from this result? What surprised you the most?

Santos just reported a record result driven by strong prices, consistent production, and good cost control across their asset base. The result itself was a small beat, 3% at the EBITDA level,  with the cost advantages coming through.

The dividend was a little weaker, but they increased the on-market buyback, which made up for the slight weakness in the dividend but also gives us some insight into management's view of the value of the stock at these levels. So they've increased that buyback by $100 million. 

The balance sheet finished the period at 22.5% gearing, which is below its target range. And that puts them in a pretty good position to make growth investments, more returns to shareholders, and do some of the corporate initiatives that I think will dominate the narrative out of that result. 

Price was a significant contributor to the profit growth - both LNG and spot LNG in particular, where you've seen prices go from $10 to $60 per gigajoule. 

Santos has 20% exposure to that spot market. Typically these producers are fully contracted but in this instance they have good exposure to the buoyant spot market. So that's driven most of the profit increase itself. 

The bottom line was an even bigger beat driven by a low tax rate in the period. Generally we can say it was a strong result relative to expectations.   

What was the market’s reaction to this result? Was this an overreaction, an under reaction or appropriate?

The stock is slightly weaker, down about 2.5%. It's a little hard to tell whether it's a reaction to the result or a reaction to weak oil prices overnight. 

But I think the market's also digesting the narrative out of this result - the asset sales and the fact they've given a final investment decision to the Alaskan oil development, which they acquired from Oil Search. The market was expecting them to sell down that asset and going FID shows that it's a high-returning project. So rather than selling the asset at a discounted price, they're prepared to develop it and extract the value from it for shareholders. 

Would you buy, hold or sell Santos on the back of these results?

Buy. We see over 20% valuation upside in this stock, as Santos' strong cashflow generation comes to fruition and the growth projects get appreciated by the market. So any form of weakness is a good opportunity to take advantage of.  

What’s your outlook on Santos and its sector over FY23?

It's very strong, particularly for LNG. Europe is displacing 100 million tonnes of Russian pipeline gas into the EU, with LNG. That's 25% of the existing supply and you can't just turn on LNG supply overnight. 

So LNG prices in particular are likely to be strongly supported for a long period until you get mobilisation of new capacity. And that could take 4-5 years. 

Santos itself is 70% gas revenue and is a low-cost producer. Very strong earnings, very strong cash flow to fund investments, and more dividends and returns to shareholders. 

Are there any risks to this company and its sector that investors should be aware of given the current market environment?

The obvious risk is the oil price. We've seen the WTI oil price tick below $90. So despite the gas dominance in the likes of Santos and Woodside, some of their sales are linked to the oil price so it has a direct effect. It also has a direct effect on sentiment within the sector if the oil price were to fall.

However, the oil market is structurally undersupplied, hasn't been invested in for many years, and is struggling to keep up with the demand that is still impacted by COVID. We would say that the fundamentals of the oil market are still strong and will remain strong. 

The fundamentals of the gas market are even stronger. 

From 1-5, where 1 is cheap and 5 is expensive, how much value are you seeing in the market right now? Are you excited or are you cautious on the market in general?

Rating: 3

Recently we've seen a recoupment of a lot of the underperformance we've seen in the market through June/July. So that pushes the market back towards fair value. 

But within that, we'd see the energy sector as relatively cheap - more like a 2. High prices, strong cashflows, and really good returns to shareholders. 

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