Harbour’s sweetened Santos offer has rough hedges

Harbour Energy’s sweetened $14.2bn offer for Santos comes with additional risk for the target’s shareholders.

A Santos gas and oil exploration rig operating in the Cooper Basin.

Harbour Energy’s revised $14.2 billion bid for Santos comes at a higher headline number to recognise rising oil prices and one that looks in the right ballpark for the target’s board.

But it also arrives with added risk for Santos shareholders, who were already being asked to shoulder currency risk in the US dollar-denominated offer.

The new offer, at $US5.21 per share (or $6.95 and up from a $US4.98 offer last week), comes with some pretty hefty hedging requirements amid a rising oil price and on a company that already has about one-third of this year’s oil-linked production hedged against oil price falls.

While the hedging is academic if the deal goes through, it will limit the upside for Santos shareholder if the deal falls over. The risks of this include Scott Morrison wanting too many conditions for privately and US-based Harbour and its privately-owned Chinese partners ENN and Hony, to accept and the 75 per cent shareholder vote needed to implement a scheme of arrangement falling short.

About 70 per cent of Santos’s total production is oil linked, coming from oilfields, LNG exports and some domestic gas contracts.

Harbour wants Santos to hedge an extra 30 per cent of this year’s production, which would mean about 65 per cent of Santos oil-linked production was hedged.

If oil prices averaged $US80 for the rest of the year, it is estimated this would reduce free cash flow by $US13 million. In the unlikely event oil prices average $US100, there would be a $US145m hit to free cash flow.

Harbour wants more, unspecified hedging for 2019, where Santos is already 10 per cent hedged on oil price-linked output. If that was lifted to 30 per cent, it would mean a $US60m free cashflow hit at $US80 and a $US260m hit at $US100.

Harbour has also added the prospect of a 5c per share sweetener to $7 (or more accurately the US dollar equivalent at a point in time) if Santos hedges 30 per cent of 2020 oil-linked production. That’s a $US100m hit at $US80 oil and $US300m hit at $US310m.

It’s a complex issue for the board to grapple with.

The often-relied-on but generally unreliable oil futures curve is showing prices are coming down. But Morgan Stanley last week raised its 2020 oil price forecast from $US65 to $US90 as equally unreliable analyst forecasts start to head higher.

Santos would be in a much better position if it had hedged more oil production in 2014 when prices unexpectedly plunged from higher than $US100.

But the company is a different one today, having completed construction of Gladstone LNG and paid down much of its debt, it is now able to generate free cash flow at $US35 a barrel oil. So there’s no need for it to take on a defensive hedging position at a time when investors want access to oil price exposure.

Harbour’s offer is largely debt-funded, meaning its lenders will want Harbour to be hedged against oil price moves. Santos, with its big presence in oil and LNG will be able to get a better-priced hedge, so in that respect it makes sense for Santos to hedge.

Depending on how big the difference in the hedge price is, the solution may be for the Santos board to give a little ground for the cost of the hedge.

Or it may be that, thanks to the recent oil price jump, price expectations of sellers with strong balance sheets and those of highly leveraged buyers have now diverged to deal-blocking levels.

Certainly, the market is leaving Santos (STO) shares at a long way below the offer price. They were up 18.5c, or 3 per cent, to $6.44 at midday.