Kevin Gallagher’s simple plan to reshape the oil crash survivor

After steering a course through the oil storm, Santos has now switched its focus to something other than sheer survival.

Santos' 30 per cent stake in the Gladstone LNG project on Queensland's Curtis Island is one of the company’s five core assets.

Kevin Gallagher has unveiled a quite rational strategy for reshaping Santos after its near-death experiences of the past two years. It is, however, a strategy that lacks the “big bang” element of the plans that Origin Energy’s new chief executive, Frank Calabria, unveiled earlier in the week.

Santos and Origin’s fortunes have broadly mirrored each other since the oil price cracked so dramatically in 2014 and have done so for a very similar reason, the massive debt-funded commitments the two companies made to their respective export LNG projects in Queensland.

The weight of those interests in the two $25 billion projects that sit, with that of the now Shell-owned BG plant, on Curtis Island off Gladstone caused both companies immense financial stress and ultimately saw the departures of two long-serving and respected chief executives.

Both were forced to raise big lumps of capital, sell assets and slash costs and capital expenditures to ride through the stresses generated by OPEC’s ill-judged attempt to declare war on US shale producers.

With a truce now apparently declared, if only for the next six months, and the oil price surging above $US50 a barrel, both Gallagher and Calabria have an opportunity to shift the thinking within their organisations from survival mode to longer term positioning.

In Calabria’s case, with his big integrated energy markets group generating solid cash flows, the initial leg of the new strategy is to spin out Origin’s upstream conventional gas assets, which have an estimated value of more than $1.5bn.

The second leg, somewhere in the medium term, would be to do something similar with its 37.5 per cent stake in APLNG and the unconventional coal seam gas resources that support the project.

For Gallagher, without the big retail and power generation assets that create Origin’s integrated energy business — Santos is an “upstream” business — the strategy now being pursued is broadly similar but quite different in detail.

After being appointed CEO at the start of this year, he focused on continuing the cost-reduction and capital conservation program started by his predecessor, David Knox, while remaking his executive team, reviewing the Santos portfolio and selling peripheral assets to reduce debt.

The strategy unveiled at an investor briefing today puts some structure on top of a continuing effort to lower the group’s break-even costs, improve its free cash flows and reduce its debt levels further.

It’s not a complex strategy, which is a virtue.

Santos has five big assets — its historic Cooper Basin operations, its 30 per cent stake in the GLNG project on Curtis Island, its 13.5 per cent stake in PNG LNG and its Northern Australia and Western Australia gas resources. They represent the bulk of its value.

Santos described them today as five long-life natural gas assets which, as a portfolio, can aim at free cash flow break-even within a $US35 to $US45 a barrel oil price range and which have long-term revenue streams and upside opportunities. From now on, that’s where Gallagher’s focus and Santos’ investment will be targeted.

The rest?

There’s about 23 assets regarded as non-core. They include resources in Indonesia, Vietnam, Malaysia and Bangladesh, as well as the controversial Narrabri coal seam gas project in NSW, its interest in the Mereenie oil and gas field in the Amadeus Basin in the Northern Territory and a number of other interests in Australian offshore gas fields.

Those are going to be handed to former AWE CEO, Bruce Clement, to run as a stand-alone operation out of NSW with a mandate to “sweat or exit” them. Whether they are just milked for cash or divested, or even spun out or merged into some other vehicle, are presumably options that will be continually reassessed in the future.

Gallagher believes the separation of his five core assets from the rest will enable improved performance and more productivity gains. It will also enable the group to invest cautiously in the latent growth opportunities in those assets and, importantly, will be accompanied by an exploration effort focused on adding to their gas resources.

The market has been sceptical of the extent to which there are sufficient unconventional gas resources in eastern Australia (given that NSW and Victorian gas has been deemed untouchable by state governments) to support the three big Queensland LNG projects. It has been particularly sceptical about Santos’ ability to support its two-train project over its life.

The Santos presentation envisages a significant increase in drilling activity over the next two years after two years where the development of its gas reserves has been halted by the big cuts to capital expenditures as the group struggled to stabilise its balance sheet.

Santos will embark on the next phase of its post-crisis experience in stronger shape. It has lowered its free cash flow break-even point from $US47 a barrel to $US39 a barrel. Upstream unit production costs have fallen 17 per cent to $US8.52 per barrel of oil-equivalent. Net debt has been reduced $US455m to $US4.3bn, with a new target of less than $US3bn by the end of 2019.

That leaves Santos is a better position to weather any further oil price volatility and with significantly greater leverage to higher oil prices if OPEC can maintain the production discipline it agreed to just over a week ago.

Next year, Santos said, a $US10 a barrel movement in the oil price would have a $US300m impact of operating cash flows.

In the medium term, demand for oil and LNG is expected to continue to outpace the growth in supply, bringing the markets for both into balance over, in oil’s case, the next couple of years and, for LNG, early next decade.

For the past two years the objective for both Santos and Origin has been to ensure that they are around and intact at the point where their oversized and, with hindsight, unfortunately-timed investments in the Queensland LNG plants start to generate returns that eventually justify the colossal gambles the companies took.

In the absence of another oil price crash, the worst is behind both companies and they can shift their focus from simple survival to how best to position themselves, not perhaps for a return to the pre-2014 boom times, but at least for a more profitable and less stressful future.