Santos faces takeover dilemma after Harbour Energy’s new bid

Harbour’s well-timed pitch comes at a time of stronger oil prices, with Santos in the early stages of a significant reshaping.

CEO Kevin Gallagher addresses Santos’s AGM in Adelaide. Picture: Mike Burton

The board of Santos has, in the post-oil price crash environment, been steadfastly dismissive of takeover approaches.

Its willingness to grant access to due diligence to Harbour Energy, therefore, indicates how well-timed and pitched the energy investor’s latest approach has been.

At the equivalent of $6.50 per share, or nearly 30 per cent higher than Santos shares had been trading, the indicative offer — worth about $13.5 billion in total — had to be taken seriously by the board that had rejected an approach from Harbour last year with an offer that was about $1.20 a share lower because of its conditionality and inadequacy.

Nevertheless, it will create a dilemma for the board given that Santos, so leveraged to oil and gas prices, is still in the early stages of a significant reshaping under Kevin Gallagher that is now combining with a sustained period of stronger oil prices.

Given that the recovery in the oil price, which flows through to LNG pricing, has been driven by the continuing extension of production curbs by OPEC and some key non-OPEC producers, there is a question mark over their longer term sustainability.

In the medium term, however, the seemingly inexorable growth in demand for LNG in the Asia Pacific region and the hiatus that has occurred in oil and gas investment during the post-2014 period — when the oil price collapsed from above $US100 a barrel to, in early 2016, below $US30 a barrel — appears to underwrite the potential for demand to increase in the context of higher LNG prices.

Santos, with its 30 per cent in the GLNG export LNG project off Gladstone, its 13.5 per cent interest in the PNG LNG project in Papua New Guinea, its Darwin LNG project and its West Australia gas assets, is very leveraged to that outlook for gas demand and prices.

With Santos having reduced its cashflow break-even point from its recent peak of around $US47 a barrel to $US32 a barrel, and a $US $US10 a barrel movement in the oil price currently adding between $US250 million to $US300 million to its free cashflows, that future outlook has a much greater weighting in its valuation than has its recent past.

When the oil price imploded in mid-2014 Santos was, with Origin Energy which had its own export LNG project, still in the construction phase for GLNG and therefore was both operationally and financial leveraged and very vulnerable.

Gallagher and his board have dramatically reduced the financial leverage through equity raisings and asset sales, with net debt falling from more than $US6 billion to $US2.7 billion while, by reducing units costs by nearly 20 per cent, increasing the operational leverage.

The positive trends within the basics of the business are continuing even as the cash flows from the group’s LNG portfolio, and most importantly GLNG, are surging. Santos’ contribution from GLNG was, for the first time, positive last year. Over the past two years there has been a $US1.4 billion improvement in the group’s cash flows, from a negative $US739 million to last year’s positive $US618 million.

Santos prepares an LNG shipment from Gladstone.

Having previously rebuffed Harbour Energy, as well as previous overtures from the mysterious but well-connected Scepter Partners, Santos will have quite a complex and difficult evaluation of its position and prospects to undertake should Harbour firm up its offer after it has conducted its due diligence assessment. That it is prepared to let Harbour inside the business suggests it believes the offer is “there or thereabouts”.

Harbour, it should be said, is a serious player. It was formed and is managed by EIG Energy Partners, which has a portfolio of $US17.7 billion of mainly energy investments including significant exposures to LNG and to unconventional gas assets.

EIG also has some history with key Santos assets. It was a lender to Tipperary Corp before Santos acquired that company’s Queensland coal seam gas assets — which underpin the GLNG project — for $US612 million in 2005.

Harbour chief executive Linda Cook, a former senior Shell executive with deep experience in LNG, led the vehicle’s first acquisition, the $US3 billion acquisition of Shell’s North Sea oil and gas assets last year and a successful Santos acquisition would be a major step towards realising Harbour’s ambition of being a global player in gas.

The group is clearly mindful of local sensitivities and potential stumbling blocks. If it proceeds with a successful bid it has pledged to retain Santos’ head office in South Australia, to invest in its assets and to acquire more natural gas and LNG assets in Australia and elsewhere, and claims its plans will contribute to Australia’s domestic energy security and economic growth.

When Harbour approached Santos last year, the South Australia government vowed to do whatever it could to block any takeover, while the issue of domestic gas availability and pricing — and the availability and pricing of energy more generally — has become a major national political issue.

Within the outline of the proposed offer provided today was the ability for Santos shareholders to elect to take scrip in the unlisted bid vehicle, with a minimum participation level of 15 per cent of shareholders and a maximum of 20 per cent.

That’s very clearly targeting Santos’ two Chinese strategic shareholders, ENN Group and Hony Capital, which between them own 15 per cent. ENN is one of China’s biggest gas distributors and Hony is biggest private equity group.

Harbour would be mindful that the agreement the two companies have with Santos that the shares they hold will vote and act in line with the recommendations of a majority of the board doesn’t preclude them from mounting their own counter to any offer. It is inviting them into its bid to try to head off that prospect as well as, presumably, to retain the valuable relationships they represent and the connections they have within China.