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Is GLNG A Fizzer For Santos?

  The story so far: The world is awash with gas. From the mighty Qatari gas fields to India and Latin America, to America's burgeoning shale gas industry and the massive projects in Australia's Carnarvon Basin, the world has so much natural gas that while the spot oil price has recovered over 100% from its GFC lows, the spot natural gas price hasn't recovered at all. It is in this environment that investors are placing a lot of stake in Queensland's untried coal seam methane (CSM) LNG projects. Of the many competing projects in the Bowen Basin, Santos' ((STO)) Gladstone (GLNG) project is one of the most advanced, having already passed final investment decision (FID) status on a first LNG train. But to unlock true value on its Gladstone investment, Santos is trying desperately to reach FID on a second train, hoping to do so before the end of this year. The stock market is also hoping this will be achieved, because analysts are expecting a big re-rating of Santos shares if it is. The bottom line is Santos must convince potential long-term contract buyers of LNG that there is enough gas available to feed a second train (reserves at this point are not conclusive) and thus render offtake agreements secure. For a project of such size it is not beholden upon Santos to try to go it alone. Thus the other side of the offtake equation is to sell off shares in GLNG to other oil & gas majors to help finance the project and to provide global endorsement of the viability of GLNG. Great excitement was generated when Santos sold 35% of GLNG to Malaysia's energy giant Petronas back in May 2008 at a time when CSM seemed like the new iron ore. But that was then. Now, there is a race on to fill what is perceived as a brief window of opportunity of only a couple of years of excess gas demand from the likes of traditional buyers Japan, Korea and Taiwan and new buyer China, before global supply goes into surplus thereafter. Not all projects, across the Bowen Basin or even the Carnarvon Basin and indeed the world, will make it. As the clock ticks, finger nails are being chewed to the bone. With plenty of projects to choose from, it is a buyers' market. And the buyers, it would seem, are in no hurry. It is thus a great positive that Santos has now contracted out 7.2mtpa GLNG production at what analysts describe as “a very good price”. (Contract gas pricing is convoluted and based on a sliding scale against the oil price). But that is one positive among many negatives. Santos yesterday announced it had sold another 15% stake in GLNG to French energy giant Total for $650m, taking Total's stake to 20%. The announcement proved to be a huge disappointment to the market given the price was some 20% below expectation. If the market had already begun to get the jitters over the clock ticking on GLNG, this news was a kick in the teeth. Santos shares were down 7% yesterday, and are down another 3% in this morning's trade. If a 20% discount were not bad enough, in selling to Total Santos forgoes a $500m milestone fee which would have been paid by Petronas when (or if) GLNG train-2 reaches FID. So realistically, the net sale price was only $150m. What's more, Santos has now thrown in all of its 100% fringe CSM acreage to the total GLNG ownership pool for nix. If anything, the deal looks like a complete disaster. At least when compared to the excitement of 2008 when Origin Energy's ((ORG)) rejection of a bid from BG sparked an absolute CSM frenzy, and massive Australian gas stock re-ratings. However, stock analysts don't necessarily see it that way. Resource sector analysts have a favourite catch-cry in the concept of “de-risking”. Mining or energy projects of any sort may be valued in terms of reserves and exploration potential and sales contracts, but until certain milestones are reached analysts will always apply a valuation discount for execution risk. On that basis, target prices are often set well below potential discounted cashflow (DCF) valuations from the outset, with incremental re-ratings applied whenever some milestone or endorsement is achieved. For those analysts, Total's decision to put its hand in its pocket for another 15% of GLNG is a major endorsement, even if the price is largely a disappointment. When your back's against the wall, it's safer to play the odds. As JP Morgan this morning succinctly put it: “Yes, an argument could be made that it has sold equity in the project for less than what it may otherwise have achieved, but what price does one put on STO avoiding potentially infinite deferrals, missed LNG sales contracts, and ultimately being left with a very large and possibly unprofitable domestic gas project?” In other words, the Total deal is a bird in the hand in a highly competitive market. It ain't 2008 no more. All of Macquarie, UBS, Citi and RBS agree with JP Morgan. Yes – the price was disappointing. The champagne has been in the fridge for a while now yet no one felt moved to pop cork last night. But the deal nevertheless de-risks GLNG considerably, and CSM LNG was always going to be a long haul for the investor. As Citi notes, a discount to DCF is not unusual for a customer to pay. Woodside ((WPL)) sold 10% of the Pluto-1 project at a 33% discount to get that ball rolling. Unsurprisingly, all of the above brokers had, and still have, Buy ratings on Santos. But Credit Suisse begs to differ. “If anything, “said Credit Suisse this morning, “the [Total] deal substantiates the inherent risks we have previously noted regarding GLNG”. CS maintains an Underperform rating, preferring Queensland CSM LNG competitor Origin. And whatever value the more positive analysts may put in de-risking, they have not upgraded their price targets as de-risking might imply. The average has actually fallen 1% to $15.98. The problem is, having foregone the $500m milestone payment from Petronas, Santos is certain to have to raise some more funding from somewhere. Indeed, something in the order of $2-3bn. As to just how Santos will raise this required capital is a point of debate among analysts. A straight out rights issue is a possibility, but then with the Santos share price now heading south, perhaps this is not a good time to be further diluting equity at a low level. All analysts have thrown the likelihood of a debt/equity hybrid issue into the mix, while Macquarie suggests leasing arrangements and perhaps the cancellation of the Santos dividend could go some way to reducing the net raising. Either way, this not good news for shareholders, and likely the reason why Santos shares are continuing to fall in value today. Underlying all of this is a possibility thrown up by the recent lifting of foreign sale restrictions originally placed on Santos by a distant South Australian government in return for access to the Cooper Basin and gas supply deals. There is always a possibility one or other oil global major might prefer not to fanny about at the edges of CSM and just dive straight in and take out all of the company and its suite of oil and gas assets. But right now that possibility is a distant thought. And despite the implicit endorsement from Total, FID on GLNG by end-2010 is by no means a given at this stage. By Greg Peel