Santos nears cash flow inflection point – Takeover rumours are a cherry on top

Santos (ASX: STO) investors have endured a challenging journey in pursuit of meaningful upside. The stock has gone nowhere in the past four years, grappling with multiple headwinds including regulatory uncertainty, steadily declining production, a substantial capital expenditure cycle, and difficulties in realising the full value of its assets.

But an inflection point is fast approaching and recent takeover rumours add a cherry on top.

Energy giants circle

Saudi Aramco and Abu Dhabi National Oil Co have been separately considering bids for Santos, Bloomberg News reported on Thursday.

"State-owned Aramco and ADNOC have been conducting preliminary evaluations of Santos as a possible acquisition target," says the report.

"Gulf countries are investing billions of dollars in gas, which is seen as an important bridge fuel in the energy transition. Qatar plans to nearly double LNG export capacity, and Saudi Arabia and the United Arab Emirates are pumping cash into domestic fields and building trading operations globally. "

Santos is no stranger to takeover bids. In 2018, they rejected multiple offers from US-based Harbour Energy. More recently, they ended talks with Woodside after preliminary discussions failed to reveal a merger that would benefit shareholders.

Santos stands out as a company where the value of its individual projects exceeds that of the unified whole. Melbourne-based fund manager L1 Capital has been a major advocate of breaking up the business. In their March quarter report, they stated:

"We maintain that Santos remains a highly compelling investment opportunity. The company has several operational and structural catalysts poised to drive significant shareholder value in the medium term. Our ongoing analysis consistently indicates substantial upside potential to the current share price when evaluated on a sum-of-the-parts basis."

Earnings inflection

Macquarie says Santos could re-rate as the company approaches a free cash flow inflection point and as the probability of corporate activity rises due to its portfolio streamlining towards LNG.

Major project capital expenditure has surged from approximately US$500 million in 2021 to over US$1.5 billion annually in 2023 and 2024. This significant increase has weighed on the company's free cash flow. However, Santos anticipates that major project capex will reach its peak in 2024 before declining sharply to less than US$250 million by 2026.

For additional context, Macquarie analysts have provided the following projections for the next three years:

Source: Macquarie Research, May 2024

The above assumes oil prices (Brent) of US$80.3 in 2024, US$68.7 in 2025 and US$65.5 in 2026.

More sell down rumours

During the company's half-year FY24 earnings call, Chief Executive Kevin Gallagher said: "We welcome shareholder feedback and opportunities or ideas to unlock or to create shareholder value ... we'll continue working with our advisers to evaluate, develop and negotiate or implement any of those opportunities or ideas as we go forward."

This communication has seen rumours emerge across several assets, including:

• 8 May: Santos exploring a sell-down of its Pikka Project

• 15 May: Santos lays off approximately 200 staff, citing slower project approval times

• 16 May: Speculation that Santos is preparing to relaunching its sale process for its stake in Dorado. Last year, Santos had Goldman Sachs assessing suitable offers for the interest of the project, according to The Australian

• 27 May: Jadestone Energy, Beach Energy and Hibiscus Petroleum as well as The Carlyle Group were among the parties that are likely to line up for Santos Western Australia-based assets, according to The Australian

Where could things go wrong?

Strong cash flows, growing production, elevated oil prices and compelling free cash flows ... so how could things go wrong?

#1 Rumours stay rumours: While divestment rumors swirl around these assets, it's crucial to consider the possibility that these talks may not materialise. If negotiations fail to produce concrete results, Santos could remain intact as its current unified entity.

#2 LNG prices: Santos will maintain its focus on LNG production, which accounted for about 56% of its total output in FY23. Throughout 2023, the global LNG market rebalanced, primarily due to weaker-than-expected demand. LNG prices have softened year-to-date, influenced by record gas storage levels in Europe and Asia.

Despite a bullish outlook for the medium-to-long term, including forecasts of a significant supply deficit in 2025 and LNG's crucial role in the energy transition from coal to gas, Santos may face continued near-term volatility.

LNG Asia (blue) and Natural Gas Henry Hub (Red) | Source: TradingView