Oil Search Ltd: An International Favorite
By: David Dittman

Oil Search Ltd (ASX: OSH, OTC: OISHF, ADR: OISHY) is a pure play on rising demand for liquefied natural gas (LNG) in Asian emerging markets.

Oil Search’s key project is the 6.6 million tonne per annum (Mt/a) Papua New Guinea (PNG) LNG project, currently under construction and operated by Super Oil and 33 percent owner ExxonMobil (NYSE: XOM). As of a Dec. 1, 2011, project update PNG LNG, in which Oil Search has a 29 percent stake, remains on track to achieve first LNG sales in 2014.

All of the contributing fields are located in the Southern Highlands and Western provinces of PNG. Over 9 trillion cubic feet of gas and 200 million barrels of associated liquids are expected to be produced over the Project life. The gas will be conditioned in the PNG Highlands and then transported by gas pipeline to an LNG plant located approximately 20 kilometers northwest of Port Moresby. The gas will then be liquefied at the LNG plant prior to loading onto ocean-going tankers to be shipped to international markets.

In the December update Oil Search and development partner Santos Ltd (ASX: STO, NYSE: STO), which owns 13.5 percent, revealed a USD700 million, or 5 percent, gross capital expenditure budget increase for PNG LNG to USD15.7 billion, a cost “blowout” foretold by the Australian’s dollar’s rise since the final investment decision on the project was made. Cost overruns have become a major point of concern for Australia-based LNG projects, but even assuming an all-in CAPEX budget somewhere closer to even USD17 billion, as some analysts have done, PNG LNG boasts attractive return potential.

The capital cost increase will be funded with the project’s existing financing terms, namely 70 percent debt and 30 percent equity contributions from Exxon, Oil Search and Santos. An existing USD14 billion project finance facility provided by export credit agencies, commercial banks and lending from co-venturers, including Nippon Oil, a unit of JX Holdings Inc, and Papua New Guinea government and landowner interests, will cover the component of the increased cost that will be funded by debt.

Oil Search has ample liquidity to fund its increased equity contribution to PNG LNG without threatening the exploration and appraisal programs elsewhere in PNG and overseas that will prove critical to providing the cash flow to fund investment in more PNG LNG trains.

Based on the revised capital costs, Oil Search’s remaining equity share of costs up to first gas is approximately USD750 million, which is fully covered by the company’s current cash position of over USD1 billion. Strong oil prices and solid production continue to lead to ample cash flow for Oil Search. It also has a debt facility of USD263 million, which is currently undrawn.

First-phase capacity from PNG LNG is fully contracted under long-term arrangements with four key buyers, including TEPCO (1.8 Mt/a) and Osaka Gas (1.5 Mt/a) from Japan, CPC from Taiwan (1.2 Mt/a) and Sinopec (2.0 Mt/a) from China. Feedstock will come from the Hides, Angore and Juha fields as well as natural gas co-produced by Oil Search’s oil fields. All of these fields are conventional onshore plays, so the technical risks associated with this project are less than those that depend on extensive offshore developments.

Heightened sensitivity to cost overruns has left some investors skeptical about the long-term viability of large-scale Australia-focused LNG projects. Despite the fact that PNG LNG represents an enormous portion of Oil Search’s asset base, cost overruns won’t threaten the company’s ability to generate a solid return, in no small part because its location means it’s not subject to prevailing Australian wage pressures.

The biggest upside for Oil Search stock will likely come from efforts to add trains to the PNG LNG project, which depend on ambitious exploration and appraisal efforts in the Highlands region of PNG and in the Gulf of Papua basin.

Oil Search embarked on the most ambitious quarterly drilling programs in its history during the last three months of calendar 2011, a program that will stretch through 2012 into 2013. Targeted fields hold potential for multi-trillion cubic feet gas development and several hundred million barrels of oil. Appraisal and development drilling commenced with the sinking of the P’nyang South well in the fourth quarter. Management is looking to P’nyang and others to underwrite continued gas commercialization and short-medium term oil production. The Trapia 1 exploration well will spud in the first quarter of 2012.

Oil Search’s total oil and gas production for the third quarter of 2011 was 1.49 million barrels of oil equivalent (boe), 16 percent lower than second-quarter production of 1.77 million boe because of a planned two-week shutdown of the Central Processing Facility and Agogo Processing Facility for the Associated Gas tie-in project, to enable oil field gas to be delivered to the PNG LNG project.

Production has since returned to pre-shutdown levels, with output for the year expected to be towards the upper end of the forecast range of 6.2 to 6.7 million boe.

Total oil production for the quarter was 1.21 million barrels, with 1.21 million barrels of oil sold during the quarter at an average price of USD117.54 per barrel. The realized price was 4.7 percent below the second quarter of 2011 but 48.7 percent above the corresponding quarter of 2010. Oil Search remained unhedged during the period.

Total operating revenue was USD160.2 million, 26.4 percent lower than 2011 second-quarter revenue of USD217.8 million, primarily reflecting lower oil sales.

Oil Search spend USD55.7 million during the quarter on exploration and evaluation activities, USD308.5 million on the PNG LNG project and USD42.6 million on oilfield development work.

Oil Search is a favorite among analysts who cover it, with 15 rating it a “buy,” while just one rates it a “hold” and one a “sell.” Management reduced the dividend in 2009 to cope with the impact of the Great Financial Crisis and resulting global economic slowdown. Successful, efficient development of PNG LNG within reasonable range of the current USD15.7 billion budget should ensure significant dividend growth in future.