Papua New Guinea shares the island of New Guinea with Indonesia. The nation has a population of just over 6 million people and is just a touch larger than California. With a per capita gross domestic product  of about USD2,500, Papua New Guinea (PNG) is a frontier economy that, like neighboring Indonesia, is rich in oil, natural gas and other vital resources.

Oil Search (ASX: OSH, OTC: OISHY) is headquartered in PNG’s capital of Port Moresby, located on the country’s southern coast. The company’s main base of operations includes the Gulf of Papua, located to the northwest of Port Moresby, as well as the Southern Highlands province.

Oil Search’s 2010 production amounted to 7.657 million barrels of oil equivalent, more than 88 percent of which was crude oil. Note that this is an annual production figure, not barrels per day. The company’s production has declined steadily over the past five years, as depicted in the graph below.

Source: Oil Search

Five years ago, Oil Search produced more than 10 million barrels of oil equivalent; at the end of 2010, its output had declined by roughly 25 percent–largely because of declining pressure in its mature wells.

The company has taken steps to offset that decline, drilling new wells in these older fields that target untapped pockets of oil. For example, Oil Search has sunk wells in Agogo, a smaller satellite field that’s adjacent to Kutubu, the firm’s largest play. One of these wells struck oil and now produces 1,500 to 2,000 barrels per day.

Fields such as Agogo should help to offset declines in Oil Search’s mature fields over the next few years. Management expects the company’s oil production to hover between 6.2 and 6.7 million barrels per year range in 2011-13. For comparison, the firm produced about 6.768 million barrels of crude oil 2010.

Rising oil prices have helped the the company’s bottom line and offset recent output declines. In 2010, for example, Oil Search’s output declined roughly 6 percent from the prior year, but revenue surged 14 percent and earnings before interest and taxation jumped 27 percent.

If all Oil Search had to offer was declining output from a handful of aging oilfields, the stock wouldn’t warrant a second look. But the company is in the midst of a transformation that should quadruple its production. The main driver of this is the Papua New Guinea LNG (PNG LNG) project.

Management estimates that constructing the PNG LNG facility will have cost $14 billion by the time it’s completed in 2014. PNG’s economy is expected to grow about 8 percent and double in size over the next five to seven years, with the PNG LNG deal contributing the majority of that growth.

The main PNG LNG complex is located near Port Moresby and will consist of two LNG liquefaction trains, each capable of producing about 3.3 million metric tons per annum (MTPA) of LNG for export. Gas to feed these trains will be sourced from the Hides, Angore and Juha gas fields located onshore in PNG. Additional gas supplies coproduced from Oil Search’s oil plays will feed these plants.

Like most projects of its size, PNG LNG is owned and funded by a consortium of companies. In this case, ExxonMobil Corp is the largest stakeholder, with a roughly one-third share, and will operate the facility. Oil Search, which holds a 29 percent stake in the project, is the second-largest player in PNG LNG. In addition, the company is responsible for producing the fields that will supply natural gas to the PNG LNG trains.

Although owning ExxonMobil would give investors exposure to the PNG LNG project, this endeavor is one among many for the integrated energy giant. With a market capitalization of roughly USD1 billion, the PNG LNG project could move Oil Search’s earnings needle substantially.  

Other major stakeholders in PNG LNG include the PNG government, which holds a16.8 percent stake; Australian energy firm Santos (ASX: STO, OTC: SSLTY), which owns a 13.5 percent stake; Nippon Oil, which owns a 4.7 percent interest; and local landholders who collectively hold a 2.8 percent interest in project.

PNG LNG is slated to come online in 2014, with both trains running by year-end. Oil Search’s share of total production will be 18 million barrels of oil equivalent per year–a huge uptick from its 2010 output of 7.6 million barrels of oil equivalent per year.

Long-term supply agreements with major gas consumers cover 100 percent of PNG LNG’s total capacity.

Source: Oil Search, Santos

Not surprisingly, China and Japan feature prominently in the customer list and would likely be interested in purchasing additional LNG volumes.

Oil Search is working on this angle. The company is performing detailed seismic surveys of some of its onshore and offshore blocks as it prepares to ramp up exploratory drilling. Management hopes that this initiative will identify additional gas reserves that would support a third or fourth LNG train.

In addition, the project partners may be able to make some more modest changes to the engineering of the two planned trains to increase their capacity by 0.3 MTPA.  

On March 28, 2011, Oil Search hosted an analyst meeting and tour of its facilities in PNG. Management indicated that they would like to accelerate some of their exploratory drilling work in either later this year or in 2012. As it’s much cheaper to build an additional train on an existing site than preparing a greenfield location, Oil Search and its partners likely will decide to add at least one additional train to the PNG LNG project. Management also indicated that recent events in Japan and the Middle East will only enhance Asian demand for reliable LNG supplies.

The financing for the project is already in place, with debt funding about 70 percent of the project. Oil Search will owe another $1.2 billion related to the project over the next three years, but strong cash flows from its existing oil projects should be enough to foot the bill. In addition, Oil Search would likely have no trouble tapping the debt markets if additional capital were necessary.

Finally, it always helps to have the most deep-pocketed company on the planet as a lead partner in a project of this magnitude. ExxonMobile has invaluable experience completing projects of this magnitude.

Oil Search’s American depositary receipts (ADR) trade thinly–only a few thousand shares change hands on most days. Investors should buy the local shares on the Australian stock exchange to ensure sufficient liquidity. Buying shares in Australia used to be a pain for US-based investors, but many brokers will now handle such transactions and some will handle the trades online. Investors who opt for the ADRs should use a limit order to avoid overpaying for the stock. Oil Search, a new addition the Gushers Portfolio, rates a buy under AUD8; the company’s ADR, which represents 10 local shares, rate a buy up to USD85. Note that the model Portfolio will track the local shares.