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Research Update: Santos Ltd. 'BBB-' Ratings Affirmed, Outlook Stable

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Research Update: Santos Ltd. 'BBB-' Ratings Affirmed, Outlook Stable

(Editor's Note: This research update was republished on March 17, 2021, to correct an error in the Country risk score in the Ratings Score Snapshot. A corrected version follows. )

Rating Action Overview

  • S&P Global Ratings has revised its industry risk assessment for the oil and gas exploration and production sector to moderately high from intermediate.
  • Partially offsetting the revised industry risk assessment is our view that Adelaide-based natural gas company Santos Ltd. has improved its asset diversity and portfolio resilience through the cycle.
  • We are affirming our 'BBB-' long-term issuer credit rating Santos. We are also affirming our 'BBB-' long-term issue rating on the company's senior unsecured debt.
  • The stable outlook reflects our view of Santos' capacity to fund its upcoming Barossa project while sustaining its improved credit metrics over the next 12-24 months.

Rating Action Rationale

Risks for oil companies are escalating amid rising environmental, social, and governance (ESG) awareness and the broader global energy transition.  We have revised our industry risk assessment to reflect our view that producers face increased uncertainties about profitability, volatility, and the evolution of the energy transition. Increasing adoption and transition toward renewable energy to address climate change are likely to have broad implications for hydrocarbon demand, prices, and producers of fossil fuels. Based on the greater industry risk and on a relative basis, we view Santos' business risk to have incrementally weakened and as such we expect moderately stronger financial metrics for the 'BBB-' rating.

The global energy transition will continue to accelerate due to the COVID-19 pandemic and the growing adoption of ESG investment mandates among global investors and financial institutions, in our view. As a result, the risk of divestment and capital market access may become more challenging and costly for hydrocarbon producers. Moreover, declining industry profitability over the past decade underscores increased industry cyclicality.

In our opinion, Santos has successfully executed its strategy to improve its portfolio's resilience and asset diversity. The company's focus on improving its unit production cost profile across assets and increasing exposure to consumer price index-linked fixed-price gas volumes in the domestic market has supported its resilience and cash flow amid weak oil prices. In addition, Santos' hedging activity and long-term liquefied natural gas (LNG) supply contracts helped it to weather the highly volatile external environment in 2020. We believe, the company's good free cash flow amid tough conditions provide some financial buffer as it approaches the final investment decision (FID) on upcoming projects.

We expect developing Asian countries to use LNG as a first step away from their currently high thermal coal dependence. To this end, we expect Asia to lag developed regions where the transition is progressing more rapidly toward renewable energy. We believe Santos' geographic proximity, cost advantage, and long-standing customer relationships in Asian markets provide it with an advantage in capturing the fundamental energy demand requirements in the region.

We forecast Santos' ratio of funds from operations (FFO) to debt to be 27%-32% in 2021 largely driven by improvement in oil price environment compared to 2020. To maintain the 'BBB-' rating, we expect the company to sustain its FFO-to-debt ratio above 25% through the cycle. This is a more onerous threshold than 20% before and reflects our weaker industry risk assessment and Santos' relative positioning against global peers. Our upgrade threshold has also been increased, to 35%, reflecting the stronger financial metrics required to support a higher rating level. In our view, if Santos were to proceed with all of its growth projects at Brent oil prices of US$50/barrel (/bbl) or below in 2021-2022 and US$55/bbl or below in 2023 and beyond, its credit measures would likely come under pressure absent material capital management levers being pulled, project sell-downs, or capex phasing.

In our view, Santos' role as the operator of its upcoming growth pipeline (Barossa, Moomba Carbon Capture Storage, Narrabri, and Dorado) gives it the flexibility on the phasing and progress of its developments. The company expects to make a FID on its Barossa backfill to Darwin LNG (DLNG) project (US$3.6 billion total project cost, Santos interest is 62.5%) in the first half of 2021. We believe Santos has sufficient headroom to proceed with its Barossa project because the FID would result in the sell down of its 25% stake in the DLNG and Bayu-Undan projects. Santos is also likely to sell down 12.5% in Barossa upon the FID. In addition, consideration for a hybrid funding structure for the project's floating production storage and offloading (FPSO) vessel could help reduce the project's capital intensity. However, we would account for the lease obligation and incremental operating costs in our analysis, should this occur.

Despite our view on Santos' current headroom, sanctioning of multiple growth projects in the next 12-18 months without a sustainable funding strategy would indicate a risk appetite that is no longer consistent with a 'BBB-' rating. For example, a willingness to progress on projects with a high ownership stake or with low contracted volumes could pressure our key credit measures in the absence of a materially firmer oil price outlook. We expect Santos to continue to manage its FID timelines with prudence and subject to market conditions.

Outlook

The stable outlook reflects our view of Santos' financial buffer to fund its upcoming Barossa project while sustaining FFO-to-debt above 25% over the next 12-24 months. The company's careful management of production costs, low exposure to spot prices, increased production volumes, and active hedging programs support our view.

Downside scenario

We could lower the rating if we expect Santos' FFO-to-debt ratio to be sustained below 25%. This could occur from one or a combination of:

  • Significant debt-funded growth capital expenditure;
  • Delays and cost overruns at growth projects;
  • Operational underperformance;
  • Persistently weak oil prices; or
  • Greater government intervention in the Australian domestic gas market, or actions to avoid such intervention, that materially reduce profitability.

A downgrade is also possible if Santos undertakes material asset sales that weaken its competitive position without an offsetting strengthening of the company's financial position.

Upside scenario

Upward rating momentum could arise if Santos' management demonstrates a commitment to, and track record of, robust financial policies to sustain a stronger financial profile. The FFO-to-debt ratio sustaining above 35% while the company pursues growth opportunities and any capital management objectives would indicate such improvement.

Company Description

Santos is a midsize exploration and production company based in Australia, with annual production of 89 million barrels of oil equivalent (mmboe) in 2020. Gas, ethane, and liquified gas contributed about 74.0% of Santos' revenue in 2020, with crude oil (15.7%), condensate (7.6%), and liquefied petroleum gas (LPG; 2.8%) accounting for the rest. Santos' business and earnings composition is primarily derived from LNG and gas sales and production.

Our Base-Case Scenario

Assumptions
  • Asia-Pacific real GDP growth of 4.0% in 2021 and 3.2% in 2022;
  • S&P Global Ratings' price deck assumptions for Brent crude prices of US$50/bbl in 2021 and 2022, and US$55/bbl in 2023 and thereafter;
  • Australian dollar to U.S. dollar exchange rate of US$0.73 in 2021 and US$0.74 in 2022;
  • Forecast production volumes of between 84 mmboe and 91 mmboe in 2021;
  • Forecast sales volumes of between 98 mmboe and 105 mmboe;
  • Upstream unit production costs of between US$8/barrels of oil equivalent (boe) and US$8.50/boe in 2021, with a 2021 target free cash flow breakeven oil price of less than US$25/boe;
  • Capital expenditure (capex) of about US$1.6 billion (including US$700 million of major growth);
  • Dividend payout ratio of 10%-30% of free cash flow.

Based on these assumptions and various sensitivities, we estimate the following credit measures:

  • FFO-to-debt ratio of 27%-32% in 2021 and 2022;
  • Debt-to-EBITDA ratio of 2.7x-3.3x in 2021 and 2022;
  • Modestly positive discretionary cash flow (after dividends).

Liquidity

We assess Santos' liquidity as strong. We expect the company's sources of liquidity to exceed its uses by more than 1.5x over the 12 months ending Dec. 31, 2021. This measure is likely to remain more than 1x over the next 24 months. We expect net sources and uses of liquidity to remain positive even if EBITDA were to decline by 30%.

We expect Santos to maintain solid banking relationships and retain access to bank and debt capital markets. This was demonstrated in 2020, when the company completed a US$750 million five-year syndicated facility consisting of a US$550 million term loan tranche and a US$200 million revolving tranche.

Our assessment of the company's liquidity considers the following sources and uses over the next 12 months as of Dec. 31, 2020:

Principal liquidity sources:

  • Cash on hand of about US$1.3 billion;
  • About US$1.9 billion in undrawn bank facilities maturing beyond 12 months; and
  • Our estimate of about US$1.5 billion cash FFO.

Principal liquidity uses:

  • Minimal debt maturities;
  • Capex of about US$1.6 billion (including US$700 million of major growth); and
  • Dividend payout ratio of 10%-30% free cash flow.

Covenants

Santos remains compliant with financial covenants. We expect the group to maintain ample covenant headroom such that it could absorb a 30% decline in EBITDA without breaching key covenants. Key financial covenants include leverage (net debt to EBITDAX [EBITDA before exploration]), interest coverage, and a net debt-to-equity ratio.

Issue Ratings - Subordination Risk Analysis

Capital structure

As of Dec. 31, 2020, Santos' capital structure consisted of about US$4.3 billion of drawn debt. The company's weighted-average debt maturity was about 4.6 years.

Funding remains well diversified and includes syndicated bank facilities across both domestic and international banks (undrawn), Papua New Guinea LNG (PNG LNG)project financing (US$1.2 billion, Santos' share: 13.5%), export credit agency loans (US$283 million), term bank loans (US$1.45 billion, including US$200 million of revolving credit facilities), and Regulation S bonds (US$1.4 billion), as well as U.S. private placement market bonds (US$227 million).

Analytical conclusions

We rate Santos' debt at 'BBB-', in line with the issuer credit rating, given that no significant elements of subordination risk are present in the capital structure.

Ratings Score Snapshot

Issuer Credit Rating: BBB-/Stable/--

Business risk: Satisfactory

  • Country risk: Low
  • Industry risk: Moderately high
  • Competitive position: Satisfactory

Financial risk: Significant

  • Cash flow/Leverage: Significant

Anchor: bbb-

Modifiers

  • Diversification/Portfolio effect: Neutral (no impact)
  • Capital structure: Neutral (no impact)
  • Liquidity: Strong (no impact)
  • Financial policy: Neutral (no impact)
  • Management and governance: Satisfactory (no impact)
  • Comparable rating analysis: Neutral (no impact)

Stand-alone credit profile: bbb-

Related Criteria

Ratings List

Ratings Affirmed

Santos Ltd.

Issuer Credit Rating BBB-/Stable/A-3

Santos Finance Ltd.

Senior Unsecured BBB-

S&P Global Ratings Australia Pty Ltd holds Australian financial services license number 337565 under the Corporations Act 2001. S&P Global Ratings' credit ratings and related research are not intended for and must not be distributed to any person in Australia other than a wholesale client (as defined in Chapter 7 of the Corporations Act).

Certain terms used in this report, particularly certain adjectives used to express our view on rating relevant factors, have specific meanings ascribed to them in our criteria, and should therefore be read in conjunction with such criteria. Please see Ratings Criteria at www.standardandpoors.com for further information. Complete ratings information is available to subscribers of RatingsDirect at www.capitaliq.com. All ratings affected by this rating action can be found on S&P Global Ratings' public website at www.standardandpoors.com. Use the Ratings search box located in the left column.

Primary Credit Analyst:Victor Lai, CFA, Melbourne + 61 3 9631 2008;
victor.lai@spglobal.com
Secondary Contact:Graeme A Ferguson, Melbourne + 61 3 9631 2098;
graeme.ferguson@spglobal.com

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