2014 was a horror year for investors in crude oil, with the base commodity falling almost 60% amid a global supply glut. The year was even worse for investors holding oil-related stocks like Santos Ltd (ASX: STO), Oil Search Limited (ASX: OSH), Origin Energy Ltd (ASX: ORG) and Woodside Petroleum Limited (ASX: WPL), which cumulatively shaved 500 points off the S&P/ASX 200 Index and accounted for most of the 50% fall in the S&P/ASX 200 Energy Index (ASX: XEJ).
Halfway through 2015, Origin Energy, Oil Search and Woodside Petroleum have all clawed back some losses, but Santos is still trading near 2014 lows despite an increase in crude oil prices in the first half of 2015. I believe this presents a great buying opportunity for a long-term investment in Santos.
Out of favour
Santos is highly leveraged to the oil and gas sector, with net debt of $7.5 billion. It currently has two liquefied natural gas (LNG) projects under construction — PNG LNG and GLNG — with the latter set to produce first gas in the second half of 2015. The cause for concern around Santos is related to these two LNG projects.
PNG LNG and GLNG give Santos a combined capital expenditure (capex) burden of $2 billion, resulting in Santos only producing free cash flows from these projects if crude oil stays above US$40 per barrel. Accordingly, many investors consider Santos to be a risky proposition, given current volatility in crude oil markets globally.
A long-term opportunity
Despite market concerns, I believe Santos provides a deep-value opportunity for the long-term investor. Santos' CEO, David Knox, ruled out an equity raising when he last presented results in February this year, indicating Santos' balance sheet (and debt covenants) can withstand short-term fluctuations in commodity prices. The 15% uptick in crude oil since January should have provided respite to Santos' bottom line, however its shares have risen immaterially over this time, substantially underperforming peers Origin and Woodside Petroleum (which have risen 13% and 11%, respectively in the same period).
Therefore, concerns around the capex requirements surrounding PNG LNG and GLNG and volatility in oil prices appears to be placing downward pressure on Santos' share price.
Foolish takeaway
With Santos set to produce first gas from GLNG by Q4 this year, balance sheet concerns should subside as the company will comfortably produce free cash flow from LNG at current spot prices. Furthermore, with natural gas demand set to outstrip supply until 2020, and an indication that the excess supply in oil is beginning to be absorbed by demand, Santos stands to benefit from future rises in oil and gas prices by being most leveraged to those sectors.
Therefore, despite being a riskier play in the oil and gas sector, I believe Santos will manage its capex burden, materially increase dividends and outperform its peers as the oil price bottoms and its LNG trains come online, providing a long-term buy opportunity for the patient investor.
