Three years ago, Santos Ltd (ASX: STO) traded at $15 per share. Today, it is priced at $3.50 per share thanks to a decline in the company’s financial performance. Santos made a loss of US$1.6 billion in the first half of the 2016 financial year. This was due mostly to an impairment of US$1.5 billion, but even so its profitability has deteriorated on an adjusted basis, too.

However, due to a bright demand outlook for LNG, could Santos become a successful recovery play and return to $15 per share?

LNG demand

Over the next four years, demand for LNG is forecast to rapidly rise. In China, LNG import growth is expected to ramp up as it retires 400,000 small-scale coal boilers in the industrial sector over the next two years. Many of them will be replaced by gas boilers as China seeks to improve air quality through a move away from thermal coal and towards cleaner burning LNG.

However, future demand from the world’s two biggest importers of LNG, Japan and South Korea, is uncertain. Imports in Japan fell by 6% in the first seven months of 2016 due to an increase in coal use. In South Korea, a nuclear reactor restart and new coal-fired power plants could also peg back demand for LNG in future years.

LNG supply

Even if there is an increase in demand for LNG, Santos and sector peers Woodside Petroleum Limited (ASX: WPL) and Origin Energy Ltd (ASX: ORG) may still struggle. That’s because any increase in demand is forecast to be more than offset by a rise in supply. LNG supply is due to increase by 50% between now and 2020. Much of this is expected to come from up to 130 million metric tons per annum of approved new LNG capacity. This will predominantly be from the US and Australia.

Beyond 2020, there is little sign that the ramp-up in production will slow down. This could mean a further increase in supply beyond the next four years, which would depress LNG prices and hurt Santos’ financial performance.

Financial strength

Santos’ financial standing provides little evidence that it will be able to turn a profit given a prolonged downturn in the LNG market. Total debt levels were only US$11 million lower at 30 June 2016 than they were a year earlier. They stand at US$5.4 billion and Santos has a debt to capital ratio of 46%. Although net operating cash flow of US$291 million covered interest repayments of US$105 million in the first half of financial year 2016, further falls in profitability could reduce headroom to zero.

Outlook

Santos is forecast to return to profitability on an adjusted basis in the full 2016 financial year following last year’s loss. However, even factoring in EPS growth of 27% in the 2017 financial year, Santos has a forward P/E ratio of 29. In my view, this shows that even at today’s price of $3.50 it is overvalued given the uncertain outlook for LNG over the medium term. Therefore, a return to $15 per share seems very unlikely.

In my view, Santos is definitely not the right stock to buy if you are seeking to turn $10,600 into $8 million, as this investor was able to achieve.

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Motley Fool contributor Robert Stephens has no position in any stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.