I think Oil Search Limited (ASX: OSH) is worthy of further investigation by investors looking for an oil and gas investment.
The company has good assets in what appears to be a very resource-rich area of the world, given that 85% of Oil Search's wells drilled in the past 5 years have struck oil. Additionally, it has a low sustaining cost of production, equivalent to approximately US$28 per barrel including sustaining capital expenditure and interest + principal repayments. This compares favourably with other peers like Woodside Petroleum Limited (ASX: WPL) and is lower than Santos Ltd's (ASX: STO) cost of production.
Oil Search also has several major prospects for expansion, can run additional LNG trains, and exploit the promising Antelope and Muruk fields. Thus, production could easily grow.
However, with regards to the company's valuation, its debt situation, and the state of global commodity markets, I'm not keen on Oil Search today. Here's why:
- Net debt is quite high, equivalent to 70% of equity
- Although the company touts $1.5 billion in liquidity, at current oil/gas prices it will struggle to fund its expansion from cash flows as it has previously suggested
- It's expensive by any measure – valued at 32x last year's underlying profits, an estimated 80x this year's forecast profits, and an estimated 37x 2017's forecast earnings of $0.20 per share (according to Thomson Reuters)
Oil Search is a growth company still deep in the investment stage of its expansion. We would expect higher debt and lower dividends as a result, and a higher valuation as well. Yet at today's prices and debt levels, there is relatively little margin for error. One obvious possible problem is further declines in commodity prices.
Although Oil Search has low production prices and good liquidity, if prices return to recent lows, much of the company's cash could go to debt repayment – or the company would be forced to cut its investment expenditure. Another often overlooked issue is the relationship between oil operators and the Papua New Guinean government. PNG has shown in the past a willingness to seize assets and, while a seemingly unlikely risk, there is plenty of potential legislation around native land rights or environmental conditions that could hurt drilling prospects.
Foolish takeaway
Oil Search does have a lot going for it, but to my mind the negatives make the company too risky to invest in today. There is a price I would consider buying the company at, but it is some 30% below where shares trade today. Analysts remain bullish on the business however, with more than half of the 13 polled by Thomson Reuters believing Oil Search will outperform.
