Is the worst performing large cap stock in the energy sector poised for a big turnaround in the new financial year?
I am talking about Santos Ltd (ASX: STO) with its 40% plus belting over the past year, which leaves it at least 20% behind its peers.
The big de-rating in Santos comes on the back of a sharp decline in the oil price, which has hit Santos harder than the sector.
As I have written before, Santos is in a similar position to iron ore producer Fortescue Metals Group Limited (ASX: FMG) as both companies are particularly sensitive to changes in the price of their underlying commodities because of their high debt profile and bigger capital expenditure requirements.
However, Santos is more fortunate than Fortescue as there is a faster supply-side response to the falling oil price than there has been for iron ore.
Global oil output is falling notably as US shale companies, the marginal producers, have cut back quickly on drilling while iron ore producers have been slow to react.
This makes all the difference and Morgan Stanley thinks the market is focusing too much on the risks and not enough on the upside for Santos.
While consensus is forecasting revenue to fall 9.4% to around $3.75 billion for the current financial year, 2015-16 will bring a big step change to just over $5 billion as Santos has invested heavily in bolstering production.
What's more, Santos has moved aggressively to cut capital and operating expenses and that means any top-line growth will trigger a disproportionately larger increase in net profit. This is the key reason why Morgan Stanley lifted its price target on the stock to $9.60 from $7.88 as it upgraded its recommendation on the stock to "overweight" from "equal weight".
The upgrade is unsurprising as it reiterates what we already know about Santos – it is the most leveraged of the major Australian oil companies to the oil price.
If you think oil will hold and build on recent gains, Santos will give you the best bang for your buck.
But I am more circumspect about crude prices and that is why I would rather buy Oil Search Limited (ASX: OSH) or Woodside Petroleum Limited (ASX: WPL).
There just isn't enough of a margin of safety for me to feel comfortable with Santos as the company needs the Brent crude oil price to stay ahead of around $US60 a barrel when the current price is $US63.06 a barrel.
Sure, the oil price will need to stay under the $US60 mark for a few years before it causes significant erosion of value in Santos' share price, but the stakes are high as that outcome will leave the company unable to sustain dividends, invest in growth and reduce debt.
It's a bit like playing Russian roulette with the oil price. Given my dismal track record at gambling, I'd gladly leave Santos to those braver and luckier than me to reap the bountiful reward.
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