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Here's why this ASX energy stock presents an opportunity

Nicholas Grove  |  10 Oct 2016Text size  Decrease  Increase  |  

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The market is too bearish on the prospect of an oil price recovery and the potential for a project in Indonesia to add value to this ASX-listed mid-tier explorer, Morningstar says.

Shares of Australian upstream oil and gas explorer AWE Limited (ASX: AWE) have fallen from a peak of about 94 cents in July 2016 to around 66 cents as of 5 October 2016, a fall of close to 30 per cent.

The decline can be put down to a market that is "not sufficiently optimistic" about a recovery in oil prices and cost reductions being made by the company--as well as the potential for the company's Ande Ande Lumut (AAL) project in Indonesia to add value, according to Morningstar senior equities analyst Mark Taylor.

"The market underestimates AAL's value and is likely to be caught short," says Taylor, who in a recent Special Report valued the undeveloped AAL project at 20 cents a share, or one-fifth of his total $1.00 fair value estimate for AWE Limited.

"A more bullish oil price and project cost improvements underpin our disagreement with the market. AWE is undervalued, with our $1.00 fair value estimate 67 per cent above the share price."

However, Taylor notes that the fate of AAL hinges on the intentions of the project's operator, Santos (ASX: STO), especially in the near term.

He believes Santos will approve AAL's development, principally because he thinks the project's economics "stack up" at his US$60 mid-cycle Brent oil price forecast.

Regardless, Taylor says there are a number of other good reasons for Santos to proceed with the project.

"Santos has had an Indonesian presence for many years and the country is integral to the company's strategy," he says. "Santos will not want to damage its operating reputation with the Indonesian government by dragging its heels on AAL."

"Given AAL's operating lease expires in 2035, the joint venture will not want to materially delay a decision."

Santos is targeting a final investment decision on the project in the second half of calendar 2017, with first oil expected in calendar 2020.

Taylor points out that Santos paid US$100 million for its 50 stake in AAL and may be loath to walk away from such investment.

"We think the fact Santos continued to spend at AAL during an oil price rout, including on expensive appraisal drilling, speaks to its intent," he says.

"Work is going ahead. Recent drilling delivered crude of a better-than-expected quality, indicating potential for lower capital and operating expenditure, improved crude pricing, and enhanced project economics overall.

"Improved economics increase the chance Santos will proceed."

All up, Taylor believes AAL is a "particularly attractive proposition" for AWE Limited due to the "very large" potential cash flows it could generate and the favourably limited free cash outflows in the lead-up to first production.

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Nicholas Grove is a Morningstar journalist.

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