Sandstone Insights: challenges emerge for Aramco and ADNOC in Santos acquisition bid

ASX code: STO

Suggestion: Hold

Need to know

• Aramco andAbu Dhabi National Oil Company (ADNOC) are allegedly evaluating Santos (STO) for potential acquisition, but serious bids are unlikely in our view
• Santos' domestic assets have significant decommissioning liabilities, which we understand has ultimately deterred potential buyers in the past
• STO share price is approaching $8.00, and we would argue anything above $7.70 is starting to factor in an M&A premium or materially higher energy prices
• Active investors should consider switching to buy-rated Woodside Energy (WDS) - we look for a dividend surprise at 2024 results in August.

Saudi Aramco and ADNOC evaluating Santos

Both Middle Eastern energy giants are said to be looking at STO for potential acquisition as they expand gas investments overseas. We understand Santos has been seeking buyers for a while, so this isn't surprising. This new mergers and acquisitions (M&A) talk comes after the failed merger talks with Woodside Energy (WDS) in 2023/24.

Preliminary assessments are common

Aramco and ADNOC often explore various LNG opportunities. The real challenge comes when they move beyond initial evaluations and face issues like decommissioning liabilities in Australia – which is significant for STO given the age of some of its assets. We understand that costs associated with STO's legacy assets have been sticking points in prior M&A discussions.

Confidentiality is crucial for Middle East energy players

Leaks can deter Aramco and ADNOC, who value privacy. While LNG is important to them, acquiring Santos would be a significant and complex move involving assets in Australia, PNG, and US assets in Alaska.

Santos’ bankers might be leaking

The leaks could be an attempt to boost Santos' share price rather than indicating serious talks. Santos and CEO Kevin Gallagher have been critical of the markets' apparent inability to value STO more highly.

Gallagher’s 2021 incentive package, in addition to base remuneration, STI, and LTI incentives, is valued at $6 million to stay with STO as CEO until the end of 2025. This would be worth about $8.5 million using a $10.00 STO share price. This is important context as free cash flow (FCF) growth from major project delivery does not ramp materially until 2026-27 financial year end. At this point, Gallagher will likely have left STO (Gallagher will be 60 years old in 2025)

STO FCF chart: builds post 2025

Possible other bidders exist

The leaks might suggest more advanced talks with another party. Potential bidders include EU majors, MidOcean, and ConocoPhillips, but they each face various challenges.

A premium bid is unlikely

Despite Santos seeking buyers for some time, no substantial offers have emerged. This is due to the complexity of running STO across multiple geographies and its old legacy assets in the Cooper Basin. The crown jewels of STO remain the PNG-LNG (STO 37.5% largest shareholder) and Gladstone LNG assets (STO 30% largest shareholder), which are where most of the equity value lies.

Of the key growth assets (Papua LNG, Barossa, and Alaska) the Alaskan assets offer the most upside relative to market expectations. We think the market carries Alaska at 50-60cps and is risked at 50% in most valuation scenarios. This implies >$1.00 per share if the project was successfully de-risked and operational. A global energy major may be able to extract value faster than STO.

STO free cash flow chart: <5% in 2025 financial year end

• _{The information provided by Sandstone Insights does not constitute investment advice and does not have regard to the specific needs of any person who may receive it. No warranty is given as to the accuracy or completeness of the information and any person acting on it does so entirely at their own risk.}