Oil shock! Is now the time to buy Santos Ltd?

Shares at seven-year lows, but is the new 'oil shock' a buying opportunity for Santos Ltd (ASX: STO)?

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The price of oil has officially gone into 'shock'.

Last week's OPEC decision to maintain production levels has sent the price of Brent crude plunging to US$68 per barrel (A$80.57) and markets reeling.

The reaction to energy producers was swift and merciless. Shares in Santos Ltd (ASX: STO) have now been slammed 24% in the last five trading days alone. Volatile share price movements are not new for Santos, so is the company worth buying (or even doubling down on) today?

Strong production growth

The most attractive feature of owning Santos today is the company's aggressive production growth profile over the next few years. Production is estimated to grow by as much as 25% in FY15 over FY13 as the company begins production from the 90% completed GLNG joint venture, as well as the commencement of production from the PNG LNG joint venture.

This growth has already started to flow, with Santos achieving its highest quarterly production in seven years in Q3. Paired with a reduction in capital expenditure and a target of 9% reduction to unit production costs in FY15 the company should be in fine form.

A strategic error

One major reason Santos' market value is being hit so hard is because of the increasing proportion of revenue that is derived from oil-linked pricing. Santos expects around 70% of revenues to be derived from oil-linked pricing in FY15, compared to around 35% in 2012.

This was likely a strategic decision in the hope of further energy price increases which looks to have back-fired.

The falling price of oil will likely have a bigger impact on Santos than on fellow producer Woodside Petroleum Limited (ASX: WPL) which has contracted pricing increases for its flag-ship Pluto LNG project, helping to insulate the company against the falling oil price.

Therefore the significant increase in Santos' cash flows which was expected to come from the growth in production looks to be dwindling fast.

In a recent presentation Santos noted that at an oil price of US$100 per barrel the company's operating cash flow will increases by 100% in 2016, but at $90, (a 10% fall), the 'consensus' was that operating cashflow would grow by just 65%. The price of oil is now 32% below $100 per barrel, which offers a bleak outlook for 2016 if prices remain at current levels.

The long-term view

The challenge for investors is anticipating what the price of oil will do next. While the volatility could well correct itself and bounce back, there have historically been long periods (decades) of stagnant prices and the current situation of oversupply could remain for some time.

Santos certainly looks cheap relative to prospective future earnings at recent historical oil prices, but with so much uncertainty around oil prices over the short and even medium term, the value of this growth is now in question. Now could well be a bargain time to buy Santos, but the company also suddenly appears to be a high risk speculation.

A safer bet than Santos

Motley Fool contributor Regan Pearson does not own shares in any of the companies mentioned in this article.

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