Santos Ltd (ASX: STO) has fallen by 24% in the last year. This is a worse performance than energy peer Woodside Petroleum Limited (ASX: WPL), but is ahead of Origin Energy Ltd (ASX: ORG). Woodside has fallen by 8% while Origin has declined by 30% in the same time period.
A rising oil price in 2016 and renewed confidence in the future price of the black gold could cause investors to consider the purchase of Santos. It may have recovery potential, but remains high risk in my view.
Oil price
This week has seen investor optimism in the oil price increase. That's because of comments made by Venezuela regarding the potential for a deal to freeze supply among major oil producing nations. The agreement could be signed by the end of the month and may have a positive impact on the oil price if it goes ahead.
However, even a freeze in supply would not rebalance the difference between supply and demand in oil over the short to medium term. In my view, it will take a number of years before demand catches up with supply. The increased prevalence of renewables in the energy mix will also cause the supply/demand relationship to remain more imbalanced for longer in my view. Therefore, consensus forecasts of US$39.40 per barrel of oil in 2020 may prove accurate.
Finances
Despite Santos' $2.5 billion rights issue in 2015, its balance sheet remains highly geared in my opinion. For example, as at 30 June 2016 it had net debt of US$4.5 billion. Although this is a reduction of 33% on its figure from a year earlier, Santos has a net debt to equity ratio of 68%. In the first half of the year its operating profit was unable to cover the US$137 million in finance charges.
Further, Santos has onerous LNG capital expenditure commitments. They will cause its balance sheet gearing to increase. Its new CFO may be unable to make debt servicing costs more affordable over the medium term. In its most recent half year results, Santos' free cash flow was negative. In the long run this situation is unsustainable and increases the company's risk profile.
Future Potential
Santos has a strong asset base which I believe offers the prospect of improved financial performance in the long run. Although demand for oil may stall, gas has been the fastest growing primary energy segment globally after coal in recent years. Santos enjoys a commanding position within the LNG industry due to its 1.4 billion barrels of oil equivalent in proven and probable reserves. Its production is forecast to increase by 22% over the next decade to 70 million barrels of oil equivalent.
However, Santos is a price taker due to its high degree of dependence on the price of oil. This makes it high risk. Its financial standing adds to its risk profile and could worsen in the medium term. Therefore, I believe that investors are better off investing elsewhere, starting with these three blue-chips.
