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Origin Energy (ASX: ORG) – Likely to Outperform in Near Term – Part 1

Origin Energy Overview

Origin Energy Limited, an integrated energy company, engages in energy retailing, power generation, and natural gas production businesses in Australia, New Zealand, and internationally. The company operates through Energy Markets and Integrated Gas segments.

The company also generates electricity from coal, wind, pumped water storage, solar, and cogeneration plants; sells electricity, natural gas, and LPG; provides GreenPower and green gas products; and supplies LPG to homes and businesses.

The company serves approximately 4.3 million gas, electricity, and LPG customers; and has a power generation portfolio of approximately 6,000 MW. Origin Energy Limited was founded in 2000 and is headquartered in Sydney, Australia.

Company’s Focus

Rebuilding the right to grow – Origin Energy Limited is continuing the balance sheet repair that it has committed to which includes the repayment of debt. This will be done through disciplined capital management as the company reduce organisational complexity and cost. Hence, the company is not expected to pay any interim dividends as it focuses on debt repayments.

Step change reduction in upstream costs at APLNG – The company will focus on a smaller and simpler operating model in order to streamline their processes. This is done with the aim of reducing costs and improving productivity.

Transforming customer experience – Origin Energy Limited is now going for a more affordable, smarter, easier and more sustainable model which they called ‘Good Energy’. The new model will aim to defend their market share and use a digital-first approach for future energy solutions.

FY17 Financial Review

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Origin’s adjusted net debt has been reduced to $8.1 billion with the underlying ROCE improving to 6%. They have managed to cut cost in different areas including a $1.2 billion reduction in capital spending and sold $1 billion worth of assets.

During the period, Origin experienced a 12% increase in EBITDA to $1,492 million including a 1,200 MW increase in committed renewable energy supply. This has indicated improvements in both the electricity and gas segment.

Energy Markets is performing well, with Underlying EBITDA for the year increasing by $162 million or 12 per cent to $1.5 billion. One of Origin’s core strengths is its gas portfolio, and the volume of gas sold to customers increased by 12 per cent. In electricity, volumes increased by 4 per cent and Origin was also able to maintain a competitive cost of energy as wholesale prices rose sharply.

Overall, looking at the headline loss, their numbers may not sound impressive. However, for energy retailers it would be best to ignore net profits as accounting rules force businesses to recognise movements of hedging instruments and derivatives. Hence, it would make more sense to look at EBITDA. Just plainly looking at the EBITDA results, the company did much better than last year showing strong retail results. The improvements in the electricity business benefitted from higher wholesale electricity prices.

Something to note would be their LNG sector which continues to disappoint. Underlying EBITDA from gas increased from $386 million in 2016 to $1,104 million in 2017 but do not be fooled by the numbers. At that point in time, Origin shredded balance sheet values for APLNG by $1.8 billion due to long-term oil price assumption and cost has increased as well due to higher local currency. Regulation remains the greatest risk to profit growth.

Picture 41H18 Financial Review

Energy markets underlying EBITDA increased by $156 million or 21% to $891 million as the baseload generation value is peaking with power prices. Their performance in the energy market is expected to be at the upper end of guidance. The integrated gas underlying EBITDA increased by $343 million to 630 million. This was partially offset by a $187 million increase in interest, tax, depreciation and amortisation.

The company has also decided to not pay any dividends for the first half of 2018 as they focus on debt repayments and prudent capital management. This make sense for the company as even though dividends are important to shareholders, focusing on debt reduction now would provide greater long-term benefits to various stakeholders.

The FY2018 guidance range for energy markets has improves with underlying EBITDA expected to be in the range of $1.78 to $1.85 billion compared to previous guidance of $1.7 to $1.8 billion. Origin also remains on track to reduce net debt to below $7 billion by the end of FY2018. More details on the debt level will be in the second article.

Industry Outlook

Oil & Gas Trends

In general, the industry feels much healthier than it did 12 months ago: The price of oil has rebounded. After appearing limited to a range between the mid-$40s and $50 per barrel (bbl), Brent crude is now trading above $70. (Effects of increase in oil prices will be explained more in the second article) The industry is thus recovering from the brutal last few years of weak prices, enforced capital discipline, portfolio realignments, and productivity efficiencies.

The fundamental challenge, of course, is the intrinsic volatility in the sector. Producers need time to address the vagaries of an over- or under-supplied market. They also need to grapple with the pace and magnitude of the transition to energy from non-fossil fuel sources.

The sector currently faces a number of supply-related challenges. There is currently an ongoing decline in new discoveries. By the end of 2017, the volume of new oil and gas discoveries, was at its lowest since the early 1950s. Only 3.5 billion barrels of liquids (crude, condensate, and natural gas liquids) were discovered in 2017, which was enough to meet only 10 percent of demand.

The reason for the decline is just because its getting harder to find the large discoveries known as “elephants” and most prospective areas have already been explored. This will make it harder for companies to keep up with the growing demand.

This contraction was exacerbated by a second challenge: the slowness of the rise in exploration spending since it fell with the price collapse of 2014–16. Globally, spending fell by more than 60 percent, from a high of US$153 billion in 2014 to about $58 billion in 2017. It is forecast to recover modestly over the near term at a 7 percent compound annual growth rate. The investment slump in traditional supply sources looks like it will continue to have an effect on new production.

Putting it into perspective for Origin, the rising oil prices prove to be a positive point for the company as seen from the recent financial results of the company. However, in terms of its supply, there are concerns by industry experts in regards to a lack of supply. Given that gas exploration and production is a major part of their business, the company would need to focus more on technology/digitalisation as they emphasise on efficiency. In addition, this would also signify that the company may need to focus on other emerging trends in the market such as clean energy especially with the recent emphasis on a low-carbon economy.

Energy Market

I am sure everyone is aware of the recent trend into clean energy and many companies are indeed jumping onto the bandwagon in Australia as well. Australia had a record year with $9 billion in clean energy investments, up 150% on 2016 and breaking the previous record of $6.2 billion set in 2011.

As a result of the increased investments in recent years, they are looking to meet the 2020 Renewable Energy Target of 33GW of additional renewable energy. In 2017, more than 1000 megawatts of renewable projects were completed and began generation, the biggest year ever for new build coming online. Experts are expecting 2018 and 2019 to be even bigger, with each year having more than double the new build completed compared to 2017. Specifically, in 2016, 6532 MW (megawatts) worth of large-scale generation was firmly announced, with more than 4,900 MW fully financed — most of which is now already under construction, with the rest expected to begin construction early this year. A further 1,600 MW already have Power Purchase Agreements in place which will soon lead to financial close.

This signifies the move towards clean energy and the increased competition in the market as well.

This sentiment has been shared by industry leaders as seen from the survey by PWC. Smart grids, micro-grids, local generation and local storage all create opportunities to engage customers in new ways. Increasingly, there is an increasing interest in the power sector from companies in the online, digital and data management world who are looking at media and entertainment, home automation, energy saving and data aggregation opportunities.

This outlook for a more open and competitive power market is shared by many of the survey participants. Nearly four-fifths (78%) anticipate greater competition and competition from outside the sector is being taken very seriously. Three-quarters see a medium to high-level competitive threat coming from companies with a technology or engineering focus and nearly as many (71%) from companies from the IT/telecoms sector. Powerful brands from the retailing or online sectors are also seen as a threat.

So after reading so much about the general trend towards clean energy and the amount of competition in the market, what does all this mean for Origin?

Needless to say, Origin has jumped on the go green bandwagon a long time ago and their renewables mainly come from wind, hydro, solar and biomass/biogas. They are definitely aware of the trend and have also said that renewables are the future. They have also recently announced a $230 million pan to expand the Shoalhaven hydro electricity scheme from its current 240MW capacity to up to 500MW. Shoalhaven would provide more reliability in peak times of energy use, like those really hot summer days. Currently only 10 per cent of Origin’s energy generation is renewable, but it wants to triple that by 2020, with goals to produce 1200 megawatts from wind and solar.

Furthermore, the increased competition should not have a huge impact on Origin as of now since their market position in Australia is really solid. They have one of Australia’s largest, lowest cost, renewable energy portfolios and are currently still expanding. However, in the long term, many things could change especially with the recent entrance by Ayala Corporation.

Conclusion

Overall, Origin has been doing great so far as seen from their latest financial result thanks to increasing sales and oil prices. However, investors would need to wait for their dividends as the company now is focused on reducing their debt level which is common for companies in the sector. For the integrated gas segment of the company the main worry in the long term would definitely be the lack of supply but this would not have a strong effect in the short terms thanks to their current dominant position in the market. For the energy market, increased competition is killing profits and Origin would need to either change their business model or invest more into streamlining and technology.



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