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Origin Energy (ASX: ORG) – Rising Oil Prices Boost Rating – Part 2

Rising Oil Prices

The big story here is the sharp rise in oil prices, which last week hit $80 a barrel for the first time in four years. But if oil analysts are right and the cost of crude is set to carry on rising, hitting $100 a barrel over the coming months, the big story of 2019 is going to be how oil came down to earth with a bump which will be explained more in the investment risk.

There are, without question, solid reasons for the oil price rises. The global economy has been performing more strongly than expected, with almost every region doing its bit to push up demand. Donald Trump’s tax cuts in the US and the reluctance of the Bank of Japan and the European Central Bank to tighten policy mean there is no immediate threat of recession.

On the other side of the equation, supply has been kept in check. Part of this – the Opec production curbs – was planned. Other aspects of it – the chaos in Venezuela and Donald Trump’s decision to pull out of the Iran nuclear deal – were not.

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According to BCG, Brent crude oil is the primary benchmark for international oil prices today, serving as the price reference for roughly two-thirds of the world’s traded-oil volume. As seen from the price chart provided, it is clear that the prices have started to increase since 2015-2016 which is mainly due to the supply agreements by various parties.

This has actually bode well for Origin as they capitalised on the increase in oil prices as seen from their recent financial results. The average price Origin got for LNG rose 13% in the March quarter from the December period and results are likely to be better in the coming periods as well.

To make things better for investors, there is a major expectation variance which is that the contract price for LNG has a 3-6 month lagged so the benefit from recent oil price rally would be experienced later. This basically means that results would be better and better due to a lagged response towards changes in oil price. If the oil prices continue to increase, Origin would continue to grow and investments in the company will grow as well.

Repayment Plans

Picture 3The difference between current and quick ratio is that quick ratio does not include inventories and other current assets which are more difficult to liquidate. Hence it offers a more conservative view of the company’s ability to meet its short-term liabilities. As we can see from the current and quick ratio it is still at a reasonable amount with current ratio standing at 1.0x in LTM 2017 Dec. Looking at just the numbers, one may ask if it would be too risky for a company to have such a low quick/current ratio. The answer would be that it depends and in Origin’s case, it is at a safe level. Generally, for Oil and Gas companies, this is a reasonable ratio since there’s sufficient cash cushion without leaving too much capital idle or in low-earning investments.

Origin’s debt is at 77.2% of equity and can be thought of as relatively highly levered. This tends to happen for large cap companies in the industry since debt can often be a less expensive alternative to equity due to tax deductibility of interest payments. In the company’s case, the debt levels are indeed high which explains management’s actions in reducing their debt. One instance would be the sale of Lattice Energy where Origin completed a $1,585 million sale of its conventional upstream oil and gas business to Beach Energy. The main purpose for the sale was to repay their debt amount.

Debt/EBITDA is just to show how much more is the debt above the EBITDA amount. EBITDA in general can also be thought of as operating cash. As seen from the table, the numbers have been going down for the company which is a good sign as it shows the repayment efforts of the company.

One question that shareholders ask is that if Origin’s debt level is generally fine/common in the industry, then why should they pay off debts or rather why are they not giving us dividends instead. The answer in my opinion is due to the long-term benefits. If Origin continues to accumulate debt, they will first lose the shareholders’ confidence and it would also mean lower credit rating for the company. With a lower credit rating, the interest charged to the company would be undoubtedly higher than what it should be.

Overall, Origin’s move to lower debt levels has a positive impact in the long term for both investors and the company itself. While the sale of Lattice Energy may be compromising the operational aspects of the company, the move must be made in order for Origin to continue expanding in the market.

Origin Energy’s Restructuring Plans

Origin will cut more than a third of the circa 1600 jobs in its integrated gas business in its efforts to slash cost and protect against swings in commodity prices. The restructuring is intended to help achieve Origin’s aggressive cost reduction targets, detailed in November, involving reducing the oil price at which APLNG breaks even and yields returns for its owners to $US40 per barrel of oil, down from an expected $US48 a barrel this financial year.

The cost targets include a $500 million saving on capital and operating costs at APLNG within 18 months. The break-even price on an operational basis at APLNG is targeted at less than $US24 per barrel of oil equivalent, down from an expected $US30 this year.

The business is looking to switch from a functionally-led structure to one centred around assets. It will involve an increased focus of jobs at operational plant sites. Origin is intending to maintain its strong presence in regional communities where it operates.

The flatter structure that Origin is going for will reduce the seven layers of management for some operations down to four.

Even though jobs are lost, it is not all negative in Origin. The move is actually long-term as it would help the company maintain sustainable earnings. As reported by PwC, given the increased competition and volatility in oil price, there needs to be a change in business model/operational strategy. Origin has maintained its strong market position over the years and they must now look to streamline their process especially with the high leverage position they are in currently.

Future Development Plans

Origin’s energy market position is improving and is looking to expand in the near future. In the near term, it would be looking to double capacity of Shoalhaven hydro scheme with an investment plan of $230 million. They are looking to expand it from its current 240MW capacity to 500MW.

In 2018, Origin has partnered with Silicon Valley power start-up Bidgely to bring its appliance cost breakdown service to Australia. This will let customers monitor the electricity usage of individual household appliances without the need to install sensors on every power-hungry device in the home. The service works by studying real-time data from the household smart meter, using “disaggregation” pattern-matching algorithms to identify the tell-tale behaviour of individual appliances amid the total power usage. The new service will start rolling out to 400,000 Victorian customers this month (May 2018), on the condition they already have a smart meter installed, and there are plans to expand interstate.

Origin has also said that a decision to start engineering and design work on the first stage of its Ironbark coal seam gas project in Queensland is set for June, with the aim of starting gas production in 2021-22. These developments will help Origin increase their revenue in the medium term as they look to preserve their dominating position.

Investment Risks

Oil Price Volatility

I understand that the current oil price is rising (as presented in the investment thesis portion) and having that as an investment risk serve as a contradiction given Origin’s operations. However, there are no clear answers whether oil price is going to rise or fall in the future and the volatility factor will still be there especially for a company like Origin. I will provide my stand on the volatility of oil price but it would mainly depend on your views/beliefs whether the oil price will increase or decrease in the near future. These are mainly separated into three reasons namely oversupply, compliance and stock market.

In the monthly oil market report, OPEC has increased its annual forecast for non-OPEC oil supply by 280,000 barrels per day. OPEC has also acknowledged that crude oil supply will overtake crude oil demand in 2018. The increase in oil prices has also led to an increase in production as companies jump on the bandwagon. With a surge in supply, the prices are forecasted to fall in the medium term.

Agreed Cuts Actual November 2017 Avg. 2017 Compliance
Total OPEC 1.176 1.360 91%
S Arabia 0.486 0.570 120%
Venezuela 0.095 0.230 63%
Iraq 0.210 0.140 44%
All Others 0.385 0.420
Total Non-OPEC 0.546 0.526 96%
Kazakhstan 0.100 0.227 328%
Russia 0.300 0.280 95%
All Others 0.146 0.019

85% of the agreed production cutbacks have been made by the big three (Iraq, Russia and Saudi Arabia), leakage from the smaller countries is of only a minor concern. Instead, a conscious decision to reverse production cuts from one or all of those three would probably be necessary to crash prices. The main reason for the success of the most recent OPEC/non-OPEC producers’ agreement is that so many countries joined the effort and adherence to the reductions has been fairly high. Still, many of the smaller members are not in compliance, and should the market weaken, attention could be focused on their failure to live up to the agreement and the larger players might see their resolve weaken. The most important case is Kazakhstan, where production is expected to rise as Kashagan production progresses towards its phase 1 plateau. That alone might not be enough to encourage the bigger players to renege, but could contribute to a change in perception amongst the other contributors, putting pressure on the remainder. The weakest link in the chain is Iraq, which has dire revenue needs and is considered a particular threat by the Saudis because of their aggressive long-term expansion plans. Other countries, like Iran and Venezuela, have minimal ability to expand production and are unlikely to have an impact on overall supply next year. However, the chances of non-compliance is low and this would unlikely happen.

Given that the economic expansion is growing long in the tooth, the potential for a slow-down or recession in the next year is very real, and could see a significant retreat in stock market prices and a sell-off in other assets, from gold to oil. Since economic weakness translates directly into weakness in oil demand, lower oil prices after a stock market retreat followed by a recession appear highly likely. This is reinforced by the fact that oil supply is not affected by demand but prices, meaning the supply response will lag the demand response, initially reinforcing downward pressure on prices.

With these factors, they serve as reasons as to why the oil price might fall in the medium term and personally, I believe that even though oil price is rising now, it will fall in the near term given the current market conditions. I am of the view that the economy is currently in a bubble and bubbles, as the name suggest, will burst when it gets too big. This reflects the current conditions where the equities market are said to be ‘overvalued’.

Increased Competition

As mentioned in the first article, one of the factors is an increased competition in the market. One of the recent news features Ayala Corp debuting into Australia’s renewable energy space through a join venture. They are partnering with UPC Renewables that involves a 4,600 MW energy portfolio in the continent. Ayala is investing US$30 million for a 50-percent ownership in UPC’s Australian business and has committed a US $200-million facility to fund project equity.

For readers who are unsure of who Ayala Corp is, they are basically the oldest and largest conglomerate in Philippines. They have an Energy and Infrastructure arm which is committed to invest $1 billion of equity over five years.

These are competitors that Origin might face in the near future due to the potential market in Australia. It serves as a deterring factor for the company and they would need to constantly find ways to either cut cost or increase their revenue base.

In light of the increasing competition, Origin Energy has stepped-up efforts to defend its share of the retail market. This has trimmed its net loss of customers this financial year as it fends off heightened competition. Looking at the data for Origin, net customer losses for 2017-18 were reduced to about 15,000 by mid-April, down from 47,000 in the six months ended December 31.

Market churn, which measures the rate of customers switching their retailer, climbed past 22 per cent in March, up from about 19 per cent in December 2016. Competition has definitely toughened for the “big three” retailing majors with the more aggressive strategies adopted by Alinta Energy, Snowy Hydro’s Red Energy and others.

Luckily, Origin is aware of the increasing competition and is constantly looking to find ways to maintain its position in the market. It should be highly unlikely for the increase competition to have a strong impact in the near future.

Share Price Analysis

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Looking at the three-year share price chart, we can see an obvious bleak year for Origin in 2015 where the share price plummet from around 14 to a minimum of approximately 4. This was mainly due to a fall in crude prices where it slumped to six-year lows. Significant fall in oil price, if sustained at low prices will result in lower cash flow and earnings.

With the recent increase in oil prices, investors are slowly gaining confidence as seen from the upward trend in the company’s share price.

In my personal opinion, Origin’s share price would continue to rise in the near terms as oil prices increase. This is especially crucial now as the full year financial results are going to come in soon and given the way that oil prices are moving, it bodes well for the company. The higher oil prices serve as a ‘tailwind’ for Origin and given the stability in their energy market, they are expected to do well in the near/medium term.

Conclusion

As seen from the investment thesis and risk, Origin seems like a outperform especially in the near/medium term given the current market conditions. However, investors would need to keep track of any sudden movements in the oil market which would have a significant impact on the company’s price as seen from what happened in 2015. With that being said, the management is looking further ahead as they aim to maintain sustainable earnings as seen from the recent restructuring and repayment plans. Overall, Origin is a safe company to invest in (at least in the near term) and caution is to be taken in terms of the oil price volatility.

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



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