Australia | Apr 12 2017
-Value in Origin's flexible generation is being exposed in the current electricity market
-Limited gas supply is reducing competitive pressure
-Upside case rests on tighter-than-expected wholesale electricity market
By Eva Brocklehurst
The outlook for energy markets continues to strengthen and brokers take a closer look at Origin Energy ((ORG)), as the company is set to benefit from the next phase of higher electricity prices. The past summer has revealed the electricity generation market is much tighter than previously believed and this is compounding the effect of higher fuel costs.
Origin is able to offset higher wholesale prices through increased output from its generation assets. These assets have been generating around 27TWh annualised since the start of 2017, 35% above the 20TWh generated in FY16. This level of output did not occur in the December half of 2016 because of an extended outage at the Eraring power station (NSW).
Electricity And Gas Prices
Citi believes the current level of electricity prices is partly a function of the limited gas supply that is reducing competitive pressure within the electricity market. This provides a choice for the company between monetising its gas within the electricity markets or the gas markets. The broker currently estimates a 50% capacity factor at Eraring, with each additional 10% adding around 5% per annum to earnings (EBIT).
The arbitrage between electricity prices and the cost of generating additional electricity from spot coal prices, the broker assesses, provides incentives for the company to use Eraring harder to capture this arbitrage. Closing this coal to electricity price arbitrage by the generators is another reason why the broker believes that current electricity prices are peaking and likely to head lower.
In the near term, Origin Energy is in a sweet spot for its gas book and the value of its gas peaking power stations. Citi observes the recent deal with Engie is monetising the best gas book in the market, upgrading to Neutral from Sell.
While the broker believes there is value in the stock and energy markets are in a position of strength, the medium-term outlook is more difficult to ascertain, given expectations for a US$65/bbl long-term oil price and the belief that spot LNG prices will be materially weaker by mid year and affect market sentiment.
The value in the company's flexible generation portfolio is being exposed as the electricity market evolves to higher peak prices and volatility. Credit Suisse suspects there is upside to its estimates as the market appears to carry a higher valuation for oil & gas assets, on which basis energy markets appear cheaper.
A rebound in output from the Eraring power station in the March quarter also points to around $50m in operating earnings (EBITDA) upside versus the previous corresponding quarter and the broker's FY17 estimates. This could mean the company is trading at or above the top end of its FY17 energy markets guidance.
With market dynamics continuing to play into Origin's hands and strong APLNG project operations, for now at least, optimism from the market is not without merit, in the broker's view, nor is the upside being tapped.
Despite the extremely strong position in the energy markets business, the broker hastens to add this is not a company without risk. A US$1/bbl move in the broker's oil price deck changes the stock's net present value by around 1.8%. Hence, this business is highly leveraged to oil.
The broker is also concerned about the balance sheet. Nevertheless, there is an upside case that rests on the proposition of sustained upside from a tighter-than-expected wholesale electricity market. The broker has previously argued for the stock to trade at a higher medium-term multiple compared with AGL Energy ((AGL)), based on an earnings profile which is less dependent on coal-fired base-load generation. This manifests in lower earnings volatility, lower sustaining capital expenditure and longer duration cash flows.
Ord Minnett also rates the stock highly (Accumulate), noting that generation volumes from the company's flexible assets have increased materially and there are benefits from higher retail prices and reduced competition. Near-term a catalyst may also come from the sale process of the company's upstream business and potentially a re-financing of APLNG, which the broker suspects could expedite the company's de-leveraging process.
The broker expects the electricity portfolio to report expanding margins during this half year and beyond. Ord Minnett also incorporates material financial leverage in its modelling, amplified because of the company's relatively high debt. On upgrading FY18 and FY19 net profit estimates by 12% and 16% respectively the broker's net present value measure increases 12% to $7.96 a share.
Additional de-leveraging could occur if the APLNG project finance is restructured so that amortisation is deferred. This could mean additional capacity for dividends to the joint-venture partners, including Origin.
UBS research concludes that the closure of the brown coal-fired Hazelwood power station in Victoria will increase the National Electricity Market's reliance on an ageing coal fleet and gas-fired generation to meet demand. Moreover, the broker believes the market is over-estimating the risk of regulatory intervention and ignoring empirical evidence.
UBS believes $80/MWh prices are sustainable, a 50% increase compared with FY16, but prices are likely to settle down following the closure of Hazelwood. The broker believes downside risk to pricing comes primarily from the potential for regulatory intervention, although this may be at the retail rather than the wholesale level.
Higher prices may lead to closures in industry and the increased use of residential solar PV/batteries, which could lead to demand destruction. More supply is needed to replace coal but an incentive price and regulatory certainty is required if private investment is to be encouraged, UBS asserts.
Deutsche Bank expects the wholesale electricity markets to remain tight following the closure of Hazelwood. Longer term, the transition from coal to increased gas and renewables/storage should hinge on the cost curve for emerging technologies. Either way, the broker believes wholesale markets will inevitably moderate as new supply comes online.
The company's recent deal with Engie means that it can supply gas and gain access to electricity generation at the Pelican Point (South Australia) second generation unit. Deutsche Bank believes this deal highlights the spread between forward electricity and gas prices, which supports the economics of increasing gas-fired generation to meet peak electricity demand. The broker incorporates a $30m contribution to operating earnings for the company in FY18 from Pelican Point.
FNArena's database shows four Buy recommendations and three Hold. The consensus target is $7.46, flat versus the last traded price. Targets range from $6.43 to $8.63.
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