Origin Draws The Short Straw On Gas

This story features BEACH ENERGY LIMITED, and other companies. For more info SHARE ANALYSIS: BPT

One of them had to give way in the dispute between Beach Energy and Origin Energy over gas pricing, and it was the latter that ended up downgrading guidance

-Market not heeding consistent earnings warnings from Origin Energy
-Subdued electricity markets meet up with higher gas procurement costs
-Further risk of price reviews for the Cooper Basin portfolio
 

By Eva Brocklehurst

After Beach Energy ((BPT)) and Origin Energy ((ORG)) thrashed out an agreement for gas prices in Victoria's arbitration courts the latter has had to issue an -8% downgrade to energy markets guidance.

Origin Energy has downgraded FY21 operating earnings (EBITDA) guidance to $940-1020m, implying an adverse outcome from arbitration. Part of this downgrade to guidance was attributed to the price review and the rest to subdued energy demand and pricing.

Morgans lowers FY21 estimates for energy market operating earnings to $980m, primarily because of the higher gas costs, having already carried a conservative electricity margin forecast.

Ord Minnett suggests the market is still not heeding consistent warnings from Origin, as consensus seems to expect earnings to double in the next two years. Overly optimistic estimates are considered by the broker to be a major driver of the stock's de-rating that occurred in 2020.

Natural gas gross profit is expected to decline because of higher procurement costs and increases in the Japan-Korea market index, as well as lower volumes and prices on commercial and industrial sales which reflect the current subdued market conditions domestically.

Origin has signalled mild weather has caused energy demand to slump, which provides less opportunity for its generation fleet to take advantage of volatile electricity prices, and has warned once again that lower wholesale electricity prices and higher gas procurement costs are going to have a material impact on profitability in FY22-23.

Credit Suisse does its valuation check after the update and calculates that at the current share price, the energy markets equity value is $0.19 and FY22/23 free cash flow forecasts ex APLNG are less than 1%.

The broker assesses prices and volumes in electricity & gas all seem to be worsening for Origin, reducing gas gross margin estimates to allow for the arbitration outcome as well as gas and electricity sales volumes.

On a macro basis, Macquarie believes the negative earning cycle for Origin has further to go, although expects a base will emerge in FY22 as earnings are sourced from more traditional retailing, along with risk management. Structurally weaker earnings are enhancing the need for debt reduction and dependence on oil hedging to remove volatility, the broker points out.

Origin had been the best performer in energy markets since February, Goldman Sachs notes, but this downgrade has brought the stock back in line with the rest of the sector. This reinforces the broker's view that FY22 will be a trough year for energy markets and a recovery is likely from 2023.

The rebound in oil prices over the past six months should deliver capital management in FY22 with an improving outlook and Goldman Sachs, not one of the seven stockbrokers monitored daily on the FNArena database, retains a Buy rating with a $6.50 target.

With Beach Energy the winner in this dispute, Citi upgrades FY21-23 earnings estimates by 13-17% but is still unable to reconcile that company's five-year cash flow guidance of $2.1bn compared with its estimate of $1.53bn, suspecting there is risk of a downgrade to guidance from Beach Energy at the August result.

Arbitration Outcome

Based on the disclosure by Beach Energy that the arbitrated gas price is around $9.30/GJ, brokers calculate Origin Energy's assumptions were -$2-3/GJ out of the money for the gas it procures from the Otway portfolio.

Origin has another 8PJ of gas supply from Beach's Cooper Basin portfolio which is under price review and facing a similar risk. The gas supply from both these reviews makes up around 20% of total gas portfolio demand for Origin and pricing outcomes are likely to cut gross profit a further -$30-40m for FY21 and -$60-80m from FY22.

From the Beach perspective this will lead to higher prices for Otway gas for the next three years and the company will be able to sell rising volumes at higher prices after the drilling program.

The Origin contract runs to June 30, 2033, with three-year market re-sets. The contract with AGL Energy ((AGL)) expires in mid FY22 and the Origin Energy contract will become a larger proportion of total Otway sales for Beach Energy.

Upgrading Otway assumptions increases Goldman Sachs' FY21-22 forecasts for Beach by 3.6-5.6% and the rating is upgraded to Neutral from Sell with a $1.90 target. The broker believes gas pricing has the potential to be negative in 2023 when the contracts are re-set again, as these will be linked to 2021-22 prices, which should drive a decline in the next reset to around $8/gigajoule.

APLNG

One positive Origin announced in the update is that break even for APLNG cash flow in FY21 has been lowered to US$22-25/bbl. This ensues from higher cash distributions that are now expected in FY21, more than $650m.

UBS expects Origin will focus on de-leveraging in FY21 but if oil prices remain above US$60/bbl into FY22 there could be upside from possible buybacks or the sell down of infrastructure within APLNG.

The drop in the share price as a result of the downgrade was excessive, Morgans asserts, given a positive outlook for the APLNG business and the other growth options.

The broker has no doubt the next 12-18 months will be challenging for the company but always anticipated that FY22 would be a low point for the business as electricity futures have been pointing to weaker earnings for some time.

Nevertheless, the company is expecting to offset weaker revenue by cost reductions and its LNG business will reap more of the benefit from higher oil prices in FY22. Origin is also realising cost improvements from investing in the Kraken platform as well as green hydrogen and oil & gas exploration in the Northern Territory and Western Australia.

The database has three Buy ratings and four Hold for Origin Energy and a target of $5.06, suggesting 21.3% upside to the last share price. The dividend yield on FY21 and FY22 forecasts is 4.8% and 4.7%, respectively. For Beach Energy there are four Buy ratings and two Hold. The consensus target is $2.04, suggesting 14.1% upside to the last share price.

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