Origin is living proof that incumbents don't manage disruption well | RenewEconomy

Origin is living proof that incumbents don’t manage disruption well

If Origin wants to appeal to investors, it’s got to get back on the path of making a future for itself. And that path lies in taking advantage of nature’s bounty.

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Origin Energy really has three assets. The first is Its investment in Australia Pacific LNG (APLNG), a finite-life gas field which has the misfortune to be burning through the years of great reserves and low production costs at a time when gas prices are low.

The second is its ownership of the largest individual coal generator in the national electricity market (NEM), Eraring. This asset, despite its lack of forward coal contracts, does benefit from a great ramp rate and is probably more effective as a firming asset than Origin’s gas generation portfolio.

But who cares? It is due to close in 2032 and anyone thinking of making the capital investment to keep it going beyond then will almost certainly be facing more carbon risk. So it’s another finite-life cash-flow stream that is seeing out some of its last decade at a time when electricity prices are low.

The third asset – and the only one with potential permanent annuity – is the sales and marketing business with its 2.6 million electricity and 1.2 million gas customers. Note that these are not all unique customers, there are some dual fuel customers taking gas and electricity who are counted twice in the 3.8 million.

Origin is working very hard on preserving the value in these customers but there are obviously big challenges in the take-up of rooftop solar, and perhaps the decline in domestic gas usage over time.

So the way we see it, Origin, if it wants to appeal to investors who have eyes to the medium and longer-term, can’t just sit around paying down debt. It’s got to get back on the path of making a future for itself, no matter how hard going that path is.

And in our view, just as with AGL Energy, that path lies in taking advantage of nature’s bounty.

The first step is to get out of APLNG. That won’t be easy but Origin is never going to be a global player in LNG and LNG is a global business. If British Gas couldn’t make a go of it, how will a smallish investor like Origin?

ITK has not prepared proper financial forecasts, and there are only scattered numbers in this note. The bottom line, as for AGL, is that FY21 and FY22 are going to see dramatic falls in profit.

Both companies are living proof that incumbents don’t manage disruption well. Both companies are hostage to decisions made years ago and, as a result, almost exclusively play defence to disruption rather than offence. Defence may delay the inevitable, but by definition you can only win by playing offence, at least occasionally.

Talking, but no walking

Origin’s results were perfectly acceptable as far as they go. It’s long been obvious to any careful observer that Origin’s, or at least APLNG’s, CSG reserves are the best in the industry in Australia.

APLNG seems to be well run, reserves have been almost maintained through infill drilling and there are prospects for more reserve additions, notwithstanding the economic strictures imposed by lower gas prices.

But that will only get you so far. In the end, Origin owns a non-controlling share in one LNG project, one with a finite life. When Origin asks investors to buy Origin, what is the investment proposition?

One of the things I’ve learned in recent years is that many investors want a “story,” more than they want “value”. Not just any story, but a good one. One that can last for at least a couple of decades. In its early years, Origin had a growth story that involved entering and then getting big in the electricity industry.

Then it had a CSG story which became one of price discovery, ie just how valuable was the vast, hitherto unknown CSG reserve in QLD? That story essentially played out as far back as 2008 when the then BG now Shell bid for Origin and then that bid was eventually rejected. The BG bid was at $15 share and was more or less the highwater mark for Origin shares which had started life in 2000 at around $1.50 per share.

With the benefit of hindsight, Origin investors, in general, would have been far better off if that takeover bid had succeeded. Australia might also be better off with fewer LNG trains in Queensland running for a longer period of time and perhaps more gas available domestically. But would have, could have and should have, are some of the most useless words in life.

Now Origin faces the same problem it has every year for the past five years and that is how to get out of APLNG and convert its energy markets business into more than a declining balance annuity.

Of course, they may have the opposite view and act as if there is not much future in energy retailing and it’s better to be big in gas, perhaps by developing the remote but perhaps promising Beetaloo resource in the Northern Territory. For me, that’s a loser strategy because it takes Origin down a gas path that only leads them deeper into the woods.

As a CEO, Frank Calabria is a great CFO

Frank Calabria the CFO turned CEO, has done a great CFO job in getting Origin’s balance sheet under control and, the dividend cut this year notwithstanding, the market will appreciate the balance sheet management.

Origin’s investment in Octopuss is similar in style to previous Origin ventures, such as those into solar cell manufacturing, hydro generation in PNG, and solar development in Chile. Or Geothermal investment in central Australia and various small technology gambles too numerous to mention. Never mind failed oil drilling off Tasmania, off New Zealand and off Vietnam, or indeed spending $1 billion on offshore West Australian gas reserves that may never be developed.

However, notwithstanding the lack of control of Octopuss and the argument that it puts the cart (management of customers) before the horse (getting and appealing to customers), it is at least skill-set relevant to Origin’s business today and perhaps can be made relevant to the business of tomorrow.

Hey wind and solar developers, how does it feel to be invisible?

Meantime, just as with AGL, the major opportunity staring management in the face every day, and just like a courier in the lift, staring back at but unseen by management, is the opportunity to be the lead player in energy supply in Australia.

“Accelerate towards clean energy” – decelerate more like it

Management doesn’t necessarily realise it, but corporate slogans are important – but only if management actually internalises them and transmits that power to the workforce. When you have a slogan but don’t live up to it, that same vibe finds its way into the culture. It’s a fragile thing, motivation and culture.

Origin’s lists of development sites, most of which appear to be just listed on a slide to look like management is doing something, don’t include any wind projects other than that constructed in the never-never time, Stockyard Hill. There are two potential solar sites, but it’s hard to believe management takes them seriously.

Certainly, wind and solar development never rated a mention in the management conference.

Figure 1. Source: Company

If I was looking at Origin as an investment this would be a depressing list. If I worked at the company and saw all the startups happily developing off-grid projects, building big wind and solar farms, installing the world’s biggest battery, developing pumped hydro in Tasmania or Snowy, I would get a bit depressed.

Here I am sitting on all these skills, my company has Australia’s biggest load and what do I do? I build spreadsheets for management to pat me on the head with.

It’s not just building a new wind or solar farm, although certainly that is where the bread and butter’s going to be, it’s the opportunity to do smart things with renewables, to build regional franchises, to work with, or even own ring-fenced network companies. To build and build out an REZ like a property developer does.

Looking at the list:- Shoalhaven pumped hydro is actually off the agenda with a cost double the initial projection even in the spreadsheet, never mind the real world. The South Australian gas assets will, at least initially, be negatively impacted by Project Interconnect. Nearly all of Origin’s gas assets are anything but fast start.

Osborne takes hours to get to peak efficiency and Darling Downs, being combined cycle, will be similar. Osborne and Pelican Point are only limited-life
contracts, anyway.

The chart only lists two VRE potential projects, both solar. In itself, that’s not a roadblock because you could buy a development portfolio without too many issues. What is a worry is the complete lack of ambition in this slide. Essentially the slide says Origin has given up on developing generation.

Given the lack of value created in the gas generation assets perhaps current management’s tendency to talk rather than act is not a surprise. But as the country’s largest electricity retailer, it can’t be the right answer.

Every wind or solar MWh produced is one less MWh available to the firming market. Even as new entrants such as Neoen and the 2GW a-year behind-the-meter industry eat Origin’s lunch every day, Origin steadfastly, year after year, stands up and talks about the virtues of Eraring being able to flex down. And by 2032 it will have flexed out altogether. No mention at today’s briefing of how that output is to be replaced.

One thing I do agree with management on is that there will be a considerable need for longer duration firming power. The studies ITK has done indicate that wind and solar production will be strongly seasonal. Batteries are certainly not going to be the only answer, although I wish it were otherwise.

Whether Origin’s gas fleet is the answer is open to question. It wasn’t really designed for a firming role but rather as the “intermediate fuel” for the time between coal and renewables that never happened. Even now, if there was a carbon price, Origin would be quite advantaged.

Losing load as well as generation share
Figure 2. Source: Company

This may well be an industry trend from energy efficiency and behind-the-meter solar, but Origin needs to do more than cut costs. To grow profit sustainably you have to grow revenue. Price is kind of controlled, now, so that leaves volume to grow revenue, and or selling different services to customers, and or growing the customer numbers.

As with AGL, bolder thinking is going to be required. Price competition is unlikely to be that successful unless costs are materially lower than that of competitors on a sustainable basis. Energy is a grudge purchase, to make it otherwise you have to convince customers to be loyal. To do that you
have to offer them a better product. For many customers (remembering that 70% of the population are climate change sensitive) that might involve providing an intangible benefit. Even price-sensitive customers want to do the right thing.

Origin’s also lost business volume, down from about 20TWh to 17.4TWh in FY20 and again with a noticeable dip in the last three years. Business volumes matter less as margins are small, say, $4 to $5/MWh. But when you are buying your power and energy those volumes help to get a good price and also help with the load shape, which in turn reduces hedging costs.

And the overall outlook is definitely tough with profit set to halve. Energy markets ebitda will be down maybe 15-20% in FY21 (~$280 m) and down
say 25%-30% (~$600 m) in Origin’s share of APLNG. Depreciation will be up. Overall that reduction in EBITDA will likely see net profit more than halve.

On Thursday’s analyst call there was concern about the dividend but, notwithstanding Origin’s improved balance sheet, the question is why pay a dividend at all?

If a rising tide floats all boats an ebbing tide is likely to do the opposite. Low oil prices mean low gas prices. ITK still has at least 6GW of new wind and solar coming online over the next couple of years. For sure the commissioning is way slower than we originally envisaged but in the end it will nearly all be on line. Even if behind the meter slows to half its current pace, it’s still, say, 3GW over three years and there would be many that would bet on more.

To some extent it’s no longer a question of price for rooftop, it’s more about consumer preferences. So that new supply will force thermal plant more and more into a firming mode. Then we get to 5 minute settlement which is going to require gas plant operators to be even better at forecasting as conventional open-cycle plants of the sort Origin operates are far more expensive to run at lower levels of capacity utilisation.

As far as management assets go, remarkably ORG management forecast a $150 million reduction in gas retailing margin, and a $150 million electricity margin reduction. Those numbers are identical to AGL management’s forecast.

Figure 3. Source: Company

Origin is just as leveraged to the downturn in electricity prices as AGL, even though it has less coal generation exposure. And nor does it look as if the outlook for FY22 is much better. ITK’s forecasts of new generation by month, no less, of commissioning, are:

Figure 4. Source: ITK

You can see a steady stream of new supply with large dollops of wind coming through in calendar 2021. Although I am not putting ITK’s price forecasts up here – you have to be a client for that – the baseload futures curve tells its own story. For Origin with Eraring, a NSW generator, the inference from the chart is that 2021 is about the consensus low point in NSW.

Figure 5. Source: ITK

This reflects the forthcoming closure of Liddell. There are major upside and downside risks to these forecasts, although probably not for the next two years. The major issues are in Victoria, where the future of the Portland smelter and Yallourn is up in the air. Without more transmission to NSW Yallourn will have grave difficulty in ramping up and down once the influx of new renewables in Victoria is finally, if ever, up and running.

Origin has no coal generation in Victoria but the combination of Stockyard Hill and Mortlake might provide almost enough comfort in the event that Yallourn closes. But Portland does not provide round two of the Hazelwood loop. As things stand we are more and more pessimistic on the medium-term outlook for Yallourn.

APLNG good operator, but killed by the oil price

It’s a fact that Origin pays more for its gas on average than APLNG receives for domestic production ($6.4 v $4.61/GJ) and that the gap increased during FY20, reflecting, I suppose, the greater oil price leverage of APLNG domestic sales.

However, the main point is the protection provided by APLNG’s contracted production which resulted in an average LNG price received equivalent to
$12.86/GJ. Overall APLNG had $4 billion of cash flow net of capex in FY20, but before interest and tax, and this compared to $US project debt of about $A9 billion.

Origin’s share of APLNG volume was 265 pj or about 43 million barrels of oil equivalent. Origin has oil hedges of 22 mmboe equivalent hedging for FY21. ITK assumes a $US45/b oil price for this note and a simple oil/gas slope of 13%. This doesn’t allow for contract v spot sales or other factors, other than a 5% slip between MMBTU/b and GJ/b to get to a realized price of something in the order of $A10/GJ for LNG sales in FY21 on say 190 PJ production that’s a $600 million reduction in ebitda in FY21.

Overall, though, the underlying point is that APLNG will still be cash-flow positive and will continue to pay down its project debt and should still be able to provide cash flow to Origin. That leaves the question unchanged – how to use the cash flow wisely?

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