Classical Gas

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

 By Greg Peel

Once upon a time coal miners used to carry a canary in a cage into a mine as a primitive form of gas meter. Were the canary to suddenly drop dead, the miners would retreat. The tiny bird would always feel a more immediate effect from deadly concentrations of methane gas. Methane trapped in coal seams was always one of the coal mining industry’s biggest dangers and subsequent problems. For many years mining companies would pipe methane to the surface and burn it off into the atmosphere to allow safe access to the valuable coal beneath.

In early 2008, a bleaker than usual Chinese winter shut down much of the industry in the more northern, snowbound regions of the country. As home to many of the nation’s coal-burning power stations, the shutdowns highlighted the fact that China’s energy supply was insufficient to maintain the country’s rate of economic growth.

At the same time a more fundamental problem became apparent. When the snow melted, the power stations could fire up again. But the reality was China was also reaching the limit of its own coal supplies. After having always survived as a net exporter of coal, there was a risk China would now need to become a net importer. When the big coal importers of Japan and Korea then sat down to negotiate annual coal supply contracts with the world’s largest coal exporter – Australia – they found they suddenly had to pay three times the previous year’s price.

The world had already begun to seek alternatives to coal-fired energy in response to perceived climate change. The spectacular rise in the oil price up to 2008 only made the need for any form of alternative energy more imperative. When the coal price finally jumped to match the general cost in the global price of energy, alternative energy saw a big jump in investment interest, but strangely enough, one alternative energy company sat conspicuously under the radar.

That company was Origin Energy ((ORG)). Origin spun off from building products specialist Boral in 2000 at a price of $1.54 per share and then went about buying up energy assets both upstream and downstream. As both a driller/explorer and retailer, Origin was a bit of a mess for stock analysts who couldn’t quite work out whether the company was an oil and gas producer or a utility. Origin acquired many diverse assets, but one area it was keen on was that of coal seam gas – the methane of which we speak. Queensland was set to privatise its electricity industry, and Origin saw great potential in converting CSM into liquid natural gas to fire power stations. LNG-sourced electricity is much cleaner than coal-sourced electricity.

Nobody paid much attention.

Yet not much earlier, LNG had been all the rage. As the price of oil began to rise alarmingly in the noughties, the value of natural gas as an alternative to dwindling oil supplies became apparent. Australia had always been a large global player in the LNG market, but attention had suddenly swung to Papua New Guinea. The country had an abundant source of LNG, and before long global giants Exxon and Nippon Oil had teamed up with Australian companies Santos ((STO)), AGL Energy ((AGK)) and Oil Search ((OSH)), along with investment from the PNG government, to exploit the country’s reserves. It was never going to happen overnight, and even if the project did get up and running there was talk of perhaps a massive pipeline back to Australia to consider, which just gave the whole thing a bit of a “pie in the sky” feel.

Analysts all agreed that PNG LNG would likely pull Santos out of its doldrums, while for Oil Search it could be a “company-making” project. For a couple of years any valuation of the shares of each company came with a caveat that a successful PNG LNG ramp-up would mean a huge jump in value – one day.

But the market got a bit bored.

In early 2008, stock analysts were preoccupied with the rising price of oil and the effect that a new regime of carbon trading might have on companies in both the traditional energy market and the alternative energy market. One such beneficiary of the latter case would be Origin Energy, they all agreed, but carbon trading has been just another element to consider for the longer term. In the shorter term, Origin wasn’t kicking any great goals with its production figures. Analysts were inclined to give the stock little more than a Hold rating.

Then in May, a bombshell was dropped.

As energy sector analysts dozed, British gas giant BG made a friendly $14.70 per share takeover offer for Origin. The price was 40% above the previous closing price for Origin shares and 50% above the volume-weighted average of trading for the previous month – the measure by which takeover premiums are priced.

The market was gobsmacked. “Take it, take it!” screamed most analysts. But loyal Origin CEO Grant King was not going to let his baby go quite so easily. He advised shareholders to reject the bid while the board considered the offer. In the meantime, the price of other companies with anything to do with gas also shot up. This was a natural gas wake-up call. And more specifically, a CSM wake-up call. BG had indicated it was Origin’s previously shrugged-off CSM assets it was most interested in.

The market was again to be gobsmacked when the board said no. Friendly takeover bids of 50% premium are rarely rejected. But King went to great lengths to impress upon the market that Origin’s gas assets were worth a lot more than analysts had ever previously given them credit for. The company quickly announced large increases in proven and unproven reserves. As far as King was concerned, BG was only making an opportunistic bid against a share price the market had incorrectly priced for years.

Soon analysts started to come around to King’s way of thinking. But if they needed any further encouragement, they got it in the form of a new bid from BG. Following discussions with the Origin board, the bid was lifted from $14.70 to $15.50 per share at the end of May. No doubt BG was sure this would seal the deal. However, having been forced to properly evaluate the potential of coal seam gas as an asset in the twenty-first century, some analysts had already started setting 12-month target prices for Origin in excess of $20.00. Only a month earlier, $10 was about par.

Nevertheless, it was going to be even harder for Grant King to convince Origin shareholders to have faith and hang on. In setting its first high-premium price, BG no doubt thought it had a killer punch. But it had also opened a hornets’ nest, drawing global attention to Australian gas. The $15.50 was meant to be a deal-sealer, and it is likely there were plenty of shareholders prepared to take the money and run. Origin fought back with more substantial reserve increases, but the obvious question was why now? Where were these supposed reserves before the bid? Unfortunately for BG however, it never saw the Malaysians coming.

Santos had long been the “Nigel No-Friends” of the Australian oil and gas sector, struggling to ever find a stock analyst who would support it. Santos would just bungle along providing disappointment, all the while constrained by an old South Australian government law which prevented it from opening up its register to major equity investors. However Santos was also quietly involved in CSM, and despite the BG bid for Origin the market had still failed to appreciate this fact. Thus when Petronas snuck around the corner and announced it had acquired a 40% stake in the Santos gas project for a mind-boggling amount, analysts fell off their chairs for the second time in a month. Targets that were previously set around $15.00 for Santos suddenly became $25.00. If the BG bid for Origin was a potential industry re-rating, the Petronas deal with Santos was the confirmation.

It is now history that Petronas probably saved Grant King from losing Origin, thereby providing the market with more than just blind ego as justification for his stance. BG was clearly livid, immediately moving to make its bid hostile. But the Brits were not going to raise their price any further. They would leave it to the shareholders to decide. The shareholders stuck by their CEO.

That was June, and we are now in November. In the meantime, global financial markets have collapsed. As a result, global energy prices have collapsed. In the ensuing period, and despite the mid-year goings on, many Australian oil and gas companies have since lost up to half of their share price value. At one stage it looked as if the great CSM/LNG story might be over just as quickly as it began.

But it wasn’t.

Origin’s shares were never going to fall as much as some of its competitors, given one assumes the BG bid was still lingering and thus providing a floor. The new world financial regime meant that what had been one of the most promising industries to be in five minutes ago was now dead in the water. With oil at US$60/bbl instead of something over US$100/bbl, alternative energy sources appeared to have lost any appeal. Renewable energy developers were the hardest hit. September saw massive selling. Yet this, of course, was a fairly short-sighted view.

For starters, Origin had taken the obligatory step of retaining an independent expert to assess the company’s claims that even the higher BG bid undervalued the company’s potential. Grant Samuel did not disappoint, coming back with a valuation of $28.55 to $30.71 for a company that had been trading at under $10.00 not six months earlier. While impressive, this valuation meant little when the world was redeeming in desperation, so it took a real deal to stop the rot. When US giant Conoco-Phillips bought a half share in Origin’s CSM assets in mid-September for $9.6 billion, Grant King was resoundingly justified. And elevated to god-like status.

One company to feel the brunt of redemption selling, nevertheless, was Queensland Gas ((QGC)), despite the fact QGC is an Origin look-alike in many respects and the first stock to jump in sympathy when BG made its original bid for Origin. But when you’ve gotta sell, you’ve gotta sell. QGC shares fell from an Origin-inspired peak of over $6.00 in May to around $2.50 in October.

Anyone who thought BG must now surely have taken its bat and ball and gone home was mistaken. BG’s original bid for Origin may have seemed opportunistic in retrospect, but it was not made simply because oil looked like reaching at least US$150/bbl in the short term. It was made with a long term view in mind, and BG’s long term view is clearly that there is value in CSM.

Having failed with Origin, in late October BG announced a bid for QGC at $5.75 per share – some 80% above where the shares were trading but closer to where they had reached when BG made its first offer for Origin. This time the market was sure QGC would accept the bid. Despite global stock market and commodity market carnage, CSM was back on the radar.

Or more generally, as it turned out, LNG. Only a couple of days later, AGL Energy announced it had sold its PNG assets, including a stake in the great PNG LNG project, for $1.1 billion. AGL had long flagged it would sell these assets as part of its consolidation, but analysts had considered this would take a while yet, given the circumstances. They had also considered about $800 million to be a realistic price.

AGL was not prepared to divulge the identity of the buyer, and it is still a mystery. However, Citi analysts are prepared to make a bet the mystery buyer is in fact Italian oil and gas giant Eni (if it’s not BG again). The reason is that Eni had previously announced a long term partnership agreement with the PNG government. The PNG government is one shareholder in PNG LNG, and AGL is another.

And so is Santos, and so is Oil Search. The AGL sale was great news for Oil Search in particular, for the company holds pre-emptive rights over the AGL PNG parcel. While it might have been nice for Oil Search to increase its stake in PNG LNG at such a time when the world appears to be coveting LNG, it would have required additional funding at a time when funding is not easily found, or at least very expensive. This meant an overhanging “equity risk”. It is now assumed the AGL sale removes Oil Search’s possible obligation, but at the same time places a accountable value on the company’s existing PNG assets – those same assets that are assumed will one day prove “company-making”. It is good news all round, as the Citi analysts proclaimed.

For AGL, it was also a win-win. Not only does the company get to book a nice valuation profit, it is also now cashed up. This means AGL is in a position to jump on any fresh assets that might come onto the market from distressed sales. NSW Electricity is still a lingering possibility. On the macro scale Citi has proclaimed that “Clearly corporates are taking long term views about strategic assets like LNG”. And on that basis, [investors] “Ignore at your peril”.

If that wasn’t enough gas news for one week, we were quickly to learn that Origin had received an upfront payment from Conoco-Phillips on its gas arrangement of US$5 billion. Given the Aussie has collapsed since the deal was struck, Origin has scored a bonus A$875 million. Only months ago Origin was stretching its gearing to near the company’s 45% limit. With the extra money from Conoco, Origin is now cashed up and, like AGL, in a position to spend.

There has been no confirmation that Grant King now reaches his office by simply walking across the Brisbane River.

American oil sqillionaire T Boone Pickens has been a major supporter of alternative energy sources, and was afforded a lot of media airtime back in June when oil was trading at over US$140/bbl. Pickens was sure oil was going to at least US$150/bbl and has recently been a big advocate of diminishing America’s dependence on foreign oil imports, particularly from enemies. He particularly favours wind energy and natural gas. In the case of the former, Pickens is in the process of building the world’s biggest wind farm in the US. In the case of the latter, Pickens is lobbying that all US road transport should be fuelled by natural gas rather than diesel. This would be a major step towards reducing carbon emissions and reducing oil imports. The US has it own sources of natural gas.

Imagine if the world’s greatest consumer of oil – by a long way – started switching to natural gas. Whether or not this is a case of rose-tinted glasses, or even a project for the distant future, there is little doubting the world’s largest oil and gas companies are currently scrambling to buy up assets that will enhance their exiting supplies and sources. Having reaped an extraordinary benefit from five years of rocketing oil prices, cashed up corporates are now consolidating their future. They’re clearly not going to let one little global recession make a difference. They are not two-year players.

What or who will be in their sights next?

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