Next Year’s Rising Gas Bills On The East Coast

This story features SANTOS LIMITED, and other companies. For more info SHARE ANALYSIS: STO

By Rudi Filapek-Vandyck, Editor FNArena

It has been one of the easiest forecasts to make.

Since about a year or so, whenever I appeared for an on-stage presentation of my views and analysis of the Australian share market to investors across Australia, one of my recurring predictions has been: you haven't heard much about this up until now, but at some point into the future you are going to hear a lot about this.

I was talking about the opening gap between demand and supply for natural gas on the East Coast of Australia, more specifically in NSW.

It has been fairly quiet on this matter for most of the year past. It wasn't that long ago one economist at one of this country's professional forecasters responded to one of my Tweets on Twitter about this matter along the lines of: Amazing huh? How does one explain this?

By now the subject of East Coast gas has landed on the public radar, especially from the point of view that large players in the industry, such as AGL Energy ((AGK)) and Santos ((STO)), ostensibly feel boxed in and limited in their actions, while consumers, both retail and industrial, are going to face a step-jump up in power costs.

Quite remarkable also that almost immediately after the Federal election had brought in a new government in Canberra in September, the issue was pulled into the limelight by freshly appointed Coalition ministers. Obviously, there had been some hefty lobbying in the background.

This makes recent developments in NSW even more remarkable. In case the matter of unconventional gas in NSW has not been on everyone's radar these past few weeks, the state government of NSW (of same Coalition ilk as the federal government in Canberra, mind you) has decided to slap a restriction on coal seam gas exploration with an obligatory buffer zone of 2 kilometers from any farm or housing throughout the state.

The precise implications are anyone's guess as the public outrage and defense of the move has become an open mudslinging contest. Needless to say, this is doing some damage to the industry overall (which will please green activists). AGL Energy, Metgasco and others have been writing down the value of their assets in the state in response to what they claim are "too strict regulations" and there are quite a number of smaller players that have put their exploration and development plans in NSW on hold.

This is not going to be a story about whether this side or the other are right or wrong, or whether NSW should look at Victoria or Queensland in order to better deal with the issue of unconventional gas. The bottom line is this: NSW is dependent for 95% of its natural gas on other states and Victoria and Queensland are going to experience their own demand pull in the years ahead. At this point, there doesn't seem to be a realistic plan in place to deal with this (or any plan, for that matter).

Hence the straightforward conclusion that natural gas prices are going to rise, possibly a lot, in the years ahead in NSW and likely in every state on Australia's East Coast. In an odd twist following on from NSW's stoic clamp down on the nonconventional gas industry and from the state's failure to otherwise secure sufficient gas to meet growing demand, it turns out households in Victoria are likely going to be the hardest hit (thank you for this information, Angela Macdonald-Smith).

The most obvious beneficiary from this will be Santos, as I have been pointing out in the year past. No doubt, this realisation is one of the factors behind Santos' share price moving above $15 from $11-$12 at the beginning of the year and from $10 at the trough in July.

Other beneficiaries potentially include emerging players in the Cooper basin, the likes of Beach Petroleum ((BPT)) and Senex ((SXY)), but they all carry a much higher risk profile.

It is easily forgotten, but true nevertheless, the predicted spike in East Coast gas prices does not only generate winners. There will be losers too.

Straight up, I don't think investors should accept the present uptick in consumer spending by definition as a sustainable phenomenon. Most retailers are firmly oriented on the East Coast. If predictions (by some) about a spike in electricity bills to the tune of 15% prove correct, there will be widespread shock and an impact on consumer spending.

It's ok for consumers to feel more confident now there's a less dysfunctional government in Canberra and on the back of rising house prices, but a spike in electricity costs hits everyone right where it hurts most: direct into cash household budgets. (This also happens to be a time when major power retailers AGL and Origin Energy ((ORG)) are starting to scale back on price discounting).

Two obvious losers from all this are Orica ((ORI)) and Incitec Pivot ((IPL)). Both have major operations on the East Coast and both are major purchasers of gas. Higher input costs means lower margins and a loss of competitiveness.

Both share prices have been under a lot of pressure this year. Orica shares started the new calendar year a little below $26, but they are now languishing below $20. For Incitec Pivot, the damage has equally been significant with the share price eroding from around $3.25 to $2.70 this week.

While it would be easy to conclude investors have started pricing in worst case scenarios, I very much doubt whether this is the case. Both companies should be somewhat protected, at least at first, from longer running supply contracts. More importantly, however, is that both analysts and investors have had plenty of other issues to concentrate on, not in the least rapidly changing dynamics in global fertilizer markets which is keeping prices lower for longer.

It appears Orica has the most time at hand to find a solution to the coming spike in East Coast gas prices with supply reportedly contracted until 2017, but then management was forced to issue weak guidance to the market in September. Apart from the slump in fertilizer prices, it turns out Orica's client base for explosives in the US coal industry is suffering serious headaches and a stronger USD is not going to improve their competitiveness abroad.

As things stand right now, it appears analysts are positioning for a prolonged period of low to reasonable growth for the company overall, with risks skewed to the downside. The prospect of having to deal with rising input costs in Australia is hardly featuring at this stage, but it will at some point when today's newspaper headlines are starting to be replaced with actual market signals indicating higher prices for natural gas.

While it may well turn out that Orica won't be feeling too much of a direct impact at first, the realisation this might become a problem is likely to keep the share price at a discount from here onwards.

For Incitec Pivot the outlook for higher gas input costs represents a much shorter-term clear and present danger. A recent report by Macquarie suggests the company could be facing higher costs from early 2015 onwards. That's only a little over 12 months away. In the meantime, securities analysts continue to downgrade their price forecasts for fertilisers while the Australian dollar remains stubbornly above US93c.

Both dynamics have to shift in reverse for Incitec Pivot to regain its past mojo. On Friday, analysts at Goldman Sachs released yet another industry update, again confirming overall sombre prospects for diammonium phosphate (DAP) prices with importers in India hampered by the weakening rupee and with prices for corn and wheat anticipated to fall in the year ahead.

The earlier mentioned challenging conditions in the US coal sector are also expected to weigh on Incitec's explosives division.

Those analysts at Goldman Sachs are not expecting much in terms of profit growth until FY15, the year that much higher gas prices on the East Coast are likely to present themselves as the next major hurdle. Under a worst case scenario, Incitec Pivot shares are now destined to trade at a valuation discount for many years to come.

In both cases, it is well possible there will be no recovery from the current down-cycle in earnings estimates until next year and by then the general focus on higher gas prices is likely to keep a lid on upside potential for the share price. Especially in the case of Incitec Pivot this seems but a highly plausible outcome.

(This story was written on Friday, 4 October 2013. It was published in the form of an email to paying subscribers on Monday, 7 October 2013).

(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions. All views are mine and not by association FNArena's – see disclaimer on the website)

FNArena subscribers might also want to read:

– Are Rising East Coast Gas Prices On Your Radar?

Here's Angela Macdonald-Smith's story about Victorian households to become the main victim in AFR:

– http://www.afr.com/p/australia2-0/gas_price_headache_only_just_beginning_ir6hvl3VTRZ68XBPLXkkZJ

And for those who are as yet not familiar with my personal market indicator (banks share prices versus consensus targets):

– Banks Now Overpriced – What Does That Mean?

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THE AUD AND THE AUSTRALIAN SHARE MARKET

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Things might look a lot different today than they have between 2008-2012, but that doesn't mean there are no lessons and conclusions to be drawn for the years ahead. "Making Risk Your Friend. Finding All-Weather Performers", was published in January this year and identifies three categories of stocks that should be part of every long term portfolio; sustainable yield, All-Weather Performers and Sweetspot Stocks.

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Rudi On Tour

– I have accepted an invitation to present to ATAA members in Canberra in late November

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