The demise of ‘old world’ energy has been greatly exaggerated
Many investors believe the energy ‘new world’ – renewables, batteries and smart grids – is going to wipe out the ‘old world’ – the centralised baseload generated from nuclear and fossil fuels. While we do accept there will be a transition, we are cognisant there are serious financial, political and practical factors keeping low cost ‘old world’ assets in demand for the foreseeable future. For the lights to stay on, supply and demand must be actively balanced 24/7 and renewables simply cannot do this yet.
The workings of electricity markets in Europe are complex and somewhat poorly understood, largely due to the interplay of national and EU-level policies. However, what is abundantly clear is the German policy of subsidising renewables has had the unintended consequence of knocking cleaner burning natural gas out of the supply stack in favour of cheaper hard coal. As high cost gas plants were removed from a price setting position and increasingly sat idle, vital ‘peak pricing’ gradually disappeared. Depressed gas prices over the past 12 months have further cut into peak price volatility. Thanks to EU-led market coupling, this power price malaise spread to France and other parts of the continent.
Without the earnings that flow from ‘peak pricing’, both hard coal and gas generators in Germany have failed to recover all-in costs for a number of years. As a consequence, 15% of hard coal and 23% of gas/oil plants have already declared decommissioning plans. When combined with the forced shutdown of nuclear and lignite plants, we estimate 30% of the total required capacity is set to leave the market by 2023.
While renewables will fill some of this gap, gas fired generation will play a much greater role, leading to a large pick-up in gas demand, as well as a significant increase in power prices. As the UK market has recently shown, a properly functioning carbon market would significantly accelerate that shift.
Market significantly underestimating gas demand
Although not immediately obvious, there are a number of links between global gas prices and European electricity prices. The current consensus view is that the wave of new liquid natural gas (LNG) projects from the US and Australia will result in a global oversupply of LNG. Europe is expected to become the dumping ground for this ‘excess’ LNG, putting downward pressure on European gas prices and by extension, European electricity prices for a number of years.
We tend to disagree for two major reasons. Firstly, the market is too focused on the supply side of the LNG equation, missing the significant growth in demand from new gas markets such as China. Secondly, we question whether there will actually be sufficient gas production in Australia and the US to meet the future volume commitments of these LNG plants.
Over the next three years, annual global LNG capacity is set to increase by around 100 billion cubic metres (bcm). Set against current LNG demand of 350 bcm, this growth in output is considerable. However in the context of global gas consumption of 3600 bcm, it does appear somewhat insignificant – especially considering China’s demand potential. Chinese gas demand has grown at 13% per annum over the last 10 years, with consumption this year set to come in at 235 bcm, up 15% year-on-year. Despite this growth, gas still accounts for less than 7% of the energy mix, well short of the government’s 10% target set for 2020.
With domestic production growth estimates largely dependent on unproven shale reservoirs, LNG is likely to supply the bulk of this additional demand. So far this is proving to be the case with Chinese LNG imports surging 50% this year. When combined with robust demand from new markets such as Pakistan, Jordan and Thailand, as well as increased gas fired power generation demand in Europe, we question whether there will be any LNG surplus at all. With LNG spot prices currently trading at a premium to long-term oil-linked contracts, we feel somewhat vindicated in our view.
Our holdings in France’s EDF and Japan’s Inpex are well positioned to benefit from this forecast rise in gas and electricity prices. While correlated, these stocks are broadly differentiated by activity and regional end-market – including resource owners, energy services, European electricity generators and Chinese town gas distributors.
French government highly incentivised to revive EDF
EDF is the owner of the largest nuclear fleet in Europe, supplying 80% of French electricity demand. It has been unduly punished by the European regulators and investors alike, who have failed to recognise the systematic importance of this asset. The power price malaise that spread from Germany to France has depressed French prices to levels EDF’s regulators had never envisioned. Investors are extrapolating these conditions into perpetuity, not recognising the inevitable transition to a more sustainable state of affairs.
As the largest producer of carbon-free energy in Europe, EDF is system critical not only to France, but to the entire continent. All-in cash cost on EDF’s fleet, even in the middle of a very heavy maintenance cycle, is still cheaper than a comparable cost measure for gas or hard coal – at currently depressed carbon and gas prices.
Energy demand is bound to increase with the economic recovery, at the same time as capacity is being withdrawn at a record pace. Electric vehicles (EVs) have potential to further increase energy demand by around 0.7% for every 5% of EV adoption rate. As marginal fuel shifts from coal to gas, Europe may find itself in a ‘power price’ super-cycle. Poor economics and tighter environmental policies will eventually drive hard coal out of the market and gas burn will increase substantially, pushing gas and electricity prices even higher.
Despite the 40% rally off the lows, the shares trade at a fraction of the replacement cost of the assets, reflecting a long streak of operational, governance and regulatory mishaps. The 63GW strong nuclear fleet – once an earnings powerhouse of the group – will likely return a cash break-even result this year. We appraise the market is valuing this at a negative €20bn equity value.
The French government owns 80% of EDF and it has already implemented a number of important regulatory initiatives to bolster the earnings of the French fleet. After funding this year’s €3bn equity injection and multiple foregone dividends, the government is highly incentivised to make the company work again. An extra 10€/MWh in power prices makes a significant difference to EDF’s earnings (+€1.8bn), but only represents +6% on the total French retail power bill – and the country enjoys a power bill roughly 50% lower than the broader region.
Inpex is trading at significant discount to its true value
Inpex is effectively Japan’s national oil company and is the operator and 62% owner of the giant $38bn Ichthys LNG project off the coast of Australia. Ichthys is effectively three mega-projects rolled into one, involving some of the largest offshore facilities in the industry, a state-of-the-art onshore LNG processing facility and an 890km pipeline, all with an operational life of at least 40 years.
By the time Ichthys reaches plateau production in 2019 it will be generating 8.9 million tonnes of LNG, 1.6 million tonnes of LPG and 36 million barrels of condensate per annum. For Inpex, this will translate into an additional output of 200,000 barrels of oil equivalent per day (boe/d), increasing its production base by almost 50%. Given the relatively low operating costs and favourable tax structure, the impact on the cashflow statement will be much greater. Yet despite this upcoming inflection, on most metrics Inpex still trades as the cheapest oil and gas producer globally; so what is the market missing?
We believe the market is too focused on what has happened, extrapolating the operational and cost issues that have also plagued other Australian LNG developments. Despite having scant tangible evidence to support their claims, the bearish sell-side analysts still forecast significant cost overruns. While we acknowledge there are residual risks, we take comfort in the fact the offshore facilities have now been installed and the project is over 90% complete. Inpex is also a victim of where it is listed, with most Japanese investors unaccustomed to valuing resource-based companies given the lack of local comparisons.
We consider the net present value of its proven reserves to be worth $20bn, compared with the Enterprise Value of $16.5bn. Bear in mind this is only proven reserves; no credit is given for possible reserves or future exploration success. Effectively we are buying the business today at a significant discount to the run-off value. As a sense check, by the time Ichthys has fully ramped up in 2019, Inpex will be on an EV FCF yield of 15%, assuming oil prices of $50/boe.
Hedging exposure through ‘overvalued’ shale
While the global energy and electric/gas utility sectors appear cheap in most regions of the world, there are also cheap ways to hedge some of the commodity price exposure via shorts in the current environment of high valuation dispersion. In particular, the North American ‘shale patch’, where the market is still extrapolating growth with very little focus on returns, still appears significantly overvalued – as do the North American utilities that have been broadly re-rated as bond proxies.
Jacob Mitchell is CIO and portfolio manager at Antipodes Partners