Origin Energy: Interim result 2015

At first glance Origin Energy's $25m loss appears a disaster but, as always, we need to make several adjustments to earnings to get an idea of what has happened in the underlying business.

Strip away changes in the value of derivatives and hedges as well as some LNG related expenses and underlying profit comes to a more respectable $346m, 9% lower than last year.

Underlying profits from the core energy markets business, by far the largest profit engine today, rose 22% to $617m which suggests a reversal following years of decline.

Again, we must pause and unpack that number because it is an important one. The drivers of that increase simultaneously reveal the strengths and the weaknesses of Origin's retail business.

As Queensland's giant LNG projects start this year, they produce huge quantities of surplus gas before volumes are high enough to run through processing facilities. This 'ramp gas' volume has resulted in the lowest gas prices ever seen in Queensland with some reports even suggesting that prices had turned negative for a while.

The gas glut was well known and highly anticipated but only Origin has been able to benefit substantially.  By replacing its own gas production with cheaper ramp gas, Origin has lowered procurement costs and increased margins today while preserving gas in the ground for future extraction at higher prices.

To make that substitution requires flexible generators and a captive supply of gas. It is because of Origin's strengths that the opportunity was available and exploited, adding $18m to the bottom line, 5% of aggregate profit.

Although the strategy contributed a 40% increase in retail margins for the half year, it will not always be on offer. And herein lays the weakness of the division: strong margins reported today may return to lower levels.

That's because electricity volumes continue to fall as they have done every year since 2008. This year, for the first time, Origin itself accepted that lower volumes are a fixture of industry demand. The old peaks won't return, which has implications for future profits.

Competitors are now competing to supply a shallower pool of power and discounting has become entrenched. Origin's clever gas strategy increased margins this time but it also lost another 30,000 accounts. Bleeding too many customers will threaten economies of scale and Origin will surely have to respond with price cuts of its own at some stage.

We are more pessimistic on the retail business than many and outlined concerns in Electricity disrupted part one and part two. Luckily, it doesn't change the case for Origin too much.

Going long LNG

Our investment case has always hinged on the success of Australia Pacific LNG (APLNG) which is now 90% complete. The oil price decline, if it persists, will reduce the value of the project and we recommend reading Origin gets an upgrade (Buy - $11.41) for our estimates on how much cash flow the project might generate.

Management say that, using the forward curve on oil which assumes prices of US$80 a barrel by 2017, APLNG should generate $900m in free cash flow per year to Origin. Our own estimates and Origin's both refute the hysterical claims that APLNG will generate widespread losses. This is no white elephant.

Within the context of a giant new project on the cusp on approval, the interim results were meaningless. All eyes are now on APLNG and all fingers are crossed for a higher oil price. What should investors do now?

We estimate that the energy retail business is worth about $8 a share and we count $2 a share for the stake in Contact Energy and the production business.

APLNG could be worth upto $6 a share to Origin meaning that the entire business could be worth about $16. That valuation depends on oil following the forward curve to US$80. With the share price now just above our $12 price guide and risk still present, we're downgrading to HOLD. 

Note: The Growth portfolio owns shares in Origin Energy