Investors should be wary of highly indebted companies operating in cyclical industries. Gearing up when conditions are favourable during cyclical upturns can prove costly when the cycle inevitably turns down and repaying the debt becomes much more difficult.
Shareholders in Origin Energy (ASX: ORG) have learnt this lesson over the past year as the oil industry cycle turned downwards, taking LNG prices – which are linked to the price of oil – down with it.
By my calculations, Origin’s shareholders have lost at least $7bn while and Santos (ASX: STO) shareholders have lost $6bn. And that’s after increases caused by news that Santos had swiftly rejected a takeover offer from private equity.
Origin’s problems stem from the billions in debt issued to construct its APLNG project in Gladstone, which it committed to when oil and LNG prices were much higher than they are now.
Plummeting oil prices have called into question its ability to repay its debt and so Origin recently raised capital, cut its dividend and announced further asset sales to try to alleviate investors’ concerns.
What’s the downside?
When investing it pays to think about your downside as well as your upside, as your analysis could be faulty or your assumptions too aggressive. Or you could just be plain unlucky.
That oil and LNG prices might decline materially seems not to have occurred to Grant King and the Origin board.
At Origin’s recent AGM, Chairman Gordon Cairns admitted that the company had not foreseen the oil price slide and underestimated its impact. However, he reassured shareholders that the company had learnt valuable lessons, and had now reformed its investment planning to include a ‘worst possible case’ scenario.
Those are some very expensive lessons.
Shareholders are entitled to ask why a ‘worst possible case’ scenario wasn’t considered before Origin undertook the APLNG project.
Gordon Cairns wasn’t alone in failing to foresee the oil price slide, as members who followed our Buy recommendations for Origin and Santos can attest.
Clearly, forecasting oil prices is difficult - and I certainly don't claim to be able to do so - but that’s even more reason for Origin to have considered a worst case scenario and tried to minimise any resulting damage.
For instance, why wasn’t APLNG funded with less debt and more equity, which could have been raised at much higher share prices to minimise shareholder dilution? Alternatively, why weren’t the first few years of LNG production hedged at the then forward prices to minimise the downside?
Answers to these questions may lie in Origin’s remuneration reports and the incentives given to Grant King by the board.
Grant King’s short term incentive compensation is based on Origin’s underlying earnings per share (30%) and the group’s ‘operating cash flow after tax’ ratio (30%), with safety, ‘engagement’ and personal key performance indicators accounting for the remaining 40%.
His long term incentive compensation is based on the total shareholder return of Origin shares relative to that of the ASX 100, with 75% of it being paid in options.
All up, he could potentially triple his fixed compensation if awarded the maximum under these plans. As such, with his compensation plans structured this way, he has a big incentive to minimise equity issuance and maximise the use of debt, also taking advantage of the tax deductibility of interest.
Amending his compensation plans to emphasise returns on capital employed would have reduced this incentive and perhaps avoided some of the shareholder losses over the past year.
In fact, Origin has proposed such a metric be included as part of his long-term incentive compensation going forward but it’s a little late for shareholders.
Perhaps influenced by these incentives, Grant King's decisions ultimately helped lose billions in shareholder wealth. As a result, he should consider resigning.
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