GDF Suez – rock in the oil waves

GDF Suez results show that the company has enough resilience to withstand the commodities weakness and that it still has flexibility to deliver small upside from cost efficiency. Capex will deliver a credible return to growth at the high end of the sector. That is initiated this year.

Revenues of Eur 74.7bn were below expectations, but Ebitda of Eur 12.1bn beat the Eur 11.1bn consensus. The outlook for 2015 for net income of Eur 3.1-3.3bn is in line. There was weather and commodities impact hitting the numbers, but in the greater scheme of the sector that impact was very contained.

The Doel/Tihange nuclear situation is largely resolved and a major overhang removed.

GDF Suez’s distinction is its diversification and growth pipeline. Despite strong sector headwinds, global gas still delivered organic growth of 4.5% y/y.

I see the business as resilient and continuing to benefit from structural growth going forward. Weaker LNG diversion margins should get compensated for by volume and new projects as well as the company’s integration hedge. Further, management has announced credible opex efficiencies that should compensate for about one third of the commodities impact for this year.

GDF Suez is still in a strong commodities position when compared to most names across the energy sector. Gas oil spreads have actually been favourable for the company as it is net short oil. Long gas short oil price exposure will in my view remain a favourable position going forward. And, the company currently benefits from oil LNG indexing in its sourcing portfolio. This is the big attraction of the company’s integrated energy business: It has arbitrage and diversification potential that gives optionality and hedge second to none.

The power capacity pipeline currently amounts to 10.4GW under construction. There is a good share of renewables projects in the pipeline.

The company has enough flexibility for Eur 6-7bn growth capex including acquisitions despite the overall capex reduction. Net debt/Ebitda of 2.5x stacks up very favourably within the sector comparison.

The underlying business is delivering the proof in the numbers. Bottom line growth is likely to come in at low single digit levels in 2015, but return to 10% y/y in 2016. That is an earnings profile that stands out within the peer group.

At 15x P/E 2015, 6.8x EV/Ebitda 2015E and a prospective yield of 5.3%, GDF Suez stands out as good value quality with one of the best growth underpinnings in the sector.

Commodities, squeeze, politics and sentiment – differentiation

Of the last round of reporting, Centrica (CAN LN) clearly stands out as by far the most negative. More important than the weak guidance are structural difficulties. Technip (TEC FP) has delivered a strong enough outlook and backlog that despite weak commodities, it is now a favourite in the sector. Ibedrola (IBE SM) is coming out of the trough and should see further upside, whilst risk still outstrips the potential for reward at EDF (EDF FP).

Centrica’s new guidance implies further downside to consensus. Management guides for 2015 EPS of to be below the 2014 adjusted number of GBp 19.2, ie below consensus of GBp 20.6.

The 21% dividend cut to GBp 13.4 is disappointing but was in my view reflected. Post cut, the shares yield 4.8% which is in line with the utilities sector. That Centrica was unable to sell three UK CCGT power stations is one of the underlying reasons for the dividend cut. That plant has become unsellable is a new. The prospect began to shine through when the plant did not qualify for capacity payments.

The GBP 14.bn impairment charge on E&P assets is not surprising but a warning sign that more of the same is likely to come in the sector. Other E&P names with more favourable hedging may not need to impair yet, but risk is high for the next reporting rounds.

Altogether, Centrica is a very illustrative case of the fallout of the combination of commodities and policies that affect the energy sector. As quoted by the CEO, the company is “completely compressed”. I see it as having pursued a viable strategy, but the speed of the commodities fall is not something it can withstand whilst being hit with the supply margin squeeze on the other end of its business. For the time being, I see no prospect of any turn in either earnings or sentiment.

Contrary, Technip (TEC FP) has beaten expectations, reiterated 2015 guidance and increased the dividend. 2015 Ebit consensus stands at the low end of the Eur 11.2-11.5bn revenue and Eur 1.02-1.1bn Ebit guidance. Further, the company’s reported Eur 21bn order backlog gives it a very comfortable shelter in the weak oil capex environment. The Yamal project illustrates good execution and cash management. All of the above combined makes it stand out in the oil services sector and justify the premium rating. Technip may well lead an oil services sector recovery rally.

Iberdrola (IBE SM)’s in line earnings now have a sustainable structure. 2014 was the tail end of the Spanish problems by and large. Industrial demand has recovered, hydro production was strong, and renewables in new geographies are positive earnings drivers. Those new earnings drivers are now strong enough to make up for other weak spots, such as UK demand. I note the performance improvement in the UK as a particular differentiator on the side. Management guides for Ebitda above the Eur 6.9bn reported for 2014, in line with consensus.  Positive sentiment should continue to drive the share price.

EDF (EDF FP) is on a rockier path, on balance still the wrong side of nuclear. The existing operations suffer from the ailments of ageing technology with high and growing capex requirement while new build is all but on track. Good French performance could not make up for the impact from the UK. The latest delay to Hinkley Point may hang on relatively minor points, but is another negative for sentiment. The details on the cfd contract need to be fully hammered out, the Chinese partners appear to have become more demanding. With both of those issues, there is a political dimension – partly because of the upcoming election, but also because of wider political considerations with regards to Chinese involvement that are tied to the project. If there is slippage beyond the election, there will be a new level of political risk to the project as a whole.

Not to forget, there is the French political dimension. Signs amount that the French state might push for an involvement with Areva. That would undoubtedly be seen negatively. Management denies any intention to make a financial commitment, but beware of who has the last word.

Consensus is in line with Ebitda guidance. But, I see sentiment as very cautious and likely to remain so. The 2018 target of positive free cash flow after dividend will be a challenge.

Transformation, risk and opportunity at SMA Solar and whether to get involved with inverters

After three profits warnings, a 60% share price decline over the past year and a new restructuring strategy, sentiment is still not yet likely to turn positive. Pricing pressure in the core market is there to stay. The company is well positioned to ship into a growing smart energy market, but it will encounter new and strong competitors. Consensus is still too high.

The share price of SMA Solar has fallen 85% peak to trough and is now standing at a new all-time low. The EV/Ebitda multiple has contracted from 6.4x to 4.5x. The next points shed some light on bull and bear points.

SMA has delivered profits warning number three. That concerns 2014 and 2015. Reduced guidance is now for a 2014 net loss of EUR 115m and a net loss of Eur 30-60m for 2015. This is on 2015 revenues of Eur 730-770m.

Management quotes generally difficult markets, weak German and European demand, competition and pricing pressure.

None of these issues are new. The issue is that the company has long time communicated a message that was meant to dissociate SMA from all of the broader market problems and differentiate from the sector. Fundamentally, the building blocks of that messages are there: Strong brand equity, market leadership in a fragmented market, and a flexible cost structure.

The big question – it has encountered doubt in the market before – is barriers to entry. That is the very centre of SMA’s problems. The company communicates a strong claim of barriers to entry, through its market position and through IP.

I agree that SMA’s product has IP and differentiating features. But, inverters in its very basic form are undifferentiated products. SMA is coming to discover that. The announcement that the company will manufacture very basic version of its inverters as a response to Asian competitors is admission of the fact. Inverters in a simple form exist en masse and at very low prices. I do see it as a positive sign that management no longer insists that its basic inverter has great features of differentiation. That should open perspectives for strategic action.

High quality inverters improve performance of solar systems and also play an important part in bankability of an overall system or project. That has initially played in SMA’s favour. But, competitors have moved up the scale and SMA’s ability to differentiate has decreased, leaving the price point more vulnerable.

Management is now addressing the cost vs differentiation issue through the modular strategy where it tags higher value added components onto a basic inverter. That latter element clearly targets low cost competition: SMA is looking to manufacture as a low cost component.

SMA’s li-ion inverter and lead battery and storage packages are still priced at the high end of the market. The domestic version retails at Eur 13-15k including modules, of which I estimate an implied battery ASP of Eur 6-8K for the 2.2kW battery. On a stand-alone basis, SMA’s battery retails for Eur 5K. Average retail prices are at the Eur 8-11K level for 5-7kW batteries. The relationship is similar for the 4kW battery.

As a whole, the end price of the combined product fall. The basic inverter should trade on a very small implied premium vs low cost competition. By implication, the value added components will be the crucial margin drivers for SMA.

With that proposition, SMA’s case is conditioned on market take up of smart features, growth of storage, demand management and the like. It is also partly conditioned upon the company’s ability to develop that market.

SMA enters into a new marketplace, with new competitors. Its new competitors are battery manufacturers, appliance manufacturers and consumer and energy services companies. Do not forget Google – it is everywhere, and is developing an aggressive energy strategy for precisely the above new energy features.

SMA would be well advised to consider partnerships in those areas, particularly downstream towards customer management, packaged goods and services and broader relationships.

The other side of the equation, the cost base, is despite great flexibility (3 shift flexibility allows capacity to be flexed by a factor in excess of three) is not adequate yet. Inverter production is highly automated and materials account for 80-85% of total costs. But the remainder of labour can make a competitive difference. And, likely, there are material cost and working capital issues that need to be addressed, too.

I have argued for long time that there will be structural and persistent cost pressure across the solar value chain. That comes from its technology driven cost progress and price decline logic, and from the need to reduce costs in order to achieve grid parity. Now that grid parity has taken another step down with lower oil prices, solar has yet more pressure. Balance of system, ie inverters, bear the brunt. The sector has held up margins much longer than any other segment of the value chain. It has to deliver now.

SMA’s cost base is still too high and too fixed. Its former high margin markets are no longer the global demand drivers.

The internationalization strategy has worked to a degree. The company claims a 30% market share in the US. In terms of revenue and earnings contribution, the US accounts for c 40%. But, the company has hardly any presence in Japan, one of the most important growth markets. There initial inroads, but not strong enough for them to be a major turnaround driver yet. China seems closed to SMA, despite the Zeversol acquisition.

Management seems to be going back to its roots in a way: It is looking to adapt in such a way that it can make a profit with less than Eur 700m of revenues. The CEO quotes 2008 as the benchmark year. That is a return to the times before the great boom. In 2008, The SMA’s net earnings amounted to Eur 167m on Eur 680m revenues. But, at that time, its market position was that of an undisputed leader in the world’s largest solar market by a distance. The world has changed and with it margins. The company’s gross margin has halved. Future revenues are coming in at lower gross margins than those of 2008. The company’s cost base has to go below that of the pre-boom times.

Sentiment had seen a short blip up after the strategic announcements of the capital markets day. But consensus movement is firmly on the negative side and I see further pressure. Current consensus for 2015 is for Eur 852m of revenues, but for a net loss of Eur 20m, well above the low end of guidance. There could be big upside if management can deliver on its return to profit. So far, the market is not giving any credit for that. The earliest it might do is in my view from H2 when the first impact of any successful execution on the strategic plans could come through.

SMA trades on an EV/Ebitda multiple of 4.5x 2015E. That compares to an average of 4.6x for the global solar manufacturers and 8-9x for the recovery driven electronic and engineering competitors. For 2016, the first year where consensus is for a profit, the shares are trading on a P/E multiple of 25x. That is a growth stock multiple and in excess of the company’s historic peak multiple of 18.6x. I do not see room for multiple expansion. Rather, there is downside risk as the underlying numbers will come down and SMA is a later stage than most of the solar peers that have already gone through restructuring.

I estimate a fair value between Eur 9.50 and Eur 12.0. The high end would require to sustain a competitive advantage and grow ahead of the market until about 2030, whereas the low end implies a business that will be somewhat greater in scale but much resemble the 2008 levels. I expect ROIC will not recover to peak levels ever.

Nuclear in Europe – will the mushroom cloud shift?

The German government may revisit a nuclear liabilities fund, but the latest proposals create cost rather than relief for nuclear operators. Areva (AREVA FP) meanwhile has warned on more provisions and write downs. Nuclear in Europe remains a high risk proposition. Not of explosion, but of continuous toxic leak.

Quoting discussion papers at the Economy and Environment Ministries, the German press reports the German government is looking to force the nuclear generators to make contributions to a nuclear decommissioning fund. The total is to amount to Eur 17bn. The current nuclear provisions would then only be meant to cover decommissioning and intermediate waste storage.

Collectively, the industry has nuclear provisions of Eur 36bn. The cost of decommissioning a nuclear plant lies in the region of Eur300-500/kW. The OECD estimates full cost of decommissioning for most Western PWR reactors of USD 200-500/kW. The German nuclear park would on that basis require decommissioning costs not to exceed USD 350/kW. At this stage, the amounts seem comfortable. But, the government may seek further protection.

This is in my view a result of the “nuclear bad bank” discussions last year and the much deteriorated financial situation at the utilities.

The utilities, particularly RWE (RWE GR), have communicated strongly on their much worsened earnings and financial situation. There is not much prospect for change as the energy transition continues unabated and power prices offer no relief any time soon. That could have heightened concerns over their ability to meet liabilities.

There have been public calls from various groups to shield the taxpayer from any potential costs at various times: At the respective earnings calls, the first nuclear liabilities fund proposal and E.ON’s (EOAN GR) split.

The government may have caught fear. E.ON’s split announcement, RWE’s comments relating to power plant displacement and reduction of generation activities, generally a harsher tone from utility managements, and the self-explaining earnings and finance directors’ comments may have led to a perception of higher risk of liabilities falling onto the taxpayer.

Final and intermediate waste storage may also have come into this. The utilities are now also suing over the Gorleben storage site. The industry has funded the development of the initial site. The government has subsequently put that site into question and is calling for a new search, with potentially further costs for which it will likely call upon the industry again.

The new debate is likely a follow on from the suggestions by the industry for a nuclear foundation last year. The discussions about the nuclear “bad bank” could have reinforced concerns over a potential funding gap. It may also have led to the idea of contributions. The industry itself had suggested openness for additional funding if the nuclear liabilities were centralised in one entity.

Much of the proposals goes towards the direction of the proposed nuclear fund.  But it looks more like a move of protecting the tax payer than relieving the utilities. They are to take full legal responsibility for the nuclear liabilities. Corresponding profit sharing agreements with the fund are mentioned. There is also suggestion of rules for investment of offsetting dedicated assets.

The nuclear provisions are dedicated, thus cannot be used for any other purpose. But offsetting assets are unlikely fully ring fenced from creditors.

The structure according to the suggested proposals would not relief the generators of the liabilities in any way. It goes half way towards creating a centralised structure to group liabilities, as suggested by the utilities. But, in the shape under discussion, it does not look like it would take the liabilities off the utilities’ balance sheets.

The latest suggestions look like the government reacting to suggestions and events in the power industry. It may be an opener for negotiations with the industry, laying out a first post for the government position. In that case there may be room for negotiations. The risk is that the government may not see much need for negotiation and legislate instead. Recent moves on other issues, eg. Nuclear disputes, coal, etc, suggest the risk is real. The relationship climate between the utilities and the government has materially deteriorated.

Amongst the two German generators, E.ON is in a stronger position as it has greater flexibility to absorb potential additional costs coming by way of legislation. RWE would benefit from greater clarity on the liabilities side, but at the price of another hit to earnings. Furthermore, because the potential contributions would likely be cash contributions rather than additional provisions, there would be a direct cash flow impact.

Meanwhile, Areva has warned of further additional provisions for 2014 and asset write downs. That is an execution problem. The delays at the Finnish Olkiluoto reactor are a big contributor as are broader issues with new build execution. The warning might mean there is further budget overrun, too.

The only bright spot was a 10% increase in Areva’s order book, but that came mostly from EDF (EDF FP) for fuel treatment and recycling.

Areva’s new CEO faces a deep challenge to redress operational execution and credibility with investors. The March 4 road map presentation will be crucial. Valuation is expensive at 10x EV/Ebita 2015E and leverage is high at 5.8x net debt/Ebitda 2015E. For sentiment to turn, credible changes to the numbers and operations have to come through.

Nuclear in Europe remains a high risk proposition. No longer of melt down, but of continuous leak.

UK shale gas: rocky times

The propositions on shale gas in the new infrastructure bill are less restrictive than market fears. The concentrated names should see a relief reaction. The macro environment is challenging with political risk and weak commodities, but operational successes in the sector are showing good prospects.

The UK government has made concessions to environmentalists in its latest provisions for fracking in shale gas exploration. The latest infrastructure bill now contains provisions that fracking will not be allowed in national parks, areas of outstanding natural beauty and areas important for drinking water collection. The trespassing provisions that allow fracking without homeowners permission are unchanged. The bill will go to the House of Lords next.

There is political resistance and the pre-election period has certainly sharpened ministers’ minds towards a sensitive issue.

No conspiracy theory, but there is OPEC’s long arm, too. I do not see any material interest by OPEC to slow down UK shale development. The quantities are important, but not of US size. But oil price weakness as a pure market phenomenon may have had an influence on legislators. Some urgency is removed.

I still see UK policy overall as supportive of shale gas development.

It may well be that further amendments are made to the bill. In the first instance, the House of Lords has the power to do so. More generally, specifications about allowed depths would not be unthinkable. The German government has taken that approach.

A stable framework that is respectful of natural assets and environmental issues is required and long term supportive for industry development. The main issues about fracking are risks to ground water contamination, wildlife protection and chemicals leaks. According to industry sources, water contamination risk can be eliminated when a distance of 800m to acquifers is kept. Noise is an issue brought up by local residents but not one of environmental scope.

The bill means a reduction of accessible reserves, but not large enough to alter the case very materially.

Scale development is required for swift build up of infrastructure and cost reduction.

Reserves in the Bowland Shale are largely 800m below the acquifers in the region. Shale oil resources in the South Downs shale are at least 650m below the acquifer.

UK shale gas is a high risk sector. This is a set back that a concept sector is bound to experience at some stage. It is a reminder that political risk is high as will be volatility in the sector.

The concentrated shale names have all seen falls in their share prices that now imply very little value for development. A reminder, this is an early stage sector where public names are very sentiment driven. The negative visibility is much stronger so than the positive operational performance of the private part of the sector.

The actual bill is restrictive, but by far not as bad as market fears. There might be a relief reaction.

Cuadrilla is the most exposed and sentiment and concept name. Its key exploration area is the Bowland Shale. There will be a negative impact over the short term. Its partner Centrica (CAN LN) is also impacted.  GDF Suez (GSZ FP)’s Bowland exposure is through its 25% stake in Dart Energy’s licenses.

Egdon (EDR LN) is also active in the Bowland Shale as is IGas (IGAS LN). Short term downside risk is larger for Egdon as IGas has greater underpinning from conventional assets. There is an impact on Total (FP FP) through its direct investment and partnership with IGas.

The large integrated names have bigger struggles at the moment, namely globally weak commodities. The shale news is a hit on a potential growth area. Albeit small, it does not help current sentiment.

The private names should see continued good prospects from operational progress even though they will need to address resistance constantly.

The wrong kind of exposure – and the right one

RWE’s earnings warning weighs stronger short term than its strategic moves. The company will continue to struggle with weak commodities and high leverage in 2015, despite the DEA sale. It may embark onto some rescuing of value through power plant sales, but it does not have the potential to deliver a similar strategic boost to E.ON. RWE is at the heat of the political storm that still has high potential to deliver more unpleasant surprises. Infrastructure and the private sector, conversely, might be beneficiaries. There are signs that private investors with longer strategic horizon are circling around distressed assets. They will gain a more important part in a decentralized energy market. Asset rotation will be a feature. My view of increasing M&A activity remains underpinned.

RWE is not out of the woods yet; investors who were hoping on earnings stabilization as indicated by the company in April 2014 may be disappointed. Management has warned on earnings, saying that the earnings trough may not occur in 2015 yet. Consensus has not bottomed out for 2015 yet and it may still come down.

Power prices are the unsurprising cause of the problem. Futures are pointing nowhere to a meaningful enough recovery, and the broader commodities environment is not any more supportive. RWE more than any of its peers, needs significant commodity recovery.

In tandem with the above comes relentless balance sheet stress. I find see little chance of material decrease of leverage. The Urenco sale will not come through short term. The CEO has further confirmed that leverage falling to 3x net debt/Ebitda by 2016 will be “extremely difficult to achieve”. I estimate just short of 4x for 2016. Attention will swiftly return to risk to the dividend.

RWE may rescue some value through selling its power stations that are unprofitable abroad as announced this week. That is clearly a strategy to mitigate cash losses. It would bring minor debt reduction.

Some of the company’s plant is new and competitive technology. The bulk of the RWE’s mothballing and closure programme is less than 20 years old, some plants are not even three years from commissioning. That concerns particularly gas. It is sensible that management looks to maximise value of otherwise potentially stranded assets.

But, a power plant cannot be displaced and sold into another location like other capital assets. High quality and well performing equipment may still find a market value in locations with tighter reserve margins and new build demand. The CEE region comes to mind. There is also an active secondary plant market also in Asia.

There will clearly be a loss of value for RWE. Investors should not hold up high hopes of significant earnings contributions from the process. Signaling power to the political powers may be stronger than actual earnings impact.

Infrastructure investors have begun to look at power generation with a view of power price recovery over the long term. The prospect for capacity payments may underpin that kind of activity. Germany is uncertain on that note, but plenty of European countries putting into place capacity markets could keep M&A activity up.

The services sector should be able to recoup order potential.

All of RWE’s strategic moves could in the end amount to a similar outcome to E.ON’s corporate split. The company has been vocal about reducing the share of generation to 5% of earnings. Most recently, the CFO has now said it no longer rules out a similar move even though management decided against it in 2012.

RWE is in a different situation to E.ON, in that it cannot bring as diversified a generation park into any potential new co. Merging renewables into a genco may remedy to a point. But in that case management would have to have a clear strategy about how it would pursue downstream brand equity and service/product packing for which renewables exposure is important. A split co will also not have the same upstream and oil and gas diversification as E.ON. That would make a genco or upstreamco resemble much more of a bad bank than in the case of E.ON.

Importantly, it would in my view have to raise capital in order to fund the nuclear liabilities that the genco would inherit.

RWE might embark onto greater strategic change beyond its already announced transformative steps. That would be a positive.  But with the chances increasing that more steps are taken, so does the probability of a capital increase.

I see significant potential for large parts of RWE’s business going private.

Meanwhile, the debate over capacity payments rages on. The Economy Minister’s has again repeated he is opposed to capacity payments, which is out of line with market expectations. The political debate bears high potential for disappointment.

Politicians quote over-capacity as eliminating the need for any capacity payments. But as capacity markets are circular, absence of capacity incentives could remove the over-capacity faster than thought. Markets would be left in great disarray. Politicians are quoted as not finding price spikes problematic. But affordability, system stability and the like will then come back to haunt.

My preferred exposure in all of this is infrastructure, engineering and market backbone.

GDF Suez on track for growth

The positioning of GDF Suez in global energy across various value chains is unique. Management has highlighted an area of strength and taken the next strategic step in the current energy cycle: Return to growth. That should see a positive reaction and lead to a re-rating of the shares.

GDF Suez has highlighted its areas of strength for growth, Asia, Middle East and Africa. The company is building these as core growth regions. That makes sense given its already strong position in those regions and above average growth. Looking through current weakness, energy demand growth will likely exceed 7% CAGR to the end of the decade (source: IEA).

Management also has proactively moved to the post deleveraging phase by committing to new growth. The company targets growth capex of Eur6.5-7.5bn for 2014-18. It is looking to dedicate about 20-30% of growth capex spend to Asia, Africa, and the Middle East.

Asia, Africa, China, on a regional, IPP LNG and energy services are the core of growth.  Suez’s target regions account for over 80% of global energy growth over the next 20 years.

The latest guidance implies power capacity growth in the above target regions of 6% CAGR, 2P reserves growth of 8.8% CAGR and energy services revenue growth of 7.9% CAGR  to 2020 on the target areas. The regions currently account for c 7% of Ebitda.

Visibility on growth is very good. The pipeline provides for 30% power capacity growth to 2020. I would only consider capacity under construction at this stage, which is just short of 1GW. The IPP model is tried and tested and merchant risk very low. GDF Suez has a very good track record of securing PPA’s at good conditions and in strong local partnerships. I expect that and the strong execution capability to continue to as the basic earnings driver.

E&P reserves growth of 5-7% is at the high end of the sector, and the gas focus in line with the broader sector. But I see GDF Suez better hedged than the average of the E&P sector, because of its vertical presence all the way through the chain. With that, I think it stands a better chance of profitable reserves conversion to earnings growth to 2020.

LNG is a risky sector at this moment. Asian demand weakness and weak oil prices are leading to price falls. Over-capacity is creeping into the market. New capacity build risks not meeting its hurdle rates. Suez currently has a feasibility study under way for an Indonesian LNG terminal. There I see risk of delay. The same goes for the floating LNG terminal project in India. I also see risk of lower utilization of the US terminals. The US Cameron liquefaction terminal may escape the heart of the storm, it won’t come to market before 2018. But the company’s vertically globally integrated business provides for mitigation. Pricing risk for the Japan and Taiwan LNG contracts is in my view relatively low as they were concluded at very tight pricing in the first place.

Eventually, gas demand in Asia will recover. On average, the IEA estimates demand growth of 4%pa to 2035 with corresponding infrastructure investment requirement. The industry estimates over USD 100bn of liquefaction and storage capex requirement alone. And for that, the company’s positioning across upstream, infrastructure and power generation is second to none.

The changing structure of energy markets with distributed generation, renewables and gas/power convergence are all playing to the company’s strength.

The energy services business will be a major beneficiary and additionally deliver strong synergies to these new growth businesses. It will also be a growth driver in its own right in China and a door opener for other business development.

GDF Suez has a unique advantage through the combination of its IPP, global gas and energy services business. That is in my view the true attraction of the company.

Sentiment will likely be cautious on commodities, but should increasingly return to reflect the early move and strong position on long term growth.

View on four themes for 2015

Commodities, reform and restructuring, yield and corporate activity will dominate the energy sector in 2015. I see engineering and consulting as well as power equipment and services as standing out. Clean tech stands to benefit from sustained activity despite weak commodities. Oil is better left for later in the year.

Commodities

Is it the great underweight or bargain territory? The energy sector globally has outperformed oil by 3000bps in 2014, oil services performance at the bottom end of the range. Oil futures point towards a late year recovery. I do think there will be some recovery, but equities may follow on a selective basis at best. The oil sector looks cheap on valuation, but the value case may not be there yet. Consensus across the board will still come down further in my view. Dividends struggle with tightening cash. Earnings impact is uncertain as are outlooks. I would let the Q1 earnings and guidance train leave the station before getting closer. Focused upstream if anything offers the most geared exposure for those looking for commodity recovery later in the year.

Gas capex cuts bear a negative impact on upstream, but gas is still relatively sheltered when compared to oil. Slow down in development will balance prices earlier. Gas is the growth sector of choice. The positive read from weak gas prices on gas utilities from 2014 will come to an end as pressure for pass through mounts (see below).

The LNG is in great danger of over-capacity. Thanks to the the oil price link prevailing for Asian contracts and weak demand, Asian spot contract prices are now around USD10/mbtu, down 50% y/y. according to Wood McKenzie. There is little prospect for recovery: Capacity is will stand underused and capital intensive projects risk not making their hurdle rates. Because of the long nature of project build, completions are now hitting the market. About 100mtpa of new liquefaction capacity is due to come to the market from 2015. Expect write-downs and weak profitability in the lng infrastructure sector on new projects.

Clean tech should be in a good position in 2015, even though the argument of rising commodities prices has weakened considerably. There will be an impact on perception of clean tech. The sector becomes more dependent on political and regulatory support and the sustainability argument. The grid parity benchmark has moved again. Particularly in the US, the impact of low gas prices will hit home.

Nevertheless, sector performance should in my view decouple from oil, in Europe more so than in the US. Consensus momentum is stronger and order books in a good shape. I see continued strong activity in 2015, not least as the energy sector builds clean tech as a substitute for low growth rates elsewhere.

North Sea offshore wind activity remains strong which will be one of the pillars of global offshore growth. But, increasingly, growth will shift from Germany and the UK towards China. Turbine size is the big battleground.

Global solar demand of 45GW in 2014 was a better than expected recovery, despite weaker than expected Chinese demand resulting from permit bottlenecks. China, Japan and the US will remain the strongest markets in 2015 in my view. Trina (TSL US) is gaining very good traction in Japan and stands out with a strong development business. Wacker Chemie (WCH GR) should benefit from the revival of growth and a tighter supply/demand balance. Wafers will bear the brunt of pricing pressure.

Weak commodity prices remove short term incentive for energy efficiency. Energy intensive industries will still be a long term end market in my view.

Utilities are likely to continue to outperform on a relative basis. But, weak commodity prices will lead to pressure on supply margins. Public powers will put end customer prices under yet increased scrutiny. Consumer groups across Europe have already been vocal to the matter of price pass through. This would have been an opportunity for proactive perception management campaigns by utilities. It is late but not too late for that yet. Risk is highest in the UK where it is election year (see below).

Reform and restructuring
Utilities are most concerned.

The UK in an election year and with the CMA outstanding is the epicentre of political risk in Europe. The UK government has put energy at the centre of its campaign.

That is followed by Germany which is to enact big market reform and coal legislation. Both of those issues are not new, but risk to German coal earnings still has some way to work itself through earnings and share prices.

Even the French regulator is itchy, saying that EDF and GDF’s supply companies are too close to the parent in their identity.

Falling supply margins will accelerate the shift towards higher margin businesses, but it will be a slow transition.

Brand equity and packaged service offering is the quest. Intense  and proactive perception management has to come with it.

E.ON (EOAN GR) has led the pack on industry restructuring in 2014. This has been just a first in what I see as a paradigm shift across the sector. The UK CMA review may bring more, proactively or forced.

GDF Suez’s industrial services business stands out.

With regards to retail, I prefer to seek exposure to the changing nature of the business through equipment, engineering, services and consulting. Solution providers with brand equity are my exposure of choice.

Corporate activity
Big restructuring across the sector spans from asset sales for cash optimization in commodity businesses over to activity coming out of a paradigm shift in downstream electricity. Manufacturing and services are changing business models and may be both sellers and acquirers.

Clean tech yieldco’s should be acquirers, as may be developers diversifying their portfolios.

The oil sector may see asset sales, yet the environment is for weak valuations. Majors and names devoid of shareholder pressure for payout may be looking for bargains. The same may occur for gas assets.

Good levels of activity should support valuations overall.

Yield
As every indicator points to a low interest rate environment with uncertainty over growth, yield remains attractive.

I prefer utility over oil dividends. Oil will struggle to balance payout vs capex in a cash preservation environment. The sector is advised to invest fro growth in order to support future dividends. But it will sacrifice short term sentiment.

Clean tech yieldco’s are attractive while US tightening is very tempered. Growth in the sector is an added attraction.

Oil gas price link – slippery or sticky?

Oil price weakness begs the question of persistence of the oil gas price link for long term contracts. Economic recovery, correction of over supply and energy fundamentals speak for long term recover of gas prices, possibly in a disconnected fashion from oil. That might along with the current oil price weakness lend support to a degree of continuation of oil price links, in Europe likely more so than in Asia. European utilities will get a major positive earnings impact. Gas midstream remains attractive.
As oil hits one low after the other, expectations for a short term recovery have no come close to disappearance.
That may have a consequence for gas pricing structures: The welldocumented oil price indexing structures for gas contracts as prevailing in Europe and Asia may hold for longer than thought.
The oil price link may all of a suddenappear attractive. The contract structure that was damned not too long ago could be seen as not as bad after all as the other side of price volatility shows its face. There are indications within the industry that the once very strong pressure to move away from oil indexed contracting has decreased.
Much depends on the timing of expectations.At the current level, hub priced gas is very close to oil priced product, prior to transport variability. In a short and sharp correction, gas buyers would be well advised not to appear overly opportunistic. Retracting from the current positioning away from the oil price link will make a change of strategy difficult later.
Another major question is whether exporters will be looking for contract adjustments and amendments now, just like buyers did on the way up. Again,it comes to strategic thought vs short term revenue maximization as well as long term image and reputation management.
European utilities are getting a major break now. The sector may increase exposure to Russian gas again.That has not been reflected inprices, but should come through reporting from 2015.That may reinforce the oil gas price linked contracting in Europe, more so than in Asia.
Asian buyers are wiggling out of LNG contracts, even those concluded at tight pricing.But, they are not substituting with oil linked product on large scale. Demand weakness is the issue. Oversupply hitting pricing
now gets compounded by the oil price. Contract momentum for LNG priced off Henry Hub will remain weak for some time.
There should be competitive LNG sourcing opportunities in the market now. Eventually, the impact of inevitable project cancellations due to insufficient economics will drive prices up again.
If a view holds that oil will not recover as governments constrain demand through policy measures (climate change, energy conservation etc), there could be a strong disconnect from gas.
Gas prices could recover and continue the upwards trajectory, nevertheless, for various reasons. Reduced supply from cancellation of oil projects with gas by products is one, forced reduction of shale development due to cash constraints is another, economics from lng conditioned projects a further factor to lower supply.
Fundamentals of gas as a backbone to electricity,gas power plant build, gas’s classification as a clean fuel and oil substitute speak for long term demand growth and positive pricing dynamics.
Increased demand for oil indexed contracts will weaken hub liquidity and reinforce the oil gas price link.
In such scenarios, I look for those companies that pursue gas sourcing strategies that look through the short term (even if that may entail some continuation of oil linked sourcing), gas upstream in the conventional sector and mid stream.European utilities will also benefit.
I prefer the names with integrated gas/electricity portfolio and low oil exposures.

New energy, new models

E.ON’s split is validation and coming of age for new energy. Clean tech will face serious competitors with deep pockets, not only from utilities. Clean tech benefits from strong consumer and public brand equity. It may need to embark onto partnerships. I expect consolidation and M&A, including involving the private sector. Solar, heat pumps, storage and demand solutions grow in attractiveness. Oil is a negative, but even if price weakness is protracted, it will unlikely reverse the trend.

The gorilla has entered the room. The clean tech sector now faces a big competitor with desperation and deep pockets. E.ON has been active in the sector before, but now it is its main focus.

This is validation and coming of age for new energy. I have repeatedly stated my view that the sector is well under way towards a structure of limited clusters of large scale concentrated generation combined with a wide spread of distributed generation, smart features, new owners of generation assets and gas/networks as the backbone.

Integrated service and equipment offering is the new game in town. Clean tech stands at a disadvantage – to a point. The big utilities still have bigger customer account ownership. That can and in my view will change quickly as the competitive landscape changes.

Some clean tech companies have embarked on greater product packaging and services offering. I still see them struggling because of their lack of experience with long standing retail customer relations, billing and the tail end of customer accounts. They will struggle with aggressive competition from utilities, supermarkets and consumer goods manufacturers. The sector would need to embark onto consumer goods strategies, at least as a complement.

Consumer brand equity (not necessarily breadth of recognition, which I gage, is lower, but positive image perception) seems greater for the cleantech sector. The utilities are suffering from the negative image of perceived over-pricing, anti-renewables lobbying and coal and nuclear generation. Those issues are still – as a side note – not only consumer marketing, but also broader pr and financial markets communication challenges. The clean tech sector has got some tarnish from subsidies dependency and impact of bankruptcies. But, generally end market perception is strong. These points hold specifically for Germany, to a degree also for the UK.

There will be a demand boost from 2016. Solar, storage heating equipment and appliance management in the broader market in Germany from the pure change brought about by E.ON. I see no material impact on wind as the bigger change happens in the consumer driven market. That is the market of smaller scale technologies.

Manufacturers will lose pricing power. The market moves from retail to wholesale. The big actors looking to be intermediaries will tighten pricing. Changing ownership structures of equipment (see last week’s feature – Further musings on E.ON’s split) may contribute to that.

There may be consolidation and M&A, including involving the private sector. I would not be too surprised to see E.ON on the look for consumer brand equity. I would expect E.ON to avoid manufacturing operations. But, that could still entail split up of manufacturing businesses where manufacturing and downstream channels are sold separately or parts of businesses dismantled. Rapid technology obsolescence furthers the process.

Clean tech businesses that successfully build up partnerships to enter the E.ON bandwagon of change in the market can see a reduction of earnings volatility and, potentially share price volatility. Multiples will change to reflect new earnings patterns. I still see the sector trading at growth multiples for the near future.

I look for new solutions providers. Amongst the well positioned names, I see Solarworld despite its cling to manufacturing and negative pr impact from some of the CEO’s actions. Trina Solar (TSL US) also stands out, but will in my view not deviate from its core manufacturing. Conergy has achieved great recovery of its brand equity and is pursuing innovative business propositions, including new ownership models. Battery names should be of interest. ASTec, for example is expanding the storage business and has just launched an “electricity bank” with MVV. I can see more new energy features from its IT solutions. Vaillant, Viessmann, Stiebel Eltron, Danfoss and Bosch, the leaders in heat pumps, should benefit from the changing market.

Oil price weakness has taken some gloss of the clean tech sector, but even if protracted, I still see all the points above holding up.