A long time coming
It has been a soggy week in markets.
While investors continue to maintain a watchful eye on the global vaccine rollout and spread of variants, it is largely in their peripheral vision. The narrative has very much become dominated by worries about inflation.
This can be seen in a recent survey of fund managers by Bank of America that shows that inflation and tapering of quantitative easing now dominate fund manager’s concerns.
COVID: no longer what keeps investment managers up at night
Source: BofA Global Fund Manager Survey
These inflation concerns, as well as expectations of falling iron ore prices, saw the market trade sideways this week.
As we have mentioned, the question around inflation is no longer “if” but is “how long for”.
All eyes continue to be on the labour market, which is now central banks’ primary focus.
We saw more jitters this week with the tightening of monetary policy beginning to creep into some members of the Federal Reserve’s discourse.
They may be a little more contemplative, given recent economic data, than their previous “not even thinking about thinking about raising rates” stance.
Amidst this backdrop of a sideways market, we received two positive updates from your companies that we have long anticipated.
Viva Energy: A win for fuel security
On Monday, the government announced a $2 billion package to back Australia’s fuel refining industry.
A key part of our thesis on Viva was that its refining operations were undervalued by the market. The market failed to appreciate the likelihood of a future government correctly understanding the compelling national security interest in providing direct support to refinery assets.
The package announced is hugely significant for the domestic refining industry and Viva Energy.
We note that Viva’s share price has risen more than 13% over the last month, likely in anticipation of this news.
Domestic refining industry
In the face of cheap imports from Asia and the Middle East, we have seen several domestic refineries close, including Exxon’s Altona refinery and BP’s Kwinana.
International competition has been compounded by depressed fuel demand post-COVID, leading remaining refiners to consider their future in Australia.
With Australia’s last two refiners contemplating their future, the Government stepped in at the 11th hour.
We only have to look to the supply chain disruptions we have seen over the past year (see One wedged ship and a few timely reminders) and escalating tensions in the Pacific to see why.
These closures would have resulted in a significant reliance on imported fuel and vulnerability to a disruption in maritime supply chains. And we remain desperately reliant on fuel (for now).
Fuel Security Service Payments
Refining margins have historically been quite volatile. The Federal Government’s package significantly reduces any downside to this volatility in prices.
As part of the $2 billion in committed funding, the government has committed to a Fuel Security Service Payment (FSSP), which is a variable payment to refineries per litre of fuel produced.
Payments will be on a sliding scale and linked to refining margins.
This is illustrated below.
Support caps downside to refining margins
Source: Viva Energy
Viva’s average operating cost is approximately A$7. Including sustaining investment, costs are closer to A$10 per barrel.
The government will now pay A$2.90 per barrel when prices fall below A$7.30 per barrel.
Therefore, even at COVID lows in fuel margins (~$3 per barrel), the refinery will now be close to breakeven on an operating cost basis. Furthermore, it will continue to benefit from any upside in margins as they recover.
This significantly de-risks Viva’s Geelong refinery, limiting the downside to refining margins while maintaining upside. This not only will improve returns from refining in the future, but de-risks the company’s refining operations overall.
The package comes with commitments from refineries, including Minimum Stockholding obligations (a requirement to keep a minimum of approximately 1 months’ worth of fuel) and a commitment to operate until 2027.
Refineries will be required to produce ultra-low sulphur gasoline by 2024 (to reduce emissions).
What surprised us was that as part of this requirement, the government will commit up to $150 million in funding to upgrade the plant at Geelong. This is approximately half of the cost of the project, a project that we believe the company would have had to carry out regardless – bolstering the already strong support provided.
We see further upside in Viva’s share price if aviation and maritime volumes recover.
With fuel volumes recovering over the past months and Viva’s refining operations being put on sure footing, its share price is closer to reflecting our assessment of its long-term value.
HT&E: Settling on Soprano
Our investment in HT&E has had an eye on two key catalysts.
One is a longstanding tax case with the Australian Tax Office, with the potential for a significant windfall for the company if ruled in their favour.
The second was its stake in Soprano Design.
Soprano Design is a communications services company that HT&E purchased a 25% stake in for A$10 million.
This week the company announced a non-binding agreement to sell Soprano for approximately A$560 million – in the form of both shares and cash.
This sees HT&E’s stake valued at A$139 million – which was above our expectations.
As part of the transaction, HT&E will also receive a pre-transaction dividend payment of A$10m, bringing the total value of its stake to $149 million – a significant return on its initial A$10m investment.
Several stages remain until the transaction is completed, however, the news validated this lesser-known value that we saw in HT&E.