Solid Energy

Some useful analysis by Chalkie at Business Day:

Meanwhile, in April 2009, Finance Minister Bill English and then SOE minister Simon Power summoned SOE bosses to a meeting and told them to sharpen up.

“We’ve got a recession and we’ve got a government that wants value for the taxpayers’ dollar,” English told reporters after the meeting. “They need to get better returns than they’ve got.”

was not singled out for dividend extraction and a dose of debt, but you can see why it might have felt the rebuke more keenly than others.

Chalkie has run the numbers on debt and dividend levels for a bunch of SOEs going back to 2005 and it’s clear that Solid Energy was slacking a bit. From 2005 to 2008 its annual dividends were zero, $20 million, zero and zero.

Such paltry returns are not what you want from a business deploying shareholders’ funds of $400m or so. No wonder English and Power wanted more.

If the state has to own commercial trading companies, it is not unreasonable to expect them to pay a dividend. Otherwise we’d be far better off selling them, and investing the money elsewhere.

We’ll come back to what Solid Energy did with its money in a mo, but it’s worth noting that the Government’s rev-up didn’t make a difference to all SOEs.

Comparing the four years from 2009 to 2012 with the previous four years, average dividends actually declined at Meridian and TVNZ, stayed roughly the same at Genesis Energy, while big dividend lifts were apparent at Mighty River Power and Landcorp.

Debt levels were also not universally increased after English and Power’s crackdown. Landcorp’s borrowing stayed in the same ballpark while TVNZ’s fell considerably.

The point here is not that debt and dividends at those companies should have been different, only that the outcomes support the view that decisions on these matters were ultimately made by individual SOE boards.

Of course. In fact it is a decision not just for the boards collectively, but individual directors. A Director has to sign a certificate or resolution they they are personally satisfied that the company can pay the dividend – and there are serious legal implications for a Director who gets it wrong.

Chalkie reckons the Government’s position in 2009 was only what you’d expect from a shareholder and how boards responded to that pressure, rightly or wrongly, was down to their judgment of what was best for the business.

Solid Energy’s judgment was that debt could be substantially increased, from $33m in 2008, to $62m in 2009, to $212m in 2010.

By June 2012 debt was $295m, which sounds like a lot but on a crude measure of gearing – debt/total assets – at 25 per cent it was well within the bounds of normal, around 50 per cent.

A better measure may be interest payments, which were also no obvious grounds for alarm. In the year to June 2012, Solid Energy had operating cashflow of $142m – a measure of basic business profitability – representing considerable headroom for its interest bill that year of $14.8m.

So the interest was around 10% of the operating cashflow surplus – reasonably conservative. The problem is that the surplus disappeared as the coal price dropped.

With 90 per cent of the world just starting up the prosperity ladder, the company said, there was only one way oil prices – and therefore coal prices, which are strongly correlated – would go.

In its best-case scenario Solid Energy saw coking coal prices at US$400 a tonne by 2020 and US$600 by 2030.

So what should an energy business do if it sees soaring demand and high prices into the future?

If you believed prices were going sky high, you might invest in more coal production, you might invest in coal seam gas and underground coal gasification.

If you believed in world energy hunger, you might invest in alternative energy sources such as wood pellets, biodiesel and lignite briquettes.

If you believed in ever-tighter oil markets and you were an ambitious, patriotic Kiwi energy company, you might want to secure big chunks of oil exploration real estate.

So in a sense, Solid Energy’s strategy in pouring so many millions into these projects had a sort of logic to it.

But only if you believed the price projection.

The current coal price is US$101 a tonne.

The Treasury’s assessment of the NRC scheme advised: “It is not clear why the Crown would wish to take such an exposure in commodity price movements based on price path analysis not shared by other experts.” The NRC idea got the brush-off from the Government, quite rightly.

But Solid Energy isn’t struggling today because it thought about getting into oil exploration. It is in trouble because a lot of the money it did invest turned out to be wasted when energy prices didn’t behave as it thought they would.

The Government was smart enough to see the implausibility of Solid Energy’s forecasts when it came to the NRC, but not when it came to wood pellets, underground coal gasification, lignite, Spring Creek, biodiesel and all the other things soaking up the company’s resources.

While all that was going on, the Government shareholder was busy getting Solid Energy to fill in its boiler-plate questionnaires seeking answers about how many credit cards it gives employees, how many staff have mobile devices and what it spent on office refurbishments.

If we wondered why state-owned businesses tend to under-deliver, just think about committees of MPs and bureaucrats poring earnestly over executive mobile phone bills. For all the good it does they might as well flag it and and go to the pub.

Chalkie reckons the Government is well aware its lack of oversight helped Solid Energy get out of hand and is doing its best to make Elder the fall guy.

There is a degree of truth to this, but this is part of the problems of the SOE model. The select committee is focused on how many credit cards a company has and shareholding Ministers are responsible for scores of companies – as well as all their portfolio responsibilities.

Of course you also have Treasury staff, and they did warn against some of the plans, but with no disrespect to Treasury, a 25 year old analyst can’t compare to the role played by professional company analysts.

If Solid Energy was listed on the stock exchange, then there would be a number of commercial funds that would have invested in it. And those funds would have an analyst whose job it would be to know everything possible about that company. They would live, breathe and eat that company. They would read every report, every statement, attend every AGM, and be constantly analysing the company’s strategy, worth and risks. The reason for this is because their job depends on it. If they get it wrong, their employer (and them) stands to lose millions or tens of millions of dollars. When it is your money at risk, you take much more of an interest in a company’s performance.

And you would have a share price that would deliver real-time daily feedback on how investors thought the company was doing.

That’s not to say Elder shouldn’t have gone – he should. But to Chalkie the main responsibility lies with Solid Energy’s board, which reviewed and endorsed the company’s strategy year after year.

I agree – the board sets and agrees to the strategy.

The Government, meanwhile, was well aware of Solid Energy’s approach but didn’t pay it much attention – complaining about it now is just hypocritical.

I think it is unrealistic to expect the Government to be second guessing the board.

Overall, Chalkie see this as another example of why SOEs are a bad business model. It’s just a shame the debacle means Solid Energy will remain 100 per cent state-owned for even longer.

I agree – the model is flawed, to say the least.

The Herald editorial agrees:

In 2010, when the Government was still forming the mixed ownership model it took to the 2011 election, this was too much to contemplate. It rejected the notion of the national resources company, encouraged Solid Energy to develop its existing resources, including lignite and “unconventional” gas extraction, but offered no additional investment.

Within two years, China’s steel production had slowed, coal prices slumped, Solid Energy’s investments were not paying off and a share float is no longer in prospect. The board’s plans might have been “off the bullish end of the charts” but private investors ought to be invited to make that judgment.

When global energy demand recovers, the Government should sell whatever stake it takes to make the most of the country’s untapped wealth.

It is indeed a pity that private shareholders were unable to invest in Solid Energy earlier.  They should be the ones making the judgement on whether the bullish plans to become a global resources company were worth investing in.

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