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Why Origin needs $800 million

Slipped in amongst Origin Energy Limited’s (ASX: ORG) half-year 2012 result announcements last week was the news that the energy producer and retailer will require an additional $800 million for cost increases related to its share in the coal seam gas project Australia Pacific LNG (APLNG).

Released under the optimistic heading: “Australia Pacific LNG review confirms accelerated schedule and earlier revenues – costs revised to $24.7 billion”, the news is another example of projects being pushed above their initial estimates.  In this case Origin estimate a 7% cost increase as a result of changes required by revised government policy on water management for coal seam gas projects, as well as cost increases in related LNG projects APLNG is involved with, and higher contingency allowances.

This will mean an increase in its obligations from $3.6 billion to $4.4 billion, costs the company can meet without the need for additional financing.  The announcement came in tandem with the news the project is 30% complete and up to three months ahead of schedule – soothing news for investors who could see the project pay off earlier than expected.

Unfortunately cost overruns on mega projects like APLNG are not rare.  In fact they are becoming common to a point where some industry analysts factor in their own buffer on top of company estimates to calculate project returns.

Origin is certainly not the first company to hit cost increases.  In July 2012 Santos Limited (ASX: STO) announced increased cost estimates for its Gladstone LNG project from $16bn to $18.5bn.  Similarly Woodside Petroleum Limited (ASX: WPL) faced a $900 million cost increase over initial forecasts in their $14.9bn Pluto project which started production in April 2012.  Then there was Chevron’s cost blowout on its Gorgon LNG joint venture with Exxon Mobil Corporation (NYSE: XOM) and Shell.

Although the reasons for the increases vary for each project; labour costs and shortages, weather delays, currency movements and regulatory changes have all featured; the net effect is to dent investor confidence in the initial project guidance provided by directors.  Perhaps Directors can’t be held accountable for unforeseeable disruptions and variability in costs, however the old maxim ‘measure twice, cut once’, when estimating project and contingency costs, might give investors more confidence determining project risk.

Foolish takeaway

For Origin investors it’s a case of taking the bad with the good.  The project, which is expected to make its first delivery of natural gas in 2015, is a long term investment with an estimated production life of 30 years.  By this view a 7% cost increase may not be significant, but with 70% of construction still to complete further increases can’t be ruled out.

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More reading

The Motley Fool’s purpose is to help the world invest, better. Click here now for your free subscription to Take Stock, The Motley Fool’s free investing newsletter. Packed with stock ideas and investing advice, it is essential reading for anyone looking to build and grow their wealth in the years ahead.  This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson. Motley Fool writer/analyst Regan Pearson doesn’t own shares in any companies mentioned.

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