Monday, 23 November 2009

Things heat up for geothermal sector
November 21, 2009

Australia's fledgling geothermal energy sector received a shot in the arm when two leading players were beneficiaries of the Federal Government's first round of Renewable Energy Demonstration Program (REDP) grants this month. South Australian geothermal operators GeoDynamics and Petratherm beat a field of 61 applicants to receive $153 million of the total $235 million in REDP funding. The REDP grants are the final piece of the funding jigsaw that GeoDynamics and Petratherm required before proceeding with commercial demonstration plants which will cost at least $200 million each.

This is welcome news for an industry which has been slow to deliver on its potential as a cost-effective, reliable and environmentally friendly source of base load power. The key challenge for Australia's geothermal industry is the technical difficulty of accessing rocks at a temperature in excess of 200 degrees, and located up to 5000 metres below the earth's surface.

Electricity generation requires drilling of two wells and fracturing of the rock separating the wells. Water is then pumped through the fracture, where it is super-heated by hot rocks and pushed up through the production well. Energy in the hot water and steam is harnessed to turn a generator turbine.

Of nine listed geothermal players, only GeoDynamics has reached ''proof of concept'' for its approach to electricity generation. But in a setback that cast a shadow over the sector earlier this year, after achieving this milestone at its Cooper Basin resource, the metal casing of a GeoDynamics' well cracked due to a chemical reaction in the steel and caused hot water and steam to rise to the surface under high pressure. The use of a different grade of steel should prevent a repeat of the problem, but GeoDynamics' progress has been set back about two years.

Look beyond the technical challenges, and geothermal's key appeal is its possible contribution to the Federal Government's mandated target of 20 per cent renewable energy by 2020. Identifying a need for about 35,000 GW hours (GWh) of new renewable energy generation to meet the target, analysts from RBS Morgans recently concluded that ''geothermal is the most likely and logical source of energy to fill [most of] the gap that wind cannot''.

GeoDynamics and Petratherm are well placed. GeoDynamics hopes to have a 25 MWs (MW) demonstration plant operating by December 2013, with a 500MW plant in operation in 2018. The Petratherm development plan will see a 30MW plant operating no later than 2015 as a precursor to a large scale (260MW to 1000MW) plant.

Petratherm and GeoDynamics have similar medium-term aspirations, but quirks of location and approach may make Petratherm the more exciting investment story. Neither companies' tenements are located close to transmission facilities and significant investment in transmission assets will be needed to deliver electricity into the national market.

Recent analysis released by the Australian Geothermal Energy Association suggests that the cost of transmission infrastructure will be about three times higher for GeoDynamics than Petratherm, due to its more remote location. This investment will be justified when GeoDynamics constructs its 500MW plant, but in the meantime the proposed 25MW plant will be largely for demonstration purposes, with the electricity generated used to power the small township of Innamincka but otherwise wasted.

In contrast, Petratherm's 30MW plant is located close to the Beverley uranium mine, an ideal customer for the commercial demonstration plant as at present the mine relies on expensive off-grid power. With a local customer and low operating costs, the 30MW plant could deliver pre-tax operating cashflows of about $30 million a year. Petratherm will hold a 34 per cent interest in this project, alongside joint venture partners Beach Petroleum and TRUEnergy.

But before proceeding with the 30MW plant, Petratherm must first prove the viability of its approach. It is looking to maximise project economics by drilling to shallower depths than its competitors, completing the heat exchange process in sedimentary rocks that sit above the granite heat source. Any investment in geothermal operators is at present speculative, due to technology and construction risk. Nevertheless, with funding risk now largely removed for GeoDynamics and Petratherm, it is surprising their share prices have barely moved since the REDP grants were announced.

At present pricing, GeoDynamics has an enterprise value of about $85 million, while Petratherm's enterprise value of just $25 million is at odds with the company's $70 million in undrawn grant funding that will effectively provide a free-carried 34 per cent interest in the proposed 30MW plant. Both companies are trading at a fraction of their longer-term valuation potential. However, the value differential, combined with Petratherm's opportunity to earn a solid return from its demonstration plant, suggest that Petratherm offers more near-term upside and is enough to attract a speculative buy rating from Carpathia.