LNG: Gold Mine Or Glut?

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(This story was originally published on 8 September, 2009. It has now been re-published to make it available to non-paying members at FNArena and readers elsewhere).

By Greg Peel

The Australian government is gaga over Gorgon. With a $50bn long term deal having been recently signed to sell liquid natural gas (LNG) to China from the Gorgon gas project – located off the north west coast of Western Australia – Messers Rudd and Swan have been sucking up the spotlight as heroic politicians who have sailed the Australian ship soundly through a global financial crisis with their infrastructure stimulus as a welcome breeze.

Never mind that Gorgon is a long term project, that $50bn is really just a number pulled out of the air, or that no Australian oil and gas company is a major player in the Gorgon project (US companies Exxon and Chevron and Anglo-Dutch company Shell share the spoils) such that Gorgon can produce only taxes and jobs for Australia but not direct profits. Gorgon is a benchmark for Australia’s natural resource future, the politicians would like us to believe, and the greatest thing since sliced cheese.

The average Australian, if oblivious to developments in Australian natural gas over the past several decades, would be forgiven for thinking Gorgon was the first ever LNG project on or off our shores, so exuberant have been the celebrations following the Chinese deal. But while Gorgon is undeniably a large project on an historical basis, it is by know means Australia’s only LNG project. Indeed, since 2008 the stock market has been in a buzz, irrespective of the GFC fall-out, over LNG. Of particular interest – beyond the massive gas fields of the Timor Sea – have been the long awaited Papua New Guinea LNG project and the more recent rags-to-riches development of coal seam gas (CSM) LNG in south east Queensland (and New South Wales too).

Between Western Australian waters and Queensland coal fields, even educated investors would be forgiven for believing Australia was on the cusp of becoming the world’s greatest supplier of LNG, thus creating an industry to match iron ore, and thus generating vast riches for decades to come. But there are various realities to appreciate regarding Gorgon in particular and Australia’s LNG industry in general (and in the latter case, the Australian-developed PNG project is considered part of “Australian” gas industry).

Gorgon is only one of many LNG projects located off WA, and is as yet fledgling compared to other longer term projects. Among such projects some are long established, some are in development but have signed “heads of agreement” deals with Asian gas buyers, and others are more of a hope and a prayer at this stage. PNG LNG, for example, is expected to achieve Financial Investment Decision (FID) status shortly (a positive assessment of commercial viability) – a status that “de-risks” a project beyond its previous hope-and-prayer level. Gorgon expects the same later this year. FID does not ensure commercial success, nevertheless. And for all the fuss over CSM, and the large sums invested to date in Queensland CSM by foreign oil and gas companies, CSM LNG has never been commercially tested.

Perhaps the most alarming reality for those believing Australian LNG is the greatest investment opportunity since Pilbara iron ore is that across the globe, natural gas is abundant. Both North America and South America are bursting with the stuff. And where you find oil, you find natural gas, meaning the Middle East is also a dominant world player. Indeed, the tiny Persian Gulf nation of Qatar has enough natural gas to potentially render Gorgon unviable.

Is Australia simply setting itself up for major disappointment?

FNArena extensively covered the 2008 Australian gas “explosion” in November’s Classical Gas and explained the LNG industry in December’s Gas, Carbon And Credit. Both are recommended reading to understand elements not re-explained in this article, such as this curious thing known as an LNG “train”.

The Existing Global LNG Industry

Natural gas is a cheaper and cleaner alternative to oil, and can be easily transported via pipelines in a local region. Australia, for example, has pipelines connecting sources to major population centres, while the US boasts a tangled web of pipelines across the country. But while the US hopes to slowly replace oil consumption with natural gas consumption to reduce its reliance on oil imports, Australia’s population could never consume its abundance of natural gas domestically. Like most Australian natural resources, natural gas is intended as an export commodity.

Transporting natural gas across oceans requires that gas to first be liquefied in order to fill LNG tankers. It is an expensive process, achieved through an LNG “train”, but still LNG remains a cheaper and cleaner fossil fuel alternative to oil and a cleaner alternative to coal. As soon as you introduce ocean-going tankers into the mix, you introduce geographical advantages and disadvantages among the various producers and consumers, as is the case with iron ore.

The global LNG industry is clearly divided into two regions – the Atlantic and Pacific. The large number of producers and consumers on the Atlantic side means that natural gas market leans more towards spot trading than long term contract agreements. The Pacific side is, on the other hand, clearly delineated between Asian consumers and nearby Australian producers and operates largely on a long term contract basis featuring 10-20 year off-take agreements. North America is subsumed with its own domestic consumption, while a planned South American pipeline to the Pacific remains more pipe dream at this point.

Australia is not, however, the only LNG supplier in the Asia-Pacific region. Malaysia and Indonesia are both exporters, but Deutsche Bank notes supplies in both countries are dwindling. This goes some way to explaining why Malaysian state-owned Petronas was keen to invest in the Gladstone LNG project in Queensland.

Gas prices on the Pacific side tend to be higher than those on the more spot-oriented Atlantic side, given mature Asian buyers such as Japan, Korea and Taiwan prefer to pay up for long term supply security, whereas the busier Atlantic side plays a more competitive spot game. Sitting in the middle of the two markets is the supplier that Deutsche Bank describes as the “elephant in the room”. Qatar is uniquely placed with nearby ocean access to both markets. At present, Qatar prefers to supply its very low cost-base gas to Atlantic buyers on a spot basis while supplying traditional Asian buyers only on contracts that are sufficiently long in duration and high in price to justify locking up future sales. Qatar’s aversion to lowering its prices to the Pacific has provided Australia with a supposedly golden supply opportunity, despite Qatar currently being the largest Pacific region supplier.

Future LNG Demand

Japan represents 60% of Pacific LNG demand, notes Deutsche, with Korea and Taiwan also major buyers. Given these nations’ propensity to support regional supply with higher priced, longer term contracts, deals with the three are low-risk for Australian producers. However, as mature markets there is little in the way of material demand growth expected to emanate from the three. The largest growth markets in Asia are, unsurprisingly, China and India.

Hence Deutsche analysts see the greatest opportunity for Australian LNG projects still in their development stages (including untested CSM) is to seek deals with China and India, despite a greater perceived counterparty risk. The aforementioned Gorgon deal is an example of exactly that.

Logic would suggest that not only are China and India offering the greatest demand growth potential in the Pacific region, they would also be offering the greatest potential globally. But given natural gas demand is on the upswing globally compared to demand for dwindling oil reserves and dirty coal as an energy source, it is actually the Atlantic region which offers the greatest demand growth potential. Research house Wood Mackenzie forecasts demand from the US, UK, Europe and Atlantic South America to increase by 200% by 2020 compared to a 50% increase in the Pacific region.

Such forecasts support Qatar’s propensity to stick with Atlantic supply contracts and spot trades on an overall volume basis, rather than more aggressively pursuing longer term but higher priced Pacific contracts.

However, the rate of growth of Asian LNG demand, when compared to existing supply, suggests that come 2013-15 there will be a Pacific supply shortfall, notes Deutsche Bank. Given most Australian LNG projects currently chasing FID status are targeting first production around 2014-15, this supply “gap” is crucial in the race to get projects up and running and crucial in assumptions of commercial viability and success. Without it, the whole Australian gas “explosion” becomes a little questionable.

Deutsche estimates that 2013-15 will see a supply gap of some 20-30 million tonnes per annum (mmtpa). However, taking recent Heads of Agreement (HOA) signed at the PNG LNG, Queensland Curtis LNG and Gladstone LNG projects into account leaves 15-20mmtpa for the remaining contenders. HOAs were earlier signed at Gorgon meaning recent supply contracts are already accounted for in Deutsche’s gap calculation.

And so we arrive at Problem One.

Deutsche estimates the remaining Australia LNG project contenders to take advantage of the 15-20mmtpa supply gap total up to 47mmtpa of uncontracted supply between them. Hence there will be winners, and losers.

However, there is also a Problem Two.

Qatar – The Real Gas Giant

If you put correctly-scaled maps of Australia and Qatar on the same page, Qatar would appear as a dot. The tiny Arab emirate sits on a tiny peninsular which sits like a pimple on the greater Arabian Peninsular, protruding into the Persian Gulf. But it’s not the size of your terrestrial landmass that counts, it’s the size of your underground or undersea natural gas deposits. Australia may boast several gas deposits in different state regions, but they still pale in comparison to Qatar’s North Field, the rights to which Qatar shares with its opposite Gulf neighbour, Iran.

The Deutsche Bank analysts have put a few things into perspective:

It was previously mentioned that the Gladstone LNG (GLNG) project was jumped on last year by Malaysia’s Petronas, such that Petronas now controls 40%. The feedstock for GLNG is CSM, which is as yet an untried process. Qatar’s North Field could, nevertheless, supply the GLNG 3.5mmtpa LNG plant with regular natural gas for five and a half thousand years.

The 9700 square kilometre field, of which Qatar controls 6000sqkm, could supply all proposed and operating Qatari LNG projects for 247 years. Qatar currently boasts nine individual LNG projects in production totalling 38.2mmtpa, with a new 7.8mmtpa LNG “mega-train” due online by the end of this year to make ten. Qatari LNG has a targeted capacity of 77mmtpa by 2011.

Recall that the 2013-15 Pacific region LNG shortfall is estimated to be 10-15mmtpa and that is what various Australia projects are targeting as their raison d’etre. Recall also that there is potentially 47mmtpa of Australian supply competing for that 15-20mmtpa gap. Yet Qatar is planning 77mmtpa of LNG capacity by 2011 with a virtually limitless natural gas supply. Despite favouring Atlantic regional trade, Qatar is currently nevertheless the largest supplier of LNG to the Pacific region.

The obvious question is: Why is Australia even bothering? Or more to the point: Why all the investor excitement, from global corporate giants to retail shareholders, in Australia’s risky fledgling LNG companies?

They are questions the Deutsche analysts have themselves assessed.

As noted, despite the obvious general growth potential of China and India it is the Atlantic region which offers the most demand growth for LNG and that is the area Qatar is concentrating on. Qatar only deals with the Pacific region if high prices are offered for long term contracts, and it would continue to need to see high prices if it is to expand its Pacific region supply. Thus to date the Qataris have shown little interest in the agreements being signed in the region between Asian consumers and Australian producers as they have little interest in playing competitive price discounting games. Why should they? With Russia an unreliable gas supplier and Europe leading the world in carbon trading, Europe, as one Atlantic example, is the “real” market for LNG in the near future. However:

“We believe Qatar has the potential to alter its marketing strategy into the Pacific Basin,” note the Deutsche analysts, “accepting lower prices to capture the shortfall window for itself, at the expense of the proposed Australian projects. We estimate Qatar projects will have 41.8mmtpa of flexible destination supply by 2013, sufficient to more than fully meet the Pacific Basin supply shortfall.”

The Australian LNG projects at real risk, suggests Deutsche, are the ones “at the back of the queue”. Those projects already with HOAs in place are likely not at risk from Qatari projects. These include PNG LNG, Pluto-1 and Gorgon in WA, and GLNG and the Queensland Curtis project (QCLNG) in Queensland. Those that are at risk are the WA projects Browse, Sunrise, Wheatstone and, to a lesser extent, Pluto-2, along with Queensland’s Australian Pacific project (APLNG).

In between lies Fisherman’s Landing LNG (which, for some reason, is not known as FLLNG), which is small in scale but likely the first CSM project to be up and running.

That’s all well and good, but for the Australian retail investor swept up in the great Australian gas explosion, it’s all about which listed oil and gas stocks are the safest and which are the most at risk.

Australian LNG Stocks

Woodside Petroleum ((WPL)) is Australia’s largest producer of LNG via its existing North West Shelf operation, and it is currently developing the Pluto project also in WA. While Pluto-1 looks well de-risked, Pluto-2 offers rapid growth if Woodside can secure third party gas supplies, but third party costs would cut into returns. The company’s investments in Browse and Sunrise appear “challenged”, suggests Deutsche, mired in joint venture disputes. They are at “significant” risk of being beaten to market by Qatar.

Deutsche rates Woodside as a Hold only. The FNArena database shows a Buy/Hold/Sell ratio of 2/4/3 and an average target price of $46.64.

Santos ((STO)) was once the most unloved of Australia’s oil and gas majors, but has gained a new lease of life since its share register restrictions were lifted and GLNG emerged as a potential “game changer” for the company, in Deutsche’s view. Its joint venture with Petronas gives untested CSM a level of credibility. A further portfolio of Santos LNG projects (including a share of PNG LNG) offers “compelling” exposure.

Deutsche rates Santos as Buy. (FNArena 9/1/0, $17.82)

Oil Search ((OSH)) is an explorer developer and not a producer, and hence its long involvement in the PNG LNG project will ultimately end with the company being gradually taken over. Deutsche believes PNG LNG is the Australian project least at risk from Qatar given its progress, making Oil Search also a “compelling”, if not one dimensional, LNG play.

Deutsche rates Oil Search as Buy. (FNArena 7/3/0, $7.12)

Origin Energy ((ORG)) is the newcomer to the party, gate-crashing its way in with its APLNG project. Origin has many strings to its bow, which is just as well as Deutsche sees APLNG at high risk from Qatar. But having already effectively monetized its first LNG train via the high price paid by ConocoPhillips to enter into a joint venture, Origin basically offers a free LNG call option, Deutsche suggests.

Deutsche rates Origin as Buy. (FNArena 8/1/0, $17.94)

Arrow Energy ((AOE)) is the “minnow” of the Australian LNG sector, notes Deutsche, but while the proposed Fisherman’s Landing project might be the smallest in Australia it may just be the first CSM LNG project to market. Arrow’s risks are thus split between size and nimbleness.

Deutsche rates Arrow as Hold (FNArena 1/4/1, $4.61)

Note that Gorgon is not considered in regard to Australian oil and gas companies, as it is an American-Dutch operation, while QCLNG is owned by Britain’s BG and Wheatstone is fully owned by Chevron.

It is interesting to note that Australia’s energy sector analysts were all caught napping in 2008, oblivious to the bombshell BG was about to drop on the LNG sector by bidding for Origin. Having since reassessed the industry and at least doubled the valuations of listed participants, the analysts in the FNArena database are maintaining a collective 27 Buy ratings on LNG companies against only 13 Holds and four Sells, three of which are on the largest player Woodside. (Notwithstanding the other interests of such companies, such as oil production.)

Deutsche (one of the database members) nevertheless implies not all Australian LNG projects can be winners in the near term even when competing amongst only themselves and before you throw the as good as infinite Qatari gas supplies into the mix.

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