LNG And The Great US Gas Glut

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This story was first published for subscribers on 24 January, 2012.

By Greg Peel

America is a strange place. But you didn't need me to tell you that. One only has to look at the funniest show on television at the moment, the absurdist comedy known as the Republican Nomination Race. Never before has a political contest been so publicly and viscerally hate-filled, and these people are on the same side.

The nomination race has taken over in popularity from last year's big US hit – The Great Congressional Deadlock. Or perhaps it's really a spin-off. The Republicans clearly feel they can destroy the Democrats by leveraging off their lower house majority and carrying their policy shut-down all the way to the elections at the end of this year. The Republicans, who are in opposition, have given the Democrats, who are in government, deadlines on public policy decisions. One of those involved a decision on the Keystone XL pipeline.

The Keystone XL is a pipeline proposed by Canadian company TransCanada Corp which would transport oil from Canada's rich tar sand resources some 2700km through the American midwest and on to the refineries in Texas. The problem for the Obama administration is the February 21 deadline the Republicans have put on the pipeline approval decision. With vocal protest from environmental groups ringing in his ears, President Obama wanted time to assess the risks of such an enormous venture and the deadline simply did not provide time enough. So Obama has rejected the proposal, telling TransCanada to come back another time.

Environmentalism is, of course, anathema to conservative Republicans. And on the other side, oil sits in second place only to God. The Republicans have thus turned the Keystone rejection into a big political deal in an election year despite having set the deadline in the first place. But as crazy as it all might be, the real craziness is defined by America's stubborn attitude to oil.

TransCanada will now possibly switch its attention to using the money it had earmarked for the Keystone construction to instead set up an oil export facility on the Canadian coast within comparative spitting distance to the tar sands operations. China, and Asia in general, would be the target market, rather than the US. Meanwhile, America despairs over its declining sources of domestic oil resources and its ever increasing reliance on Middle East imports. Yet in the climate of such despair, America is experiencing a natural gas glut.

Once upon a time US energy companies decided to build liquid natural gas facilities on the US coastline. These were not export production facilities, they were import receiving facilities. It was believed that while natural gas was in abundant supply in the US, one day demand would outstrip supply and thus imported LNG would be needed. Today there is talk of converting those LNG facilities so that LNG can be exported, not imported. And where to? China of course, and the rest of Asia.

There have been two major technological advances in the US oil and gas industry in recent years, notes JP Morgan. One is horizontal drilling and the other is hydraulic fracturing, known as “fracking”. Horizontal drilling has provided the opportunity to tap into oil reserves still sitting in long abandoned wells on the US mainland which traditional vertical drilling could not reach. Fracking, as every Australian now knows too well, allows for the release of gas and liquids trapped in coal and shale seams. Fracking has given birth to the burgeoning coal seam gas industry in Australia, and has suddenly opened up vast new resources of shale gas in the US. The race is on on both sides of the Pacific.

One can understand why LNG receiving facilities were built in the US when one considers US natural gas production has never been as high as it was in 1971. At least, not until now. Production records are being broken once more as the contribution of shale gas moves from 5% of net production five years ago to 25% now. The Wall Street Journal describes current US shale gas production as “relentless”.

One would expect Americans might be extremely happy about the situation. Surely domestic natural gas is a lay-down-misere substitute for crude oil imported from bitter enemies. Legendary American oil billionaire T. Boone Pickens has been lobbying for some time now for all US trucks, and you can imagine how many of those traverse the country every day, to be converted to gas-powered instead of diesel-powered. Sure – T. Boone made a major investment in gas first but his idea makes sense to just about anyone except those that matter, such as politicians. His pleas have fallen on deaf ears.

Now the northern hemisphere has been hit with an unusually mild winter. Americans may not be able to fathom the concept of running eighteen-wheelers on gas, but they are very familiar with gas home heating. Given far less than typical demand, US gas storage has reached record levels. Even if temperatures were to fall to average for the rest of the winter, notes Citi, inventories would be sufficient to carry through the summer, thus making summer gas production redundant. Add in the shale gas supply surge, and the US natural gas price, as measured by the price of futures contracts for delivery to the Henry Hub, have collapsed.

Natural gas contracts for longer term delivery are traditionally priced off the crude oil benchmark at an appropriate ratio. That ratio rises and falls over time but until the GFC has always been within a familiar range. Since the GFC, crude oil prices have quickly bounced back to over US$100/bbl, including a price rise of over 50% in the past two years:

By contrast, the natural gas price has fallen by over 50% over the same time period, rendering the traditional ratio redundant:

The way things are going, the US gas industry has now resigned itself to the expectation the Henry Hub price will fall below US$2/mmbtu. While the cost of gas production varies greatly from producer to producer, depending on source, location, ease of extraction and so forth, prices for some producers are already below net costs. Which is why last night Chesapeake Energy – America's second largest domestic gas producer after Exxon – announced a plan to cut its number of operating “dry gas” drilling rigs by 24 by the end of the quarter, out of 47.

“An exceptionally mild winter to date has pressured US natural gas prices to levels below our prior expectations,” explained Chesapeake, “and below levels that are economically attractive for developing dry gas plays in the US, shale or otherwise.”

While Republicans are up in arms about the president's rejection of a pipeline to bring expensive tar sand oil in from friendly Canada, the US gas industry is shutting down development due to an over supply of cheap natural gas.

The obvious question arising out the current state of the American gas market is: What does this mean for all the faith being put in Australia's massive LNG developments?

Before addressing that question, we must first acknowledge that one mild winter is just one mild winter and next year's might be extra cold. However there's only one direction for shale gas production at this stage. We must also acknowledge that just because the US gas price is dirt cheap, it doesn't mean Australia's gas price must also fall. If gas can't be transported by pipeline, it must first be put through the very expensive process of conversion to LNG if it is to be exported by sea. Hence there can be vast discrepancies in domestic gas prices across the globe. As we know, Australia's gas price for domestic consumption has been sharply on the rise in the time the US price has been sinking.

What we must acknowledge, however, is that while gas demand out of China and the rest of Asia is expected to rapidly grow over the next decades, everyone with any gas is lining up as a potential seller. Australia wants to sell offshore Western Australian gas and east coast CSM, the US wants to sell shale gas, and Canada may now sell tar sand oil to Asia instead of the US. And that's before we look at other gas sources including India and Indonesia, and also Qatar, which has so much gas to sell it deliberately limits production.

When it comes to Australian LNG production, and investment therein, we think Woodside Petroleum ((WPL)), Santos ((STO)), Oil Search ((OSH)) and Origin Energy ((ORG)) as the biggies, filtering down through a plethora of smaller caps such as Beach Energy ((BPT)) with its own shale aspirations, and further down to every company currently running around rural New South Wales with a drill rig inciting some very angry farmers. That's not including the extensive WA operations of BHP Billiton ((BHP)) or any of the world's Big Oil internationals with interests either side of the continent, or both sides.

For the most part, Australian energy stock analysts are keen on what they see as significant long term value in all these gas projects, while also admitting it will be a case of first in, best dressed. The BA-Merrill Lynch analysts, on the other hand, have a different view. On the release of Woodside's December quarter production and sales report last week, Merrills had this to say:

“Australian LNG costs are still accelerating at a disturbing rate. Most recently Ichthys set a new record with a $4,000/ton cost estimate. This is not good news for greenfield developments which already suffer from thin economics. With increasing supply side competition from the likes of Canada, Mozambique and US buyers are not short options and expensive Australian gas may find itself homeless.”

Woodside is also struggling to find any new gas of its own to feed the planned expansion of its Pluto operation in WA to a second and third train, and that only adds to costs. Most analysts now concede the company will be forced to buy in third party gas, thus undermining Pluto's value for shareholders. Merrills has an Underperform rating on Woodside. Believing gas will have to be bought in for a second train, let alone a third, JP Morgan matches that with Underweight. Otherwise every other broker in the FNArena database rates Woodside a Buy (or equivalent).

With regard to coal seam methane, the Merrills analysts state bluntly “Not a CSM believer”. Yet Merrills has a Buy rating on Santos, which boasts two of the faster moving projects in Gladstone LNG and its share of PNG LNG alongside Oil Search.

Merrills does not ascribe much value to the Santos LNG assets, believing that “CSM will prove more costly and difficult to extract than currently expected”. But Merrills is otherwise bullish on gas prices. Australian domestic gas prices, that is. While the focus of Australia's energy sector has been squarely on LNG for many years now, ever since BG made an unsuccessful play for Origin in 2008, Santos has also been plugging away expanding its conventional gas operations in the Cooper Basin and beyond. With domestic east coast gas demand and pricing on the rise, and CSM yet to offer a viable alternative, Merrills' positive valuation of Santos is all about the delivery of conventional gas.

The other Buy ratings for Santos in the FNArena database are all about LNG's long term upside.

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