Are Rising East Coast Gas Prices On Your Radar?

This story features SANTOS LIMITED, and other companies. For more info SHARE ANALYSIS: STO

By Rudi Filapek-Vandyck, Editor FNArena

There is a mini-storm brewing on the East Coast of Australia. It hasn't as yet received a lot of attention from the media, stockbroker research reports are also still few and far between, while the upcoming Federal election won't shine a light on this issue either.

It is, however, but a matter of time before everyone, including non-suspecting consumers in NSW and Queensland, will be forced to pay attention.

Give it another two years or so. Maybe more, maybe less. By then buyers of gas on the East side of Australia will be confronted with price increases of 50%, or maybe it will be 75%, or even 100%, or even more. There are still so many possible outcomes that whatever might turn out as the end result remains today very hard to accurately predict. One things seems to be a 100% certain outcome, and that is that domestic gas prices will rise and they will do so in big numbers.

For investors in the share market, it might be wise to take a look into this matter well in advance, because there will be winners and losers.

Let's start with the main ingredients: forty years of relatively stable, cheaply priced, long term gas contracts are now creating the ideal platform for a rapid acceleration in demand in the years ahead. Estimates vary greatly, as one would expect, but a tripling of today's demand in five years' time does not seem out of the question.

On the other side of the equation, we have local users of gas (the "buyers") that probably have become used to low prices for a little too long, while governments have hardly paid attention to specific, forward looking industry dynamics, allowing a small group of export-oriented asset owners to effectively control the local gas market (but with commercial interests directed towards Asia) while on the other hand, pressured by environmentalists and green activist groups, making life difficult for emerging producers of non-conventional sources of gas.

The combination of all these factors makes for a simple, old-fashioned supply-demand squeeze. One day Australians will wake up and read in the newspapers (hear on the radio) there's not enough gas available for the domestic market. Prices will jump. That will be the turning point when the ABC and others will start asking the obvious questions: how can it be that (by then) the world's largest producer of gas is unable to satisfy its own domestic usage?

I mean, can anyone imagine Saudi-Arabia not having enough oil inside its own borders?

Because we are talking relatively slow moving market dynamics (just think about how long it takes to get projects such as Gladstone and QCLNG in production), it has already become a near 100% certainty that domestic gas prices will jump dramatically in the years ahead. Of this both buyers and sellers are convinced. This is why the likes of the Australian Industry Group have been voicing their concerns via the media, while producers such as Santos ((STO)) and Origin ((ORG)) have been telling investors higher prices are but set in stone.

What is yet to be determined is by how much gas prices will/can rise in the years ahead.

To determine what is likely and probable we need to understand the specific dynamics that are currently playing out on Australia's East Coast. If both Santos and Origin play their cards right, they could end up dominating a gas-hungry market with little short term alternatives. The problem both companies are facing is there is no shortage of undeveloped gas throughout the region. Both could temporarily squeeze their local customers to the max, and possibly achieve much higher prices than most are willing to contemplate today, but both know all too well that high prices will instantaneously trigger enough new activity to bring online a tsunami of new supply that will ultimately bring prices down to much lower levels.

This is the point where one can enter just about any scenario or possibility for the years ahead. Not making it easier, is the fact that most large projects in Australia are either owned by foreign companies, such as RD Shell, Exxon, Sinopec and PetroChina, or local owners Santos, Origin and Woodside ((WPL)) have been selling long term supply contracts to customers in Asia. Australia has been one of the most expensive places on the globe to finance and develop large new resources and energy projects in years past. All new major gas projects have sought access to higher international prices to achieve acceptable returns on investment.

The irony is that some of these projects, including both GLNG and QCLNG, will initially be forced to buy in domestic gas to meet contractual obligations in the years ahead. Yet more gas that will be shipped offshore and that will leave domestic users scrambling to meet growing demand.

There's no consensus about what the new contract prices for gas in domestic Australia will look like. Industry observers believe future contracts will be relatively short as both suppliers and buyers will be reluctant to commit for too long. In terms of prices, one of the least bullish teams of experts works at Macquarie, but even they believe prices are likely to double between 2010 and 2014-15. The price in 2010 was A$4/GJ. This implies A$8GJ in two years' time.

The good news is that at such a price level, many of the non-conventional sources of gas in Australia, including projects in the Cooper Basin, are believed to be commercially viable. The other side of the coin is that at that price, switching to coal also makes sense from a purely cost-based angle. As a matter of fact, some users of gas have recently been making the switch and analysts following the sector are predicting (some) Australian businesses will at least temporarily make a switch back into coal again in the coming years. Call me naive, but isn't this the opposite of what the Federal Government is trying to achieve?

If the September election brings in the Coalition as the new government, and carbon pricing ends up in the bin, switching to coal is to become even more financially attractive.

Below is an overview of estimated costs to develop major new sources for gas supply in Australia. Assuming all these projects will come online, a price of A$9/GJ should be expected in the years ahead. This is considerably higher than the A$2.5/GJ price point that defined the past four decades in Australia and more than double the A$4/GJ domestic users paid as late as 2010. Experts believe the average price point right now sits around A$6/GJ (there is little visibility as everyone is playing cat and mouse and long term contracts are not up for renewal until 2015 and later).
 

If, however, one was to take a more bullish view on price potential, then much higher prices become possible. Experts at Goldman Sachs and at Credit Suisse believe the tight domestic market will force users into accepting oil price-related pricing mechanisms. This could potentially open the gate to prices of A$10/GJ, or even A$11/GJ, or higher. Not everyone is convinced this will prove the case. Macquarie, for instance, very much doubts such an outcome. But even then, Macquarie believes domestic gas prices are likely to temporarily spike to double-digit prices as the market will be trying to discover a new equilibrium.

This implies we could temporarily see prices spike to double today's prices of circa A$6GJ, not the A$4/GJ reference point from 2010.

For suppliers, the risks under such scenarios is that politicians might feel compelled to jump into action on the back of public outrage and broad media coverage. This remains one of the known unknowns the industry will face in the years ahead.

Luckily for Australians, household electricity bills on average only carry around 33% throughput from wholesale prices. There is, however, no two ways about this: consumers and other users of electricity will be hit in their pockets from all this. The projected price increases are simply too large to go unnoticed.

For suppliers like Santos, the potential benefits are obvious and easy to determine. After touching $10 earlier this year, Santos shares have climbed back to $14 on the back of returning optimism for global growth prospects and a higher oil price. If positive scenarios start unfolding on the East Coast of Australia and investors are willing to value future revenue streams according to the new price dynamics, Santos' share price could potentially rise to well into the $20s.

This is not the same as stating Santos should be treated as a one-way bet on East Coast gas prices. There's still a lot that can twist and turn and Santos has numerous projects and challenges at hand. Other potential beneficiaries include smaller players in the Cooper Basin. Think Beach Energy ((BPT)), Senex Energy ((SXY)), and others.

Consider the following quote from a Macquarie research report from a few months ago: "Of the large caps, STO is best positioned to capitalise on the tightening local market given that 28% of its NAV [Net Asset Value] is exposed to the east coast gas price (while only 9% stems from its share in the GLNG development). Indeed, if east coast prices rose to A$9/GJ (the top end of STO's guidance range) then we estimate that STO's NAV would rise ~9% to A$19.66/sh. Meanwhile, BPT, [Drillsearch] DLS and AWE are also significantly exposed with between 40-60% of NAV exposed to east coast prices meaning a price of A$9/GJ could see NAVs rise between 12-18%."

What is all too easily forgotten is this development will also have its losers. Consider, for example, that higher prices might well have a dampening effect on demand, as this is usually how it works. Already Xstrata has cited rising gas prices as a key factor in its decision to shut its Queensland copper smelter, Cement Australia and Adelaide Brighton ((ABC)) have both switched operations across to coal and Alcoa has suspended its expansion of the Wagerup alumina refinery. Analysts have already questioned management at APA Group ((APA)) about it and noticed there is right now no strategy in place to deal with this. Unknown risks for one of the major market darlings in recent years? Retail power operations at AGL Energy ((AGK)) could be hit for that very same reason. It is widely believed Origin Energy is better equipped to deal with the new situation in the years ahead.

Most obvious losers would be Orica ((ORI)) and Incitec Pivot ((IPL)). Imagine for a second what it means for these producers of ammonia when direct production costs for their plants are for 70-80% determined by the price of gas. For ammonia used to produce explosives, both companies operate on contracts that allow for raw material pass-throughs, however, this does not quantify the impact on demand from higher prices. For its fertiliser plants, Incitec Pivot, has no ability to pass on increases. Its product will, all else left equal, simply become less competitive.

One of the least obvious beneficiaries would include BHP Billiton ((BHP)) with investors, at least at this stage, more obsessed with the price of iron ore, the future of Jansen Potash and the domestic gas price outlook in the US. Under scenarios explored by analysts at Credit Suisse, the BHP/Esso JV alongside smaller Cooper Basin producers might end up becoming major beneficiaries from a potentially ultra-tight gas market in Queensland and NSW.

Consider also that, on calculations by Macquarie, a rise in gas prices up to A$8/GJ would add A$3bn to the eastern states' annual gas bill, assuming there is no offsetting impact on demand. That's equal to approximately total annual sales at Santos in 2012.

Consider also that, on present estimates, the east coast of Australia has circa 150,000PJ of known recoverable gas reserves and contingent resources – sufficient to meet demand for over 60 years. If the circa 300,000PJs of prospective shale and tight gas resources are included, this could grow to 175 years. Yet, and as rightly pointed out by Dow Chemical Australia and New Zealand managing director, Craig Arnold, in an opinion piece in newspaper The Australian recently, Australian consumers are now migrating from paying a low price (as is custom for a country that is a major producer) to a high price that usually applies to countries that have little or no supply and have to rely on imports.

On current estimates, no less than 70-80% of all new gas supply on the East Coast in the years ahead will be exported. Consider that politicians in the US become uncomfortable if the comparable percentage over there exceeds the 10%. Then again, low energy prices are currently re-energising the US economic outlook. Don't count on the same effect in Australia, coal seam gas or no coal seam gas.

(This story was written on Monday, 05 August 2013. It was published on that day in the form of an email to paying subscribers).

(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions. All views are mine and not by association FNArena's – see disclaimer on the website)

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THE AUD AND THE AUSTRALIAN SHARE MARKET

I have been researching and writing an eBooklet titled "The AUD and the Australian Share Market". From late July onwards this eBooklet has become part of the bonus package that comes with a 6 or 12 months paid subscription to FNArena. If you are not as yet a paying subscriber, maybe now's the time to consider joining?

My previous eBooklet (see below) is also still included.

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DO YOU HAVE YOUR COPY YET?

At the very least, my latest e-Booklet "Making Risk Your Friend. Finding All-Weather Performers", which was published in January this year, managed to accurately capture the Zeitgeist.

All three categories of stocks mentioned in the booklet are responsible for the index gains post 2009 and this remains the case throughout 2013.

This e-Booklet (58 pages) is offered as a free bonus to paid subscribers (excl one month subs). If you haven't received your copy as yet, send an email to info@fnarena.com

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Rudi On Tour

– I will present at the Trading & Investing Expo in Melbourne, August 23-24 (where FNArena will host a booth) – ticket promotion to follow – title of presentation is "What Works In The Share Market?"

– I will present to members of AIA NSW North Shore at the Chatswood Club on Wednesday 11 September, 7.30-9pm

– I have also accepted an invitation to present to ATAA members in Canberra in late November

– I might give my final presentation for the year at the ASA's Sydney Investor Hour in December

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