Natural Gas Glut A Problem For LNG Projects

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This story features SANTOS LIMITED, and other companies.
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By Greg Peel

The following is a two-year weekly chart of the benchmark crude oil price:

The chart clearly shows the big sell-off into the GFC followed by the China-driven path to recovery toward the current price over US$80/bbl.

Crude oil and natural gas are not instantaneously substitutable, but as fossil fuels exploited for interchangeable purposes the prices of the two usually run in tandem, albeit with the odd fluctuation from the demand-supply balance. Over time, the benchmark natural gas price has averaged around a 1:10 ratio to the crude oil price.

But not recently. The next chart shows the benchmark natural gas price over the same period:

The gas price followed the oil price out of the GFC depths initially but has now almost returned to those depths. The current price ratio is now closer to 1:20.

The reason for the divergence is quite simple – there is a natural gas glut at present. Inventories of crude oil have also been hovering around record levels even as the oil price has recovered, but as the world's most actively traded commodity oil has become a financial asset in its own right, used by investors as an inflation hedge or by central banks as a diversification from US dollar investment.

The same cannot be said for natural gas, which is a lot more difficult and costly to store than oil. But stored it is, in vast quantities in the US alone at present. Not even the February snow storms in the US could clear the glut, followed, as they were, by an unseasonably early spring.

The inherent weakness in the benchmark spot gas price comes at a time when the Australian LNG market is in a boom phase. Offshore gas projects in WA such as Gorgon has the government all excited and over in Queensland, coal seam methane LNG is being coveted by global oil & gas majors. Many significant projects on either side of the continent, operated by the likes of Woodside Petroleum ((WPL)), Santos ((STO)) and Origin Energy ((ORG)), are scheduled to reach final investment decision status (FID) this year.

Decisions on investment are heavily reliant on sealing longer term off-take agreements with major Asian gas buyers such as China and Japan. The production of LNG is a costly business, and the production of CSM LNG can be even costlier. Obviously the gas price at which long term contracts are set is crucial.

“In our view,” say the gas analysts at Morgan Stanley, “this is not an ideal time to be launching new projects, and either prices or volumes will have to give ground”.

Given the extent of merger & acquisition activity in the Australian gas space over the past couple of years, global producers and buyers are noticeably in it for the long term and are not concentrating on today's spot price. But when one sits down at the negotiating table, the spot price is a starting point – just look at iron ore.

So the bottom line is a weak spot gas price will not help in sealing successful deals. Aside from well known projects in the Carnarvon Basin in WA and the Bowen and Surat Basins in Queensland, there are a number of other smaller projects being planned by both majors and juniors alike.

A successful start-up of these projects was already a dicey consideration, as explained in last year's FNArena feature LNG: Gold Mine or Glut and very extensively in the FNArena special report emailed to subscribers earlier this year entitled “The Australian LNG Explosion”*.

The Morgan Stanley analysts note in the meantime that the current round of quarterly production reports from Australian oil & gas producers will take a back seat – share price reaction wise – to impending news on project FIDs. The analysts suggest no local O&G major looks cheap at present given valuations are being supported by undeveloped gas resources.

The question is: Just what impact will weak spot gas prices have on contract negotiations and FIDs? Disappointment seems a strong possibility.

It is potentially good news that eleven of the world's major gas producers decided to meet yesterday to discuss the oversupply problem, including Russia, Qatar, Venezuela, Algeria and Iran. The suggestion on the table is that an OPEC-style cartel should be formed to control gas pricing via agreed production controls.

In theory, the Organisation of Petroleum Exporting Countries controls the global oil price by imposing production quotas on its members. In practice, the oil price was US$147/bbl in mid-2008 and US$32/bbl by the end of 2008. So much for control.

* This article was emailed to subscribers in February and to new subscribers on signing up. If you have not recieved the article or would like a re-send, please contact info@fnarena.com.

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