LNG: Where The Resource Sector Upside Lies

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Note: This article was first published for subscribers on April 26, 2012 and has now been unlocked for general access.

By Greg Peel

Alphinity is a boutique fund manager established 18 months ago after the four founders left a well known institution together to do their own thing. Prior to leaving, the team had racked up eight years of equity fund management returning an average 2% above the ASX 300 index. Today Alphinity has $1.5bn under management for both retail and high quality institutional clients.

Alphinity's sole focus is on investing in quality undervalued companies undergoing an earnings upgrade cycle. The managers' valuations are deeply rooted in assessments derived from talking at length to those “on the ground” in the various industries which make up the sectors of the Australian stock market. Aphinity's portfolio currently consists of 14 stocks (only one change has been made in 18 months) representing, at present, the sectors related to resources (and resource servicers), the consumer, the US housing market and insurance.

Today's article will deal specifically with the resource sector.

Over the course of 2011, Alphinity had meetings with over 600 industry and company contacts, undertaking research across 32 cities or regions in order to gather information on the drivers impacting Australian stocks, whether in China or Gladstone (Queensland). Company specifics remain the most important factor, although one must also appreciate first hand the bigger macro picture behind those drivers.

Of particular note is that China currently accounts for 90% of all global commodity demand growth (be careful not to confuse actual demand with demand growth) and that the timely understanding of policies and demand strength is absolutely critical in assessing price shifts. It must also be noted that Australian financial regulations and borrowing costs are directly influenced by developments in the US and Europe, and that 45% of ASX 200 earnings are derived outside Australia.

China, as is well understood, is undergoing a self-induced economic slowdown implemented by liquidity tightening across the system, particularly within the property sector, to stem inflation and reduce the risk of a property bubble. Clearly a slowdown in property development impacts on China's demand for steel (hence iron ore and coking coal) and other commodities.

As the red line on the following graph indicates, China's rate of steel production growth shot up in the period 2002 to 2005 but has since declined at a steady rate (smoothing for the GFC blip). 

Again it is important to distinguish production rate of growth from total production. As the blue bars indicate, China's total steel production has grown every year from 2002 to 2011 with the only blip being a flat 2007-08. Nervous investors have a tendency to run for the hills any time anyone mentions “China slowdown”, despite the implication being a slowing only in China's rate of GDP growth rather than any suggestion of economic contraction.

This translates in recent suggestions by analysts that the so-called “super cycle” is over, at least for now. Such statements make for rather scary sensationalist headlines, but all it means is that the double-digit, runaway growth China has undergone in recent past years will settle back to a more manageable growth rate at which China will continue to consumer a vast proportion of the world's raw materials but just not at the same pace of annual consumption growth as we have previously experienced. The Chinese “miracle” continues, but it is now rolling out from the major cities and into the regional areas before continuing on to far-flung provinces. The Chinese government has become a lot more experienced at managing its economy through fiscal and monetary measures.

Were this not becoming more apparent, and were there widespread fears Beijing will bring the Chinese economy in for a proverbial “hard landing”, the world's largest mining and energy companies would not be investing the billions they have now earmarked to finance production expansion which will largely service one customer – China. China may yet still suffer a hard landing, but that is not the popular bet.

Alphinity agrees that China's rate of steel production growth will slow from here in the longer term picture. However it is also universally assumed Beijing will respond over the course of 2012 with further policy easing measures that will serve to avoid any dangerous dips in economic activity. On that basis, Alphinity believes that the world has become too negative on China in the short term and that a steel production recovery is already underway on the back of easier policy. The following graph tells the tale:

Here we see a graph of the net change in orders for steel from Chinese end-users in the various denoted sectors from local mills and intermediaries (traders). The trend is clear, and Alphinity is expecting 4% Chinese steel growth in 2012.

The infrastructure and construction sectors show the sharpest bounce in demand in this graph, which are two sectors in focus when it comes to discussing hard landings. Beijing began an enormous fiscal stimulus infrastructure program in late 2008 and it is easy to see how the pace of such building will now have eased. However, the aforementioned rolling out from the major cities is reason to assume infrastructure will continue to be built in China for many years to come. As for the highly contentious property market, Chinese home sales were shown to have increased 30% year on year in March as easier access to cheaper mortgages drove solid Chinese first home buying.

That's the demand side. Then there's the supply side. As suggested, BHP Billiton ((BHP)), Rio Tinto ((RIO)) and Fortescue Metals ((FMG)) are among the companies across Australia and the globe madly undertaking expansion of iron ore production capacity, as well as coking coal (the two constituents of steel) and everything else besides. The bulk of new iron ore (seaborne) supply will begin hitting the oceans from 2014.

So China's steel production growth rate will be easing as Australia's iron ore production increases. The balance is, however, that Australian iron ore producers will tell you China is buying every rock that is currently being pulled out. The shortfall is covered by China's own domestic iron ore production, but Chinese iron ore is low-grade and expensive to produce, and that cost is is increasing by 5-10% per annum. Greater supply of Australian (and Brazilian) high-grade “fines” will result in greater exports to China and less Chinese required production of domestic ore. The following graph from Alphinity includes such expectations:

China's consumption of Australian iron ore will thus increase by volume, but the balance will be a fall in price, Alphinity forecasts. A price of US$140-155 per tonne (CFR) is expected as a support level for 2012-13 but prices will begin to decline thereafter as cheaper seaborne supply replaces high cost domestic supply.

Such a view, again, supports a more widely held view that the “super cycle” is over for now. In the super cycle, commodity prices just kept going up. From here on volumes will continue to rise, but earnings will be balanced by price declines.

Alphinity holds Rio Tinto in its portfolio. On the domestic steel front, Alphinity holds OneSteel ((OST)). For mining services, Alphinity holds Bradken ((BKN)), Monadelphous ((MND)), NRW Holdings ((NWH)) and Seven Group ((SVW)), with the latter based on the company's ownership of WesTrac.

Let's now talk energy, and do so by leaping straight into the next chart:

This chart depicts Australian export revenues from liquid natural gas (LNG), hard coking coal (HCC), used for steel production, thermal coal (TC), used for power generation, and iron ore (Fe). The blue bars represent actual 2011 revenues while the red bars represent Alphinity's forecasts for 2020 revenues (which incorporate volume and long term price assumptions).

We note that iron ore was the stand-out provider of export revenues in 2011 and will again be in 2020. However in 2020, iron ore revenues will be all but matched by LNG revenues despite LNG revenues being the lowest of the four in 2011. The rate of growth of LNG revenues over the period will dwarf that of iron ore revenues.

In 2020, suggests Alphinity, Australia will become the world's biggest producer of LNG, overtaking Qatar. 

[This writer was taken aback by this statement at the Alphinity presentation, given Qatar is supposed to be sitting on a Persian Gulf natural gas reserve that could supply the world for a couple of hundred years. And that represents only half of the total reserve of which Iran owns the other half. Qatar has built “mega-trains” to supply the world with LNG, and is so influential in the global supply balance it chooses not to over-produce, OPEC-style, in order to maintain a good price.

Alphinity's Stephan Andre knows the claim well. But he believes the claim has now come under scrutiny to the point of being disputed. Andre is off to Qatar shortly to assess the situation for himself.]

Australia's LNG production production will increase from 20mtpa to 80mpta plus by 2020 based on currently sanctioned projects alone, lifting Australia's global LNG export market share from 9% (fourth place) to 25% (first place). Australia has accounted for 70% of all LNG capacity sanctioned globally in the past five years.

It is important here to note the difference between natural gas, which can be piped but not otherwise transported, and LNG, which is exported in pressurised ocean-going tankers. It is very costly to convert natural gas into LNG and LNG production facilities are very expensive and time consuming to build. The price of export LNG is linked to the price of oil and not to the price of natural gas per se. The US natural gas price is currently wallowing at decade lows but this does not impact directly on Australia's current LNG export price. 

The reason US natural gas is at so low a price is because of the sudden “explosion” in US shale gas production. So swift has been the US shale ramp-up that BHP has already been forced to move the drill rigs at its recently purchased Eagle Ford project away from gas-producing sites towards sites offering the more valuable shale liquids. The US had never previously given much thought to using its gas reserves to produce LNG for export, but that's now the plan. The US is, however, a long way behind Australia on the production time line. 

Yet it is one reason why Australian LNG potential is seen as a “first in, best dressed” concept in which the slow movers will fall by the wayside. There is also an important side-effect to Australia's LNG export race, which is good news for Australia's natural gas producers and bad news for Australia's energy consumers. Alphinity concurs with those who suggest Australia's east coast natural gas price will rise by 50% over the next five years.

Think wine, a couple of decades ago, think lamb in more recent times. Domestic production that Australians used to enjoy at enviable prices is no longer cheap because of the export dollars on offer. Once the east coast LNG industry ramps up (from 2014) the price of domestic gas will have to rise to meet that of prices paid by LNG producers seeking export riches.

Once the US becomes a viable LNG export producer, the same domestic price impact will be felt.

It is no stretch of the imagination to appreciate that the prize export client targetted is China. Consider the following graph:

This graph depicts the comparative energy intensity of China alone, the BRICs combined (Brazil, Russia, India, China), the world combined, and the US alone. Energy intensity is measured in barrels of oil equivalent per capita. In other words it measures the average consumption of oil, gas and coal, measured as barrels of oil equivalent, by every member of a population each year.

The chart shows that the US, despite being far and away the world's most indulgent energy consumer, has at least begun to become a little more efficient. China appears to have become a lot less efficient but in reality China now leads the world in alternative energy investment and Beijing has for many years been fighting energy intensity by cracking down hard on inefficient and “dirty” plants and factories. The jump up in China's 2010 intensity from 2000 is simply representative of its oft cited “industrialisation and urbanisation”.

China, of course, has a population of 1.2 billion people to America's 300m and if you move onto the BRICs you get India with a similar score. So energy intensity for these regions can only shoot up from here, meaning ongoing consumption growth. Brazil and Russia have their own resources but Chinese and Indian demand for LNG, which is cleaner to burn than coal or oil, can only rise in the usual dramatic fashion.

Yet were one to add up the world's proposed LNG production capacity growth that figure is actually much higher than anticipated demand growth. Alphinity is not alone in suggesting “There are risks – it is important to back the right companies”.

Alphinity notes the risks include global production capacity growth (including from the US), risks of new supply (China is now exploring its own shale gas potential, for example) and individual capex overruns for LNG aspirants.

Alphinity holds Oil Search ((OSH)), Santos ((STO)) and Woodside Petroleum ((WPL)) in its portfolio alone with energy sector service provider WorleyParsons ((WOR)).
 

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