LNG: A Problem Of Surging Supply

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As the long-awaited Australian ramp-up in new LNG production capacity begins to manifest, the issue is one of global oversupply.

– Nine new LNG trains to start up globally in 2016
– Asian demand growth under question
– Pressure on export pricing
– Australia to become world leader

By Greg Peel

After many years of development and billions of dollars in investment, liquefied natural gas is set to soon become Australia’s second biggest export commodity. The problem is the long-anticipated surge in LNG supply will coincide with lower prices and weaker than expected demand in an already oversupplied market.

The fundamentals are unlikely to change for the next five years, ANZ Research suggests.

Over the past four years, LNG facilities have come on line at Pluto, PNG LNG, Queensland Curtis LNG, Asia Pacific LNG, Gladstone LNG and Gorgon to join previous facilities at Darwin and the North West Shelf. Next year, Wheatstone, Ichthys and Prelude FLNG are expected to come on line, while expansion is targeted at most of the other facilities.

At the same time, the US has become an exporter of LNG having previously been an importer. The development of the US LNG export industry is underway albeit beholden to strict government regulation. Global LNG supply is forecast to rise by 50% by 2020, ANZ notes, predominantly due to Australian and US expansion.

LNG Pricing

When Australia first started exporting LNG to Japan from the North West Shelf in 1989, pricing was determined on an oil price-linked basis and on long term delivery contracts. The reason was that in the twentieth century, the prices of crude oil and gas never shifted very far from a consistent ratio, and being the most heavily traded commodity in the world, crude oil provided an efficient and transparent benchmark.

Today, LNG importers in Asia still largely prefer longer term contracts and oil-linked pricing, but the number of cargoes traded at spot pricing is increasing and the plunge in the price of oil has made oil-linked pricing that much cheaper. Cheaper still are prices charged by US exporters, who benchmark not off oil but off the US domestic Henry Hub gas price, which has also remained low due to the abundance of available US shale gas.

At the end of 2015, LNG prices to Asia hit seven year lows and to North America and Europe ten-year lows. ANZ does not believe US oil prices can remain as low as they are given growing domestic demand and a growing export industry, but any gains will also be capped by idled production that can quickly come back on line.

The lag between price setting on longer term contracts, delivery and payment is typically six to seven months. This implies Australian LNG producers are only now beginning to catch up with the big drop in the price of oil last year and into this year. ANZ believes prices to Japan will drop from US$16.0/mmbtu in 2015 to a forecast US$6.9/mmbtu in 2016.

Spot prices do not exhibit the same lag ANZ expects the LNG spot price to end the year around US$8/mmbtu and, on the mix, Japanese prices to level out at around US$10/mmbtu.

While this decrease in prices is not good news for Australian producers, it does mean that US exports at Henry Hub pricing are no longer that much cheaper. And for the Americans, it costs more per cargo to transport LNG to Australia’s prime customers Japan and South Korea given the greater distance, leaving South America and Europe as more viable destinations.

The Demand Side

Together, Japan and South Korea account for around half of all global LNG imports. Not only did Japanese demand fall 6% to July this year, imports from Malaysia also exceeded imports from Australia in the latter months, ANZ notes, reducing Australian volumes to their lowest levels since June 2015.

The plunge in the price of coal swung Japan towards cheaper coal-fired generation, although thermal coal prices have since rebounded, while Japan’s idled nuclear reactors have also finally begun to restart, albeit at a glacial pace.

It does not help that weather forecasters are suggesting Japan is in for a warmer than normal winter.

It has also been warm in South Korea, which has helped LNG imports grow by 3% to August for air conditioning. That said, the Koreans have also built new coal-fired power generators and have restarted a nuclear reactor.

China is a growing LNG import customer but in China’s case the weather has brought heavy rains, allowing for record hydro-electricity production. The plunge in the price of oil has also prompted a switch to oil-based products.

On the positive side, in its push to reduce pollution the Chinese government has reduced the regulated domestic gas price by US$3/mmbtu and aims to retire some 400,000 small-scale coal boilers in the industrial sector and replace them with with gas-fired. ANZ expects Chinese LNG imports to continue their path growth in 2016.

Europe has also been experiencing mild weather of late. This has restricted gas demand, but Europe boasts copious amounts of gas storage capacity and stocks remain well below average levels. Europe has long been beholden to gas imports from Russia via pipelines which in the past, due to strong domestic demand in Russia, have been turned off. One major pipeline also passes through the Ukraine, which introduces its own risks.

To that end, Europe has been looking toward the surge in global LNG production by building regasification plants, with 31 new plants being currently developed or proposed, ANZ notes. As a result, European LNG imports were up 5.2% to July.

The Supply Side

2016 is expected to see nine new LNG liquefaction trains start up, some having been delayed in 2015. They will contribute around 35mt of capacity to the global market, which ANZ estimates will total around 260mt per annum in the year.

Most of the increased supply will emanate from Australia and US, where 100mtpa of supply is under construction in the form of initial or additional trains. Additional supply is also anticipated from Malaysia, Indonesia and Angola this year.

Over the next five years, ten new trains are planned to start up in Australia, which would take Australia’s share of global exports to 25%. Given Qatar is controlling production in order to preserve depleting reserves, by 2020 Australia should be the world’s biggest producer. ANZ projects Australian LNG exports to grow by an average 15% per annum in 2010-20, one and a half times the rate of growth in 2000-10. By 2018, LNG should become Australia’s second largest commodity export, after iron ore.

ANZ forecasts US exports to grow to a market share of 10% by 2020, putting it in third place behind Australia and Qatar. Aside from the aforementioned additional cost issue of transporting LNG from the US to all the way to Asia, the US government sets controls over exports in order to prevent domestic gas price volatility (something Australia is virtually alone in the world in not doing) and tough government approvals must be met before exports can be delivered to countries with which the US has no free trade agreement.

The US presently does not have FTAs with any of Japan, South Korea, China or India.

Beyond 2020, Australia’s advantage over the US should expand further. The US is only a recent newcomer to the LNG export game, and while the first US facilities are now beginning to ramp up, ongoing capacity increase will require largely starting from scratch with new greenfield development.

In Australia, capacity increases will come mostly from brownfield expansion – additional trains at existing facilities or projects currently on hold pending oil price improvement that have moved at least some way along in the planning stage. While Australia suffers from higher operational costs than its competitors, ANZ notes, expansion should be achieved at a lower cost.

That said, there is no indication oil prices are set to leap up anytime soon. ANZ forecasts an average US$60/bbl for the next few years, which would still leave large brownfield projects such as Woodside Petroleum’s ((WPL)) Browse, currently stalled, a touch and go prospect. High costs in Australia, and attempts by gas producers to cut rather than increase capital expenditure, mean new greenfield projects seem a distant possibility at this time.

In the nearer term the picture is nevertheless brighter. Of the 65mtpa of new capacity in Australia, 90% is already secured under contracted volumes.

The Heated Gas Issue

The US can at least feel safe in the knowledge that were LNG producers to decide to proceed with further capacity development, there’d be no shortage of available gas to liquefy. That’s not necessarily the case in Australia, depending on whom you talk to, and indeed the subject has prompted angry debate.

It’s all well and good to outline Australia’s LNG production capacity, but LNG production requires sufficient NG to meet that capacity. Late in August pipeline operator APA Group ((APA)) declared “we are finally in agreement that there is sufficient gas forecast to be produced to satisfy both LNG and domestic demand…so there was no gas crisis after all, which is what APA has said all along”. So no problem really.

But the energy analysts at Credit Suisse beg to differ – stringently.

With no new volumes sanctioned, or close to being sanctioned, large reserve downgrades over the past 18 months, a paucity of capital among resource owners, potential upstream challenges at GLNG and other assets, the situation couldn’t be more critical, says Credit Suisse. And the analysts see things only getting worse.

Feedback from the gas companies themselves to Credit Suisse’s assertion has largely been in the form of agreement. APA, on the other hand, has accused the analysts of simply pushing out into time a view they held earlier which has proven erroneous. But Credit Suisse has a comeback to that accusation.

If Australian LNG capacity ramp-ups had gone according to plans held five years ago, 2016 would be the year an abundance of new LNG would hit the market all at once. It was on that basis Credit Suisse queried whether there would be enough gas available come the time to feed all the new capacity. In the meantime, ramp-up schedules have been delayed, firstly by the sort of setbacks one should expect in major construction work, and secondly due to the plunge in the oil price and subsequent plunge in gas company cash flow.

So yes, Credit Suisse has now pushed its lack-of-gas warning out from 2016 to 2018-20, assuming all planned ramp-ups do proceed. But even in 2016, the analysts believe there is enough evidence to dispute APA’s declaration of sufficient gas.

When AGL Energy ((AGL)) found itself slightly short gas recently, the Queensland domestic spot price shot up significantly. Santos ((STO)) has declared it is unable to ramp up GLNG as quickly as previously planned due partly to a lack of equity, given low prices, but also due to problems sourcing third party gas supply. And this month’s South Australian electricity price spike crisis occurred when the owner of the Pelican Point gas-fired generator decided it could make more money selling its contracted gas to the hungry LNG export market instead of consuming it in domestic electricity generation.

“The problem exists,” says Credit Suisse, “and it will undoubtedly get worse”.

For years energy analysts such as those at Credit Suisse have been warning of east coast domestic gas prices surging as a result of volumes required for more lucrative LNG export. Adding to the issue has been pressure on politicians to prevent the coal seam gas industry moving in to areas of agricultural significance, or just about anywhere really, thus limiting the potential growth in gas supply.

Given there are no legislated requirements in this country, as there are in just about all other energy-producing countries, to quarantine a percentage of gas extracted from crown land for domestic consumption at regulated prices – producers of gas in Australia are free to sell as much gas as they want to foreign consumers via LNG export – the risk is the benefits to the Australian economy of becoming the world’s largest producer of LNG could well be offset by the economic drag of soaring electricity prices.
 

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