Commodities | Apr 21 2010
By Chris Shaw
The US is a major producer of natural gas, which Barclays Capital notes has resulted in questions as to why producers in that market continue to drill when the market is not in need of further supply.
The answer is not so simple, Barclays suggesting it is to some extent tied to producers trying to deliver on the expectations of equity investors. Rising production targets are viewed positively by investors as it implies growth for the company, even if it also means oversupply for the market.
The other issue for producers of natural gas is the market is very fragmented, so an individual producer's actions with respect to drilling has little bearing on prices on its own. Barclays points out this means prices are very difficult to predict, making it tough for producers to both respond to spot and forward prices and balance the economics of incremental drilling activity.
Such drilling activity is also necessary given one-third of North American production needs to be replaced by new wells each year. Barclays sees this as a reason the market remains in contango, meaning forward prices are higher than spot prices, as there is an inbuilt expectation at some point producers won't be able to keep pace with the declines.
With LNG prices weak at present Barclays expects at some point this year producers will cut the level of drilling activity, meaning cuts to production guidance. Short-term however it expects the rig count will edge higher.
Shifting from the producer side to the consumer side, Barclays notes over the past decade Chinese gas consumption has risen 298% to 80.7 billion cubic metres in 2008. This makes China the second largest Asian consumer after Japan, with a move to the top spot likely by 2015.
At present natural gas accounts for just 3.5% of China's energy mix, well below that of coal at 69.5%. This should change going forward, Barclays noting the government has a target of a 10% share by 2020.
This has implications for suppliers of LNG to the Chinese, as Barclays points out in 2008 China turned to an importer of natural gas for the first time. That year the country imported 4.6 billion cubic metres, while International Energy Agency (IEA) estimates suggest imports could hit as much as 35 billion cubic metres by 2015. This would make China a far more significant player in the global LNG market than is presently the case.
What will emerge as China's import demand increase will be competition between pipeline gas supplies and LNG from elsewhere, meaning the location of end users along with LNG contract specificity will be of great importance, according to Barclays.
While the market will grow as Chinese demand increases JP Morgan remains relatively bearish on the outlook for Asian LNG markets, seeing a race to capture remaining demand within a timeframe of around 2015. Losers can expect to see projects deferred.
Following deals by PetroChina and Tokyo Gas, the coal seam gas LNG story has been legitimised. To this end JP Morgan's view is the Gladstone LNG projects are among those best placed to secure new customers in the next six months, along with Origin's ((ORG)) APLNG project, Chevron's Wheatstone project and Browse's Ichthys project.
In contrast, JP Morgan doesn't see the Browse or Sunrise projects as being at a mature enough stage to secure any Heads of Agreement, while Woodside's Pluto-2 project requires exploration success to meet its target Final Investment Decision date of the end of this year.
To reflect this JP Morgan's recommendations across the large cap plays favour those companies with relatively mature projects, which means its sector preference is Santos ((STO)). Meaningful upside is on offer from the Gladstone project, as a single train project appears ready for approval.
Final Investment Decision is expected in the middle of this year and should be for a single 3.6 million tonnes per annum train. This may not satisfy the market, but as JP Morgan points out there is the potential for a second train to be approved in the first half of 2011.
A second customer for the gas would validate the project in JP Morgan's view, while the stockbroker notes Santos management is confident it can sign up a third party customer and farm down equity. Both would be positives if achieved.
On JP Morgan's numbers, Santos is valued at $16.14 per share assuming a single train, rising to $19.73 for a two train project. This supports its Overweight rating. Oil Search ((OSH)) similarly attracts an Overweight rating as the company is seen as offering good potential to outperform peers on a relative basis given its leverage to a project that has essentially been de-risked.
This is the Papua New Guinea LNG project, which is operated by Exxon Mobil. JP Morgan suggests Oil Search is putting some pressure on Exxon to pursue an expansion of the project by discovering alternative gas sources, partly via exploring a number of drilling prospects such as Korka, Manada Footwell and Flinders.
JP Morgan sees potential for further gas reserves to be used as feedstock for third or possibly even a fourth LNG train at the project. Given this, its earnings forecasts for Oil Search remain above consensus, while its price target is $6.43.
Having previously rated Australian Worldwide Exploration ((AWE)) as Overweight, JP Morgan has downgraded to a Neutral rating following the company's lack of success with the Hoki-1 well. The well offered a significant potential payoff of $6-$8 per share but was high risk, so its failure reduces the value on offer from the AWE's exploration program. This leaves the stock as fair value in JP Morgan's view, hence the downgrade. Price target is $2.80.
Beach Energy ((BPT)) is also rated as Neutral. While the company offers potential upside from its shale, tight gas tenements in the Cooper Basin require an increase in gas prices of around 20-40% on the broker's numbers to become economic.
As well, some of the shale gas assets are in a joint venture with Santos and these are not Santos's main priority, meaning Beach is going it alone in terms of trying to prove up additional reserves in its own acreage. JP Morgan has a price target on Beach of $0.80.
Roc Oil ((ROC)) is rated as Underweight by JP Morgan given what it sees as limited scope for continued outperformance due to delays at the Beibu Gulf development and the fact the company has only a limited cash balance.
This limits the growth potential, especially as the joint venture partners on the project are unlikely in the broker's view to approve additional development wells given the complexity of the reservoirs and the costs associated with down hole interventions and sub-sea tie ins.
With respect to Woodside, which JP Morgan rates as Neutral with a $44.90 price target, one issue is downside risk to consensus earnings estimates in 2011. Having normalised its numbers for foreign exchange and oil prices estimates JP Morgan's forecast is 23% below consensus. This reflects an expectation of a lower than capacity contribution from Pluto-1.
This, plus the uncertainty of whether or not enough gas can be found for Pluto-2 before FID this year leaves the broker cautious on the stock. In terms of how these companies rate with other brokers, the FNArena database shows sentiment readings of 0.5 for Woodside, 0.4 for Santos, 1.0 for Oil Search, 0.6 for AWE, 0.0 for Beach and 0.2 for Roc Oil.