Australian LNG And The Low Oil Price Environment

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This article was first published for FNArena subscribers on May 27 and has now been opened for general readership.

By Greg Peel

Every picture tells a story and the picture below is particularly telling. The price of West Texas Intermediate crude oil has, in the space of twelve months, fallen 50% from high to low and rallied back 25% from the low. Given falls are measured from the top down and rallies from the bottom up, the oil price remains 40% lower than where it was a year ago.
 

The sharp rebound for oil caught many in the industry by surprise, given it was assumed the lag between production curtailment in the US and a wind-down in supply meant oil would remain oversupplied for some months even as the US rig count fell swiftly. However the WTI price appears to have consolidated here around the US$60/bbl level for now, whether or not the snap-back rally represents technical ephemera or is fundamentally sound. The spread between the WTI and Brent prices has also steadied for now at around US$6.

Long Term Pricing

Citi’s oil & gas sector analysts have upgraded their 2015 average Brent oil forecast by 17% from previous bearish levels as a result of the rebound, but have trimmed their 2016 forecast by 3%. This puts Brent at US$63/bbl for 2015 and US$68/bbl for 2016.

The fall in the WTI price from last July was due to global oversupply, and in particular OPEC’s determination not to cut its own production quotas in the face of unrestricted US shale growth, but was also exacerbated by US storage facilities not being able to keep up with supply increases. With storage either unavailable or very expensive, the impetus on producers is to sell immediately and thus force down the price.

That storage issue is now beginning to ease as infrastructure is addressed, but Citi still believes oil prices are at risk of tipping over again in the second half of this year. The longer oil prices remain above US$60/bbl, the more incentive for higher cost production to return to growth. The market will again suffer oversupply issues later in the year and thus the oil price will come under renewed pressure.

Citi nevertheless retains a long term oil price forecast of US$75/bbl.

Goldman Sachs sees the long term picture differently. Over the medium term, Goldman’s analysts see increased productivity, as opposed to actual production, amongst the major US shale oil plays as a key driver of increased supply. Add in sustained growth in OPEC production, particularly from Iraq and Saudi Arabia, and new projects coming on line, and Goldman has set a long term Brent price of US$55/bbl. That’s down from US$70/bbl previously.

The good news is the analysts see 2015-19 prices remaining in an average US$58-65/bbl band.

The “long term” price is by convention considered to be five years hence. Readers might be inclined to think analysts are kidding themselves if they think they can accurately forecast commodity prices that far into the future. But for the analysts the practice is not one of desire but of necessity. The value of oil & gas projects (and in the same vein, mining projects) is greatly determined by the life of those resources and thus the cash flow that will emanate from them. In order for analysts to determine the value of an oil & gas company’s share price, that “life” must be valued, and to do that, a long term oil price assumption is needed.

Goldman Sachs’ low-end long term forecast becomes an important factor in the broker’s view on the value for Australia’s oil & gas majors. The broker also notes Australia’s LNG projects are facing cost escalation and are in need of structural labour market reform, but this comes down to politicians.

Stock Preferences

To that end, a combination of low oil prices and rising costs weighs heavily on the leveraged balance sheet of Santos ((STO)) and hence Goldman ascribes a Sell rating. Woodside Petroleum ((WPL)) by contrast has a strong balance sheet and attracts a Buy rating.

The combination of low oil prices and debt among the majors also worries Credit Suisse.

Woodside Petroleum’s Pluto LNG facility has been operating since 2012, Oil Search’s ((OSH)) PNG LNG began operation last year, and both Origin Energy’s ((ORG)) APLNG and Santos’ GLNG will begin operation this year. Santos also has a minority stake in PNG LNG. For shareholders, these operations are all about providing step-jumps in cash flow and thus dividends and/or share buybacks.

Santos’ and Origin’s asset portfolios and balance sheets have been “built for higher oil prices”, Credit Suisse suggests. Woodside and Oil Search have left themselves with far more capacity to both invest and distribute cash to patient shareholders than Santos and Origin have. Unless oil prices rebound towards previous highs, life after the excitement of first gas from GLNG and APLNG may “not be as rosy as people think”, the analysts warn, for Santos and Origin, albeit Origin has its base downstream business to fall back on.

Credit Suisse has a Buy (Outperform) rating on Oil Search, is Neutral on Woodside, and has Sell (Underperform) ratings on Santos and Origin. Amongst the FNArena database brokers, those two Sell ratings are loners. Six brokers rate Santos a Buy, with one Hold, while five brokers rate Origin a Buy, with two Holds.
 

One of those brokers ascribing a Buy to Santos is Citi. For the market, one area of concern with regard the Queensland coal seam gas plays is whether or not the operators can source sufficient gas to feed into the LNG plants. But Citi believes an important factor is being overlooked.

It all comes down to the certification of reserves. Under international industry rules, gas reserves are classified as either “proven” (1P), “proven and probable” (2P) and “proven, probable and possible” (3P). Only proven and probable reserves can be certified.  On current 2P reserves, gas field production would begin to decline for GLNG by 2025 and APLNG by 2030, Citi notes. But the analysts believe there is an inconsistency between what the industry rules consider as probable in the case of shale reserves and probable in the case of coal seam gas reserves.

In other words, were the rules to be consistent, Citi believes more of the two projects 3P reserves could be classified as 2P reserves, suggesting longer field lives and less risk of gas declines. If so, 3-6 years of production would be added to GLNG, adding an additional 71c per share to the broker’s valuation of Santos, and 8-10 years to APLNG, adding 33cps to Origin.

This is where those long term oil price forecasts come into play.

Supply and Demand

Beyond the four major LNG projects noted above, BG’s QCLNG project in Queensland is now up and running and Chevron’s Gorgon project in WA is set to commence production this year. Chevron’s Wheatstone in WA and Total’s Ichthys in the Northern Territory are targeting 2016 and Shell’s Prelude floating LNG facility off the WA coast is targeting 2017. On the basis of lower global oil prices and elevated Australian project costs, any new projects are now expected to be delayed.
 

That was at least one of the themes at annual Australian Petroleum Producers & Explorers Association conference, held recently. The industry is well aware of the challenges it faces, and hence Morgan Stanley notes the mood at this year’s APPEA conference was much more subdued than last year, when oil was at US$100/bbl.

The reason oil prices are now much lower is due to global oversupply. Oversupply implies supply beyond which demand can account for, and that means the other side of the coin with regard the outlook for shale production, rig counts, OPEC quotas and the like is the outlook for global oil & gas demand.

The Oxford Institute for Energy Studies presented at the conference and suggested this period of oversupply will prove short term, but just how short term depends primarily on demand growth out of Asia. Here the two big swing factors are China and India.

As to how much Chinese demand for seaborne LNG imports can grow is dependent on just how much China’s GDP growth slows by, and also on the arrival of Russian pipeline gas as an LNG alternative. Given that pipeline is not expected before 2020, the next five years of LNG demand growth will come down to the performance of the Chinese economy, the Oxford Institute suggested.

India offers enormous LNG demand growth potential and no pipelines on the way, but for India the issue is one of price.

That said, the Institute acknowledged credible forecasters who are predicting a massive rise in Asian LNG demand over the next ten years based on industrialisation, population growth and a move towards cleaner fuels.

On that basis, another wave of global LNG production development is still viable beyond today’s issue of a low oil price. However for Australia to participate in this new wave, a significant reduction in costs is needed, the APPEA conference warned. PNG, on the other hand, still offers strong prospects.

Australia’s high labour costs are one issue but as Morgan Stanley took away from the conference, cost reductions via technology and more efficient project management, planning and logistics are also important. The US shale experience suggests greater standardization is required and LNG facilities potentially need to be smaller, not larger.

Shell’s Prelude floating LNG facility will be the first of its kind in the world and Woodside is also planning an FLNG facility for its Browse project which, at this stage, is loosely targeting a 2021 start-up. Australia has an opportunity to take the lead on FLNG and develop the technology and a service skills base that can be imported globally. Australia’s risk is that the US is also targeting LNG export, and thus is a clear competitor.

The Juniors

There is much speculation at present within the Australian junior oil & gas industry with regard possible consolidation and merger & acquisition activity, especially amongst the Cooper Basin players. Here Beach Energy ((BPT)) and Drillsearch Energy ((DLS)) are amongst those deemed most likely to be involved.

As to exactly in what way, there are many possibilities. The two could both be targets for larger companies or candidates for a merger. Given investment company Seven Group Holdings ((SVW)) owns sizeable stakes in each, there is speculation whether it might be Seven that initiates a consolidation.

Whatever the case, FNArena database brokers are largely in agreement the two stocks are currently overpriced as a result. Drillsearch attracts only one Buy rating against five Holds while Beach attracts no Buy ratings, four Holds and three Sells.

The two are not the only potential players in the game, Morgans notes. While the market has focused on Beach and Drillsearch, it has ignored other possibles such as Cooper Energy ((COE)) and Senex Energy ((SXY)).

Cooper Energy, despite its name, has only a small acreage in the Cooper Basin but does boast attractive holdings elsewhere, such as in the Gippsland and Otway Basins, and is a half owner of the strategically important Orbost gas plant (with Santos), Morgans notes.

Senex is very much a Cooper Basin player and boasts significant acreage covering both conventional and unconventional resources and substantial unconventional prospectivity.

Wouldn’t you know, Beach is Cooper Energy’s largest shareholder and thus would be the obvious suitor, Morgans suggests, albeit Seven Group might also be interested. Seven Group is rumoured to hold a stake in Senex but not significant enough to be registered, while Morgans believes Senex is an obvious target for Beach, or Drillsearch, or anyone else who might want to play.

The bottom line is that Cooper and Senex have underperformed Beach and Drillsearch over the past twelve months, and Morgan expects that gap to close.
 

Technical limitations

If you are reading this story through a third party distribution channel and you cannot see charts included, we apologise, but technical limitations are to blame.

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