Commodities | Dec 23 2010
This story features SANTOS LIMITED. For more info SHARE ANALYSIS: STO
By Greg Peel
Last week Santos ((STO)) signed a long term offtake arrangement with Korean gas company KOGAS for 3.5mtpa of liquid natural gas (LNG) from Santos' Gladstone LNG project in Queensland – one of several untested coal seam methane (CSM) projects in the region. In exchange, KOGAS will take a 15% stake in GLNG.
The deal surprised analysts for a couple of reasons. Firstly, it was thought KOGAS would only take a 5-10% stake leaving Santos to raise a further $1.0-1.5bn in capital to finance capex on GLNG. As it is, Santos is now only raising $500m. All around that's a good result. But the other surprise was that Santos has now pushed its final investment decision (FID) date on Gladstone forward to next month – later than had long ago been hoped but earlier than anyone more recently thought possible. The surprise here is that Santos is prepared to move to FID without even being sure it has enough gas.
That's not usually how it works.
The thing about these large, highly costly and very long-term LNG projects is that Shoeless Joe Jackson's advice of “if you build it, they will come” does not work here. Rather, you find some gas, you decide you might have enough to justify building at least one LNG train, and then you first sign long-term supply contracts to make the money you're about to spend worthwhile. If you don't have that money, you finance the capex by joint venture arrangements or selling off stakes in the project, just as Santos has done with GLNG.
Then you set about making sure there really is enough gas before making the final decision to go ahead – or “FID”. Santos has broken the usual rules and jumped the gun. But really it's not that great a surprise when one considers the current state of the Australian LNG market.
The race is on in the Bowen Basin in Queensland, in the offshore gas fields of WA, in the Cooper in central Australia and in the wilds of Papua New Guinea to build LNG trains to supply the burgeoning demand for natural gas coming out of Asia. When we began 2010, I wrote an extensive Special Report on the subject and while almost a year has passed since, little has really changed.
[Access The Australian LNG Explosion (in PDF) here.]
There is a slight difference however, and the analysts at BA-Merrill Lynch put it succinctly by suggesting 2011 is “the year we expect the LNG boom to become reality on the ground rather than a series of proposals”. In other words, it's time to deliver.
The KOGAS deal has seriously “de-risked” GLNG for Santos, all analysts agree, which means the latent value trapped within the share price all of last year and beyond can now begin to be released. GLNG should now safely be able to move to two LNG trains, but it's still a bold step to take to do so without confirmation of gas reserves.
One need only ask Woodside Petroleum ((WPL)), which has spent all year desperately trying to find enough gas to justify a second train at its Pluto project offshore from WA. Woodside has been poking around all over the place, but sufficient success has proven elusive. The threat is that Woodside will need to buy in gas from its competitors or worse – sell off stakes in the project just as Santos has always known it would have to do for GLNG. And all the while the costs of building even Pluto 1 have been growing and growing over the course of the last couple of years, and the project has met with many pitfalls.
Oil Search ((OSH)) has never been under any allusion about selling off stakes in its vast PNG LNG project – that's exactly what this explorer had always intended. Yet of these Big Three projects owned by Australian gas companies (which thus omits the enormous Gorgon project, among others), Oil Search's PNG LNG is the most advanced and has the safest gas deposits. PNG LNG has pretty much sown up a third train, and the mighty Exxon is a partner. (Santos has a stake in PNG LNG as well.)
That's why analysts rate Oil Search ahead of the others in terms of potential success. As to whether this is reflected in stock ratings depends on whether the market is behind the curve or too far ahead. LNG investment is very much a game for the patient, and highly risky. But the rewards are potentially enormous.
Yet there's no sign of any global gas shortage, and there's no lack of projects across the globe trying to seal the deal with long term buyers before the buyers are satisfied. Just as was the case as we entered 2010, there will be winners and there will be losers. There will be failure. Santos knows this all too well, which is no doubt while it has so quickly moved to FID.
For the smaller players, of which there are many, failure looms large. However, Merrills suggests that after a disappointing 2010 the small and mid-cap gas players will likely seek M&A opportunities. Merrills also suggests (the analysts were writing before the KOGAS announcement) “there is great pressure to act early on investment decisions to gain an advantage. This may increase risks”. A prescient prediction.
The price of natural gas is linked through a complicated mechanism to the prevailing price of oil. Suffice to say the higher the price of oil, the higher the price of gas, although 2009-10 has seen the oil price rally strongly while the gas price has remained largely in limbo. This reflects to a great extent the abundance of gas and gas projects across the globe. But the current northern freeze has finally started the natgas price moving.
Merrills is forecasting the oil price to reach as high as US$100/bbl in 2011 as demand rises but wonders whether OPEC, which showed unusual solidarity this year in production controls, can do so when three figures are dangled. The result is that Merrills does not see much upside beyond US$100.
LNG's value lies not only in being a substitute for oil, but also in being a cleaner substitute for oil. With the likes of the US and Australia dragging the chain on carbon pricing and Europe already well into their second model, China is now leading the push on alternative and cleaner energy sources. It's not simply a magnanimous gesture – Beijing has seen first hand the effects of serious pollution and is also sick of paying ever higher prices for traditional commodities.
This is important, because as noted there is plenty of gas about. The world is now moving into a brief window of tightened supply but the number of projects planned and in construction mean this window won't be open for long. That's why it's so important for Santos and co to sign up customers now while the demand is there and the supply is not guaranteed. Yet it's still very much a buyer's market, so the beauty contest is on in earnest.
As yet there is a distinct bifurcation across the planet into The Atlantic gas market, of which the US and Europe are players, and the Pacific gas market, of which Australia and Asia are players. The Pacific still favours long-term contracts but the more mature Atlantic market trades mostly off spot pricing. This often means quite different pricing given neither side much encroaches on the other's territory.
The US was never much into exporting LNG because it has plenty of domestic demand for gas. But with the rapid development of the burgeoning US shale gas industry, the US is now looking to becoming an LNG export player. Will it stick to its own side of the fence? Well that remains to be seen.
Qatar, on the other hand, which has enough gas to supply the whole world for decades and beyond, mostly plays in the Atlantic but still makes forays into the Pacific. Qatar is a danger in this sense, but it is expected that, like OPEC, Qatar will control its supply and not disrupt other participants.
So the bottom line is: the potential for growing natural gas demand out of Asia is enormous, but the number of projects chasing that demand are also many meaning supply can also be enormous. Those who get in first will reap the riches. Those who are too slow will be left out in the cold.
2011 will be another nail biter in the LNG game.
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