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Whereto Now For Australia’s LNG Producers?

Feature Stories | Apr 21 2016

This story features SANTOS LIMITED. For more info SHARE ANALYSIS: STO

By Greg Peel

The Oil Price

There was never any indication the meeting of OPEC and non-OPEC oil producing nations held in Doha last weekend was going to result in a production freeze agreement. Saudi Arabia was sticking to the line it would not freeze if Iran did not join in. Iran has always stuck to the line it was not going to freeze.

The meeting appeared destined to descend into farce even before it began. As it was, Iran announced at the last minute it wasn’t going to bother turning up. As Morgan Stanley noted, at least back in February the relevant parties were able to reach a non-committal agreement, for whatever that’s worth. This time there was no agreement whatsoever, suggesting progress has moved backwards.

The only surprise is that so many in the oil market seemed to be hanging on to a possibility of a freeze, and thus the likelihood of an oil price collapse following a 40% rally from the low were a freeze not to eventuate. Morgan Stanley was among them, suggesting a bull case of US$45/bbl (WTI) in 2016 and US$80/bbl long term were a freeze agreement to be reached. The broker’s bear case scenario, in light of no agreement, has oil falling back to US$30/bbl in the short term.

The prevailing view among traders is that oil will remain in a range of US$35-45/bbl to the end of the year. The fact the oil price did not collapse on the “no agreement” outcome suggests few had faith in the first place, implying the recent US$40 level for oil was not pricing in a premium for such an agreement as many assumed. However the “right” price for oil post-Doha is a little hard to pin down given coincidental supply-side issues among OPEC members, including a strike by oil workers in Kuwait.

While strikes typically represent temporary issues, this particular strike may yet be a harbinger of things to come. Oil analysts now fear that relationships have broken down between OPEC members to such an extent a production war is quite possible, threatening to send oil prices back to previous lows on sheer oversupply. But OPEC members, and non-OPEC members such as Russia, are suffering such a critical loss of government revenue from low prices the risk is they are forced to reduce oil worker wages, as Kuwait has attempted to do, thus sparking more strikes and the opposite effect – supply reduction.

Now that would be ironic.

Commonwealth Bank’s oil analysts take the popular view of a US$35-45 range in 2016 a step further and suggest a range of US$35-55 over the next decade.

In the June and September quarters of 2016, CommBank sees the oil price tracking higher as US production continues to track lower. As UBS notes, US oil production is currently running at around 9.0 million barrels per day, representing a slow decline from a peak of 9.6 million in June 2015. On most recent data the US rig count had fallen to 354, down from 734 a year ago and 1510 two years ago.

The number of bankruptcies among marginal US shale oil producers is growing by the day.

But CommBank sees oil prices tracking lower again in the December and March quarters due to increasing Iranian production, high levels of OECD inventories and the potential for US shale production that has simply been idled, rather than bankrupted, to restart. This is the critical conundrum for the US shale industry, which is the true swing factor in global oil production. CommBank estimates a price of US$55 is enough to encourage the restart of idled production, or maybe even US$50 if the cost of production can be further reduced, as has been the trend in the past several years.

The only road to sustained higher oil prices is therefore sustained lower oil prices, at least for a sufficient amount of time to enforce actual production abandonment rather than just mothballing. Debt defaults and bankruptcies in the US hold the key.

Outside of the US, Commbank suggests the threat of a complete disintegration of OPEC is real, as member countries continue to compete aggressively on price to steal market share away from each other, which is anathema to the original purpose of the Organisation.

At the very least, Morgan Stanley analysts are now suggesting, in the wake of Doha, that their previous assumption of a 2017 recovery in prices could now be pushed out to 2018 on such a supply war.

Then there’s the demand side.

The International Energy Agency recently revised its forecast for non-OECD oil demand growth higher. Morgan Stanley believes this forecast to be optimistic, and the US Energy Information Administration, and indeed OPEC, are beginning to see it that way too. The EIA notes that while the demand for oil products from non-OECD countries has increased in 2016, the pace of increase has been falling since August.

The IEA also assumes growth in Chinese gasoline demand will be about the same in 2016 as it was in 2015, despite signs of continued weakness. While there is indeed promising demand growth apparent in India and other emerging markets, this is unlikely to overcome falling Chinese demand, Morgan Stanley believes.

The LNG Price

From a time when Australia first started shipping liquid natural gas to Japan from the North West Shelf, LNG cargo pricing has been linked to the price of oil. This suited both buyers and sellers as the correlation between oil and gas prices had remained in a reliable range throughout history, and oil was a liquid, internationally traded market offering price discovery when no such international gas market existed.

Aside from being oil-indexed, LNG pricing has also always been settled on a long-term contract basis. Spot pricing has only ever been used for cargos required to cover shortfalls. Again, long term contracts suited both buyers and sellers, as buyers would achieve security of supply and sellers would be guaranteed of funds flow to justify the extensive initial cost of building an LNG export facility.

Australia’s major new LNG projects on both the east and west coasts, built over the past decade, are now beginning to ramp up. Just as the oil price has collapsed. But while the oil price has traded down to US$30 post-GFC, up to over US$100 and down to under US$30 again, the price of gas as measured by the US benchmark price has barely moved, destroying the longstanding price correlation.

When the oil price was up in the heavens and the US gas price was not, LNG buyers argued oil-index pricing could not be justified. But the sellers could always argue the US benchmark price was a US domestic price only and given the US did not export LNG, irrelevant. Unfortunately for the sellers, excess shale gas production has meant the US has now begun to export LNG. The US is a long way behind Australia in turns of ramp-up, but the oil-index price argument no longer stands up, even if the oil price has come all the way back down again.

Furthermore, low oil prices are not providing an incentive for LNG buyers to continue to lock in long term supply contracts, as one might expect. For one thing, the gas price has not fallen alongside oil, it was already near its lows. And for Japan, long term LNG contracts are not desirable at present given the uncertainty over whether the country’s nuclear power generators are now in a restart phase or not.

Japan is thus pushing for shorter duration contracts and greater contract flexibility. Ord Minnett notes LNG sales not on long term contract now account for 29% of the market. The problem with short term contracts is they do not provide the incentive for LNG producers to commit to high cost developments when little price and volume security exists.

When Australian producers were committing to large scale LNG developments a decade ago, a primary assumption was that global LNG demand would grow steadily into the future to ultimately absorb the step-jump in supply the new developments would affect. This thesis remains intact but a decade ago no one predicted the North American shale oil/gas explosion.

LNG demand is expected to be driven to a large extent by the move away from coal on an environmental basis. The problem recently is that coal has become so cheap, it is offering emerging market economies a more economic power source and thus hampering the rise in gas demand. China is a swing-factor nonetheless, as Beijing has pledged to reduce its carbon emissions by 2030 and the government’s shift towards “green” energy includes a preference for gas over coal.

Were LNG buyers to insist on shorter term contracts, longer term supply projects and expansion will not be incentivised, Ord Minnett suggests, leading to a supply shortage down the track against assumed demand growth. That would mean much higher LNG prices in the future.

Ords also believes the days are numbered for oil-indexed gas pricing, but in order for gas pricing to stand alone, a liquid global spot market is required and none exists at present. West Texas Intermediate crude futures provide global benchmark pricing for oil – the most highly traded commodity on earth – but US Henry Hub gas futures remain very much a domestically-driven US price mechanism with little relevance to the rest of the world, until, perhaps, the US becomes a major player in global LNG export sometime in the future.

Oz Energy Stocks

The share prices of Australia’s big energy names have come back strongly from near death experiences in February when the WTI price hit US$26, now that WTI is back at US$42. As to the outlook from here, however, it is very difficult to find consensus.

Macquarie points out, for example, that the ongoing development of Oil Search’s ((OSH)) PNG gas growth options mean the commissioning of a third LNG train grows ever closer. Santos’ ((STO)) second GLNG train is set to deliver first LNG this quarter, thus ending a long and difficult development period for the company.  Woodside Petroleum ((WPL)), on the other hand, is delivering strong near term cash flows from the North West Shelf and Pluto but has no growth options.

Macquarie thus prefers Oil Search and Santos over Woodside.

Morgan Stanley, who we recall sees oil falling back to US$30, notes that while Oil Search, Santos and Woodside all offer similar upside value were oil to rally further, Oil Search and Santos offer greater downside than Woodside given their debt levels.

UBS has crunched the numbers and estimates Woodside can break even on free cash flow in 2016 at US$30.26 and Oil Search at US$33.25, but Santos requires US$47.09.

Citi is the only broker in the FNArena database with a Buy rating on Woodside. On the balance of cash flow today and no growth tomorrow, the other seven brokers in the database rate the stock a Hold.

That’s where any agreement ends. Oil Search attracts four Buys, three Holds and a Sell (UBS) and Santos attracts four Buys, two Holds and two Sells (including Morgan Stanley).

Obviously broker valuations are highly dependent on broker oil price forecasts, which at this stage vary rather notably.
 

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