Origin and Santos: Australia’s bungling Gas Giants

Gas has issues and no short term fix

In the cold light of day the key issue for gas consumers is that gas supply other than from Queensland CSG is running out and increasingly more expensive to produce.

This really shouldn’t be news although the speed of the problem has been exacerbated by the increased call on gas caused by the early and successful closure of Hazelwood.

In our view the only real source of fresh gas in the South is LNG imports. Those imports – of 100 PJ per year at AGL’s target rate – require both a big price and a long term contract.

There is gas available from the Queensland CSG producers to  consumers in the South including to their own (in Origin’s case) electricity generators. It just has to be at broadly the export parity price. That is not LNG net back cost, but somewhere in between.

The high gas price is being used to produce short term electricity profits before the inevitable increase in new renewable supply once again puts those under competitive pressure.

I don’t expect anyone reading this to feel much sympathy for Origin (OTG), or Santos (STO). Heck, I don’t feel much myself.

Nevertheless, it’s worth pointing out that however much gas consumers feel they are being squeezed, shareholders of the two companies are doing it a lot tougher still. For a fascinating mix of ideology, anecdote and analysis read on …

Even the big guys get thrown under the bus

• Share prices down by 2/3 over say seven years (Santos) or in half (Origin),
• no dividends,
• maybe over $10 billion written off between them,
• too much debt and now …
• the Federal Govt wants to set your domestic gas price in the best socialist tradition. I mean, it worked really well in Venezuela. Perhaps that is too long a bow, but as we know first it’s a small liberty and before you know it you’ve been sold down the river. “Trust the market-sure can” as Rolf Harris used to say before ending up in the darn thing (the can), painted with a different brush.
• Forcing prices down will have short term gain but it will obviously slow down or prevent development of new supply in the South and limit substitution (in electricity production) alternatives. This is high school economics and its been proved correct in many countries round the world. We mention Venezuela but Cuba is another and there truly are countless other examples. We say again if you want to operate in a market economy you have to allow for periods of high prices as well as low
• Three years ago when gas was being sold on the domestic market at prices as low $1.50 GJ during the ramp up period of the LNG plants no one much complained or said the market was wrong. That was a well functioning market even though it contributed, with the benefit of hindsight, to lower than justifiable electricity prices. As soon as prices go up, it’s game over.

ORG and STO must be feeling a bit like they’ve fallen into a Breugel painting.

Figure 1 Pieter Breugel – The Triumph of Death 1562

Origin wrote $3 billion off its assets in FY17 and probably close to another $1 billion in prior years. All of the write offs in FY17  related to its oil and gas assets and $1.8 billion to its 37.5% interest in APLG. So APLNG itself wrote off $4.5 billion in just one year.

ORG has barely ever earned its cost of capital ever since APLNG was first thought of.

The company is not paying a dividend.

Santos is in even worse shape.  As near as we can work out the company has written off about A$8 billion pre tax over the past three years.

STO’s adjusted share price has fallen from say $12 to say $4, i.e: shareholders have lost 2/3 of their money. ORG share price has gone from say $14 in 2010 to say $8 today, so shareholders haven’t lost quite as much.

These share prices are adjusted for equity issues and both companies have had to raise substantial amounts of equity.

ORG still has too much debt. That’s why the new CEO is trying to float off most of the company’s non LNG oil & gas assets.

ORG hasn’t been that successful in electricity but it sure looks a heap better than LNG from today’s perspective.

We agree to disagree on some things

Your analyst fully appreciates that there is a very strong anti-CSG comunity, especially among readers on this site and  strongly allied on this cause to Alan Jones and his supporters.

I’m just going to say I have read 000s of pages of EIS and independent reports  into the environmental risks of CSG extraction and, with the possible exception of fugitive emissions, I haven’t found convincing scientific evidence of systematic environmental damage from CSG extraction.

I think the industry continues to benefit regional QLD. I’m very strong on CO2 risk and the need for speedy global decarbonisation based on the science. Of course, burning the CSG involves further CO2 emissions. Anyway …

NSW almost certainly has far worse CSG economics than QLD

It’s clear there is substantial opposition to CSG in NSW. However, we doubt if that would have stopped AGL’s Gloucester project if there were enough dollars in it. Drilling results were never publicly released but we suspect they didn’t justify the project cost.

As for Santo’s Narrabri project we haven’t seen the data that would justify the investment but maybe that’s in the future. It’s easy for Federal politicians to run the world from the podium in Canberra but hard economics depend on a lot of details.

Maybe $70 bn invested in LNG in QLD – most of Australia was on board

It’s hard to keep track of the real money invested in the QLD LNG industry. It depends what and how you count.

The electricity industry often considers the “overnight cost”. The capital cost that excludes the capitalised  interest incurred during the plant build.

The LNG industry must wish “if only”. It was in 2008  that ORG rejected BG’s (now part of Shell) $15 a share takeover offer choosing instead to build an LNG plant with Conoco and later taking on Sinopec as 25% partner and major offtaker.

It’s not until 2017 the plant is fully commissioned.  Enormous EIS and comprehensive EIS studies, approval by State and Federal Govts and – whatever the current Federal Govt. might say now – never a peep was heard from them at the time.

Financing took years. These projects were a big team effort by corporate and political establishment in Australia with very significant international cooperation.

Capital investment in the project was somewhere between $25 bn and $30 bn.

GLNG’s project was cheaper at say A$20 bn, mainly because it had less upstream gas development cost. GLNG never had enough gas for two  trains and arguably only just had enough for one.

The Shell project was likely round the same price as APLNG maybe a touch cheaper.

If you are going to incur sovereign risk, might as well piss everyone off

APLNG’s consortium includes a major US Company and a major Chinese Govt company. GLNG’s consortium includes a major French company, a major Malaysian company and a major South Korean company.

Bank financing was obtained from international development banks as well as many global credit providers. These guys may see it from Australia’s point of view, but then again maybe they’ll just put Govt interference in the bank for later settlement.

CSG reserves are uncertain and there is every chance they will become more expensive to produce

By their nature CSG reserves are less easy to certify to the same standard as conventional gas reserves. It’s too expensive to drill the number of wells required to prove the reserves to the 1 P standard. [1 P = Proved, 2P = proved & probable and 3P = proved, probable and possible].

So, mostly the reserves are financed on a 2P basis. In a bull market, though, 3P reserves can be valuable. The point here is that over time the gas in the coal seams drains away  and the field pressure drops and it becomes more expensive to extract the marginal PJ.

That may never occur and alternatively it might not occur for another 15 years but in our view it’s a reasonable concern.  The LNG producers need  to have enough gas to satisfy their longer term contractual obligations.

Gas price controls now, can electricity be far behind?

In the end it’s only business that cares about the gas price, but there are plenty of votes in controlling the electricity price, and after that what about house prices?  A little bit of price control will keep voters happy.

Of course, if you happen to be AGL considering an LNG import terminal or someone considering a new power station you almost certainly will be learning from the Govermnent’s moves right now.

And what you will learn is the Government has no respect for markets. Their definition of a good market is one where prices are perpetually low.

Enough of the ideology what are the learnings of today

The two key features from Monday’s reports into East Coast gas and supply (from the ACCC and AEOM) are:

• Production from the BHP/Esso Gippsland Basin Joint Venture [GBJV] will decline from 330 PJ this year to 244 PJ, both due to natural decline and investment decisions. In our view this was the only real news of the day. We will be surprised if most market participants knew this before the report’s release. It’s a big decline and emphasizes that the GBJV
  • Otway basin production is declining from 83 PJ to 59 PJ
  • In my opinion production from ORG’s offshore Otway will start to decline sharply from about 2019 or 2020
• We can use the AEMO’s table of supply and demand over the next two years, feed in the ACCC’s view of GBJV and our own numbers for QLD PV plants to end up with:

Figure 2: Gas supply and demand. Source: ACCC, AEMO, ITK

As much as showing the shortfall the table shows how totally dependent Southern State gas supply is on GBJV. It’s 2/3 or more of the known Southern supply.

GBJV is an old field. At an absolute minimum this means costs of producing the marginal resource will be sharply higher.

There is no known resource in Southern Australia capable of replacing GBJV. Perhaps CSG gas in Victoria might have that possibility. I’ve never seen any studies on the technical merits. Certainly, it’s not coming from NSW or the Cooper Basin.

Figure 3: Gas summary map. Source: ACCC

Not all of the pipelines in figure below are identified on the map above but a summary of the gas pipe line flows South of Moomba over the past 12 months is;

Figure 4 Selected gas transmission flows. Source: AEMO

Conclusion 1 – Gas imports are by far the most logical solution and they are expensive

Unless the Federal Govt wants to completely nationalize the QLD gas industry and essentially force the LNG exports to put their long term contracts at risk, then a new source of gas is required in the South.

This could be Northern Territory but imported LNG remains a realistic, relatively short term and predictable solution.

Imported LNG will need to meet the world price. Interference in the domestic market will make development of new sources of supply less likely.

Conclusion 2 – Forcing gas prices to ACCC’s estimate of netback cost will come back to bite the ACCC

For one thing it’s overt price control. However, more importantly it will mean a steep INCREASE in gas prices if either the oil price increases or the A$ declines.

Conclusion 3: The faster renewables can replace gas the better off we will be

Most grids with high renewables penetration use either hydro or gas for the balancing load.

We need to use the gas we have more smartly. As this figure shows almost half the gas used for power generation in the NEM is used in South Australia. Stronger interconnector links could cut that use. An interconnector link with Tasmania facilitating more wind development in the region could potentially cut gas use in Victoria.

David Leitch is principal of ITK. He was formerly a Utility Analyst for leading investment banks over the past 30 years. The views expressed are his own. Please note our new section, Energy Markets, which will include analysis from Leitch on the energy markets and broader energy issues. And also note our live generation widget, and the APVI solar contribution.