From Credit Suisse:
As the ACCC inquiry rumbles on for the East Coast gas market, the LNG projects have started and sadly capital continues to get pulled from the domestic space. We try and take a holistic look at how much capital, through cycle, would be needed to sustain the domestic market. Unfortunately at present, a large share of unsanctioned resources remain in the hands of those with no capital to invest. The reality is a mixture of M&A, further equity and demand destruction may be needed to balance the market. But how much?
■ Spreadsheets don’t build projects…We have taken a look at the collective balance sheet capacity for growth capex from our coverage universe with exposure to assets in Eastern Australia to try and understand how much real capital may exist to develop the gas that AEMO’s spreadsheet tells it will be developed. We have assumed a target gearing of 25% in 2020 (huge downside risks exist to equity given all use $80/bbl+ oil for impairment testing). The numbers are of course skewed by Santos and Origin, however we see them needing to collectively de-leverage a further ~A$1.7bn. So not only is no collective capital for growth, there isn’t enough to pay down debt to get gearing to 25%. All have other calls on capital too.
■ …Capital does (and we need >A$15bn spent by 2020): We have taken a look at what, through cycle, the annual spend needed is to continue to honour domestic gas requirements. If we assume domestic demand drops to ~550PJa (~100PJa goes from gas-fired generation and 50-60Pja of ‘voluntary’ demand destruction), and that ~200PJa may be needed as thirdparty gas to the LNG plants (e.g., Horizon contract, etc.), then ~750PJa will be demanded. If we assume F&D costs for new gas is $4-5/GJ (Santos guided ‘D’ costs in Cooper infill are $4/GJ) then replacing each molecule will see A$3-3.75bn/yr spent. That is A$15-18.75bn from 2016-2020 inclusive.
■ A ~$16.5-20.5bn shortfall left for someone to fund: Given the A$1.7bn capital deficit, ~A$16.5-20.5bn of capital must come from elsewhere if demand is to be met. BHP/Exxon can fund some in Victoria (up to 40- 50PJa), but Arrow (ACCC dependent) is likely to largely be replacement gas for QCLNG. Hence a huge shortfall will exist, that will have to come from assets currently owned by these Australian corporates.
■ Combination of four outcomes likely to happen: The resolution of this dilemma is likely to have a profound impact on equity markets. We think a combination of four outcomes are likely: (1) M&A brings in better capitalised businesses to Eastern Australia, (2) equity is raised to fund development by those who retain the assets, (3) domestic demand destruction and/or LNG projects export less than contracted volumes, (4) gas is brought in from other regions (most obviously the NT pipeline). The ACCC is looking to ensure adequate competition in the market; the reality is that the market needs to be created before we worry about its orderliness. The alarm bells have been ringing for years, the worry is who is actually left in the classroom.
Without any shift in the regulatory regime to domestic reservation and assuming decent competition in the provision of gas locally it will be the export net back price that determines the mix in the shakeout. This is in itself a complex question involving the prospects for the global oil price, the degree of erosion in the LNG contract system during the forthcoming glut and the weakness and evolution of the LNG spot price.
My base case is that oil will remain around $50 indefinitely delivering a contract price of roughly $5mmBtu net back to Australia. The LNG spot glut will push that price even lower, to more like $3mmBtu net back. The current mix is 80/20 contract but I expect that that will evolve to more like 50/50 over the coming decade.
Thus the determining net back price for east coast Australian gas is likely to average about $4-5mmBtu. That will not be enough to cause much local demand destruction so I see Australian LNG export volumes priced out and falling in the base case.
If the oil price is higher then we’ll see more exports and local demand destruction.
If the oil price is lower then we’ll see less.
