From Credit Suisse:
The wolf pack meets the PM
In perhaps Aesop’s most renowned of fables, The boy who cried wolf, a lonely shepherd boy devised a plan to get more company by falsely claiming to his fellow villagers that a wolf was close to where his flock of sheep were. Many rushed out to meet him, eager to help.
Soon thereafter, buoyed by his initial success, he tried the same again with equal success, but with the villagers once again unable to see a fox they grew cautious of him. Roll forward a few days, when a wolf really did come to prey on his flock, off he ran to the villagers screaming “wolf, wolf”, but so untrusting of him were they by this stage that no one believed him and no one came out to help. Sadly for the sheep, the wolf made quick work of them.
So it is in the East Coast market that the hunters have in many ways become the hunted. Whilst pockets of the gas supply chain have occasionally stuck their head above the parapet, the metaphorical wolves who have been the big producers or wholesalers are now loudly proclaiming the size of the crisis. For tomorrow at least, the shepherd of this pack of wolves, is the PM Malcolm Turnbull who, rightly, is demanding some answers as to what can be done to fix the situation.
There is not a solution to the short term that provides a fix to the medium and long term, nor a solution to the medium or long term that will fix the short term. They are, in reality, two entirely different challenges. The problem is that if you don’t fix the short term then the market you are trying to fix in the long term will be considerably smaller.
We thought it was worth a brief follow up on our recent note, The Ass, the Cock and the Lion, to discuss recent developments given that in the course of the past two weeks we have gone from outliers in our view to alarmingly consensus.
We are cognisant that this work all remains, to a degree, bereft of clear investment ideas for investors. The reality is that data remains scant on the current sales agreements, pricing, well performance data to better understand the scale of the shortage and many other things (interestingly the ACCC will have much of this information from its work last year). However, we believe that we need to be focused on this issue as whatever the resolution is, it likely to have a meaningful impact on the equity market.
We have once again tried to put some rough quantification around the scale of losses/potential need for compensation around the various options to resolve the shortterm issues. We also discuss the merit of Aussie Aramco, a state oil company, as a method of aiding future development of gas on the east coast. A few thoughts from us:
■ Targeting the third-party volumes (largely into GLNG, but also QCLNG) remains the most viable, and lowest total loss, option in our minds. It provides cheap gas, which is there now, for the market. The biggest debate is who sells that gas – does GLNG get to resell it (and minimise its loss) or do the domestic sellers to GLNG get to sell that gas and potentially recover some of their loss in the case of Santos by getting Horizon priced up to a “market” price. We believe the FCF delta to GLNG if those volumes are taken off it is ~A$560mn p.a. Procurement benefits to the LNG off take JV partners could be ~$200mn p.a. and Santos, if allowed (which is likely to be a hotly debated topic), could claw back ~$100mn p.a. at Horizon. So the potential true economic loss to make up (somehow) could be around A$250mn p.a.
■ Importing LNG has many advantages. It can be relatively quick, can be turned off when not needed, doesn’t carry upstream performance risk and is probably fairly easy to hedge in deep oil and Henry Hub markets. However, if we assume for argument’s sake that the gas comes from the US with Henry Hub at US$3.50/mmbtu then it is still going to be around ~A$11/GJ gas to the jetty. If we assume that the desire is to say get A$8/GJ gas, at least pre transportation, to customers then a ~A$3/GJ subsidy is needed. If the whole of that 160PJa of GLNG third-party gas is needed, that could cost ~A$480mn p.a.
■ Conceptually doing nothing is an option, leaving it to those good, old market forces. However, this is not a price clearing mechanism – there is a physical shortage of gas in the near term and therefore we will just witness large parts of industry shut down if nothing happens.
■ The much discussed other option is a country-to-country deal where the LNG buyers agree to forsake a few cargoes to divert domestically. The reality, somewhat perversely, is that this could be an even greater sovereign risk than many other options. Offer any of the buyers a chance to take 50% less volumes from Curtis Island and they would be economically rational to bite your hand off given the relative cost of the gas versus what they could contract, or buy spot, in today’s market. So, do a deal with one country and another ends up pretty miffed. This also only works to the extent that the Australian price received compensates them versus global prices to resell into or buy from. You are taking oil price risk, or having to subsidise an LNG project, if the numbers move against you.
■ We also discuss the concept of Aussie Aramco (AA), a state owned oil company a la Kumul Petroleum in PNG. What you effectively see is state participation replace the additional profits tax. In theory, if perfectly designed (with perfect foresight), the government take is the same. It does however have some keen benefits for new projects which would be key in promoting more gas to be developed on the east coast: 1) project IRRs are higher due to lower tax take, so easier to get through board rooms ($ NPV is the same, just a higher IRR on lower share of molecules); 2) AA would have its equity entitlement of molecules, effectively reserving that gas if it is needed, without mandating a reservation policy; 3) private sector funding requirements are lower, potentially with government ability for concessional financing for key projects on top.
The path to a solution starts tomorrow?
It seems unlikely that the meeting between the PM and the east coast gas suppliers will finish with a solution for the problem tomorrow. The strong rhetoric is that the suppliers have been put on watch and need to find a solution for themselves, or else one might be mandated on.
Should the meetings extend to the boardrooms?
We are not wanting to drag up past mistakes, nor does it do much good to lay blame for where the situation is, but we suspect it is not just the CEOs that need to be brought on a journey here. Any decision to sanction new projects, divest projects that are being sat upon or put more money into existing projects have to be signed off by boards.
Whilst it is uncomfortable to remind ourselves, the underinvestment on the east coast has been exacerbated by the decisions of Santos and Origin (as large owners of undeveloped resources) to both leave their equity raisings extremely late in the cycle, not recapitalise enough to have sufficient capital to now develop new projects and potentially also hold onto attractive long-term assets that others might be able to develop quicker.
It is an unavoidable fact that a number of board members of both organisations have been there through large parts of the journey from export project sanction to where we are now. We would suspect that the government may also want to get a feel for what the boards’ visions for resolution are too.
Where do the pipeline operators sit in this all?
Whilst the ACCC review of the pipeline operators was only completed a few months ago, it would appear that the underlying assumptions on the gas market from AEMO/ACCC have now changed.
It is interesting to note that only six months ago APA said on its investor call that “we are all finally in agreement that there is sufficient gas forecast to be produced to satisfy both the LNG and domestic demand……so there was no gas crisis after all, which is what APA had said all along”.
Whilst it is safe to say that we never fit into that “royal we”, it appears that now almost everyone is finally in agreement of quite the contrary. It will be interesting to see if APA holds its stance and potentially even provide the solution that many, including us, are missing. Or whether it may now acknowledge the crisis.
Either way, one suspects that the pipelines are likely to come under increased scrutiny again. Certainly if you are an E&P being asked to bring new gas to market and you are faced by the level of transportation costs seen in Eastern Australia, it is hard to imagine them being shy in highlighting the pipelines as an issue to revisit.
Could a national oil company help fix things?
We continue to believe that the greater challenges to fixing the east coast gas market are in the medium to long term. There is a (seemingly) undeniable shortage in the next couple of years that has the costly challenges to fix it, but if nothing is done to also bring new gas to market, the challenge, and the size of the subsidy or detrimental impact, will only keep growing.
With the evolution of the situation, and our frequent writing, we don’t want to rewrite the Encyclopedia Britannica every time. So a focus on any single topic today should not be taken as presenting it as the only angle or resolution. In reality myriad things are going to have to happen to have a functioning gas market in the future.
The South Australian government’s commitment today to give 10% of royalties to landowners is the kind of action that will need to be replicated. We wonder whether there is something larger scale at the political level that could be done though?
Welcome to Aussie Aramco?
We are pretty average analysts, let alone politicians, so we’ll skip past the doubtless huge challenges of state versus federal in what we are about to discuss. What we have got to wondering though, as part of the medium-term fix to get more gas developed, is whether a state owned oil company could have a place in the market.
We would envisage it in a similar way to Kumul Petroleum in PNG, where the NOC (national Oil & Gas company) receives participation in the project itself in place of there being a super profits tax on the project.
State participation versus super profits tax is a debate for the oil industry the world over. Where we think the scales may be tipping towards a state participation in Australia is largely threefold:
■ If you had perfect foresight (let’s be honest, the industry struggles to agree in hindsight let alone foresight) then the fiscal take from state participation should be the same as a super profits tax. By taking a share of the reserves for “free” at FID, in exchange for no super profits tax, what effectively happens is that the IRR of the project increases for project participants. They are getting a higher IRR over a smaller share of the gas though, hence in the perfect world the $ NPV should be the same. A higher IRR does make it far easier to get projects through the boardrooms though.
■ If Aussie Aramco had say a similar ~16.6% stake in all future projects on the east coast, a la Kumul Petroleum, then this effectively bypasses the need for a mandated domestic reservation policy. Effectively Aussie Aramco has control of its equity molecules to do with what it sees fit.
■ State participation would also lessen the funding requirements from the private sector, a clear bottleneck in new supply at the moment. Indeed, one wonders what the potential for using the government balance sheet to underwrite lower cost project finance could be in this all too?
Many long roads to many needed fixes
We don’t want to simplify the challenges faced in resolving the gas market. The reality is that for part of supply maybe there is no palatable solution and we do have the unfortunate situation of part of industrial consumption having to relocate or close. Whatever path you take for resolution there are going to be parties (both independent and with vested interests) telling you that you are doing the wrong thing.
The moral hazard of letting the upstream industry off too lightly from it all does have to be balanced with the necessity for that industry to be incentivised to develop the next round of gas.
There is not a solution to the short term that provides a fix to the medium and long term, nor a solution to the medium or long term that will fix the short term. They are, in reality, two entirely different challenges. The problem is that if you don’t fix the short term then the market you are trying to fix in the long term will be considerably smaller.
As more clarity unfolds it should become clearer what the impact is on listed entities (from the upstream, intermediaries and pipeline companies to the industrial users). In the meantime we do think that the equity market needs to keep on top of the issue as it is hard to see a resolution without some pockets of cash flow appearing, disappearing or swapping amongst the listed players.
If we need any such warning of potential magnitude of impacts, Brickworks came out today and said that their recent gas contract negotiations, to secure gas to the end of 2019, will see it pay 76% more on average. This equates to ~$20mn p.a. by 2019, equivalent to >25% of its Building Products earnings in 2016.
You’re hired.
