Reserve gas or Australia dies

The campaign against gas reservation has begun at the AFR. Santos CEO Kevin Gallagher:

…Australia relies on foreign investment, but sovereign risk is rising fast. In a low-risk country, governments recognise that contracts between commercial parties must be honoured and not broken by governments favouring one party over another. In a low-risk country, governments do not intervene in negotiations between producers and consumers or insist that resources be supplied at prices that pay no regard to production costs.

However, if governments continue to escalate their interventions to change the rules after investments have been made in export projects, they increase the prospect of investors assessing Australia as being just too risky a destination for their funds.

Without new supply sources, there is only so much that industry can do before investment – and gas supply – dries up. No amount of price regulation will solve that problem – in fact more gas fields will become uneconomic and instead of more supply and lower prices, there will be even less investment and less supply.

Is there sovereign risk in reserving gas? Sure, there’s some. Export contracts will need to be renegotiated.

But that happens all of the time. There have been many LNG supply contract renegotiations over the past few years for both price and volume between many countries as prices crashed. It’s not at all unusual. West coast suppliers have already done so, including the massive Gorgon project.

Moreover, if we do not reserve gas then the alternative is a national disaster. An LNG import cartel will form to match the export cartel and Australia will completely lose control of its gas and electricity prices despite having the finest natural resources to supply both in the world. If international prices rise then we will pay the highest prices for both anywhere.

Is this a viable outcome for a nation completely reliant upon commodity revenue to sustain its standard of living? This is not bananas we’re talking about here. It is energy. The lifeblood of industry and household living standards, the very building block of our civilisation and the defense of it.

So, the question before us is not whether the sovereign risk is worth it but is the risk to the sovereign worth not doing it? Only if you’re completely nuts.

If we reserve gas at $6Gj on the east coast then:

• gas prices will crash;
• electricity prices will crash;
• the decarbonisation process will be entirely derisked, and
• gas investment will proceed anyway to supply the export market but gas producer margins will be hit because that gas is more expensive to extract.

As well, Australian GDP and income will actually rise thanks to the energy price falls. Economic modelling done on the impact of the LNG plants was conducted by Victoria University in 2014 when MB and others were warning of perverse outcomes. It shows that the economy is better off the lower the LNG price goes:

Construction of the new LNG facilities stimulates national employment, but when building is complete, the direct stimulus ends. In the long-run, the new LNG production has a negligible impact on employment, but lowers the real wage rate.

The explanation of macro effects begins with the impacts on the national labour market. Figure 2 shows percentage deviations away from base case values in national employment (persons employed) and in the national real wage rate.

The LNG projects are expected to increase real GDP.

Figure 3 shows percentage deviations away from base case values in real GDP. The solid line shows the overall impacts. Initially, because of the LNG construction real GDP increases by around 0.3 per cent relative to its base case level (i.e., its level without the new LNG projects). This increase dissipates over time, with the long-run impact being an increase of a little less than 0.2 per cent.

The outcomes for real GDP reflect the balance of two offsetting forces. The expansion in LNG exports at the high global price results in a terms-of-trade increase for the economy. This tends to reduce the real cost of capital, leading to increased capital and increased real GDP. We call this the quantity effect. It is shown in Figure 3 by the upper dashed line. By 2020, the quantity effect adds around 0.8 per cent to real GDP. The annual increment persists thereafter.

Offsetting this, though, is the increase in gas prices for domestic use. The increase gas price allows for larger than normal profit for the local gas producers, but it also raises the cost of production for gas-using industries. Many of these industries cannot pass on these increases, and so cut production. Thus for these industries the increase in cost of gas means reduced production, employment and capital utilisation, resulting in a loss of real GDP for the economy generally. In Figure 3, this adverse price effects is shown by the lower dashed line. By 2020, the price effect subtracts around 0.6 per cent from real GDP.

Low-price (Baseline) compared to full-price (Baseline)

There is some uncertainty about the future international LNG price. The price assumption for the full-price (Baseline) is shown in Figure 1. To gauge the sensitivity of the modelling to changes in that assumption, we have simulated an alternative Baseline in which the price rises from the current average price of $4.50 per Gj to $7.75 per Gj, which is half the increase assumed in the full-price (baseline). Figure 7 shows percentage deviations in real GDP implied in both simulations. In the years to 2018, the absolute difference in results is relatively small, with the full-price (baseline) being less stimulatory than the low price (Baseline). The difference is magnified in the long-run. Roughly, with half the price increase, we get nearly twice the increase in real GDP.

This rule follows for most of the other results. For the long-run, in the low price (Baseline) scenario relative to the full-price (Baseline) scenario the sign of the deviations is the same but the magnitude of the deviations is roughly doubled.

Of course Santos is upset about it. It’s profits will get hit and it’ll have to write down the value of the Curtis Island plant again. Too bad. It should never have been built-out and it knew it, formerly from The Australian:

As Santos worked toward approving its company-transforming Gladstone LNG project at the start of this decade, managing ­director David Knox made the sensible statement that he would approve one LNG train, capable of exporting the equivalent of half the east coast’s gas demand, rather than two because the venture did not yet have enough gas for the second.

“You’ve got to be absolutely confident when you sanction trains that you’ve got the full gas supply to meet your contractual obligations that you’ve signed out with the buyers,” Mr Knox told ­investors in August 2010 when asked why the plan was to sanction just one train first up.

“In order to do it (approve the second train) we need to have ­absolute confidence ourselves that we’ve got all the molecules in order to fill that second train.”

But in the months ahead, things changed. In January, 2011, the Peter Coates-chaired Santos board approved a $US16 billion plan to go ahead with two LNG trains from the beginning….as a result of the decision and a series of other factors, GLNG last quarter had to buy more than half the gas it exported from other parties.

…In hindsight, assumptions that gave Santos confidence it could find the gas to support two LNG trains, and which were gradually revealed to investors as the project progressed, look more like leaps of faith.

…When GLNG was approved as a two-train project, Mr Knox assuredly answered questions about gas reserves.

“We have plenty of gas,” he told investors. “We have the ­reserves we require, which is why we’ve not been participating in acquisitions in Queensland of late — we have the reserves, we’re very confident of that.”

But even then, and unbeknown to investors, Santos was planning more domestic gas purchases, from a domestic market where it had wrongly expected prices to stay low. This was revealed in August 2012, after the GLNG budget rose by $US2.5bn to $US18.5bn because, Santos said, of extra drilling and compression requirements.

The simple truth is Santos mis-allocated its capital and its time it paid the price rather than everybody else doing so.

Reserve gas or Australia as any kind of functional entity dies. It’s that simple.