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03 Oct Why #LNG greenfield projects will struggle to get launched

Canada’s oil and gas sector is all a-twitter this week with the news that the Federal Government met its legislative deadline and provided a final positive decision on the Pacific NorthWest LNG project. The project is not assured – the proponents have clearly stated that they would need to revisit the project anyway since so much time has passed since the project was first proposed.

 

But it got me to thinking about the current state of the global LNG sector and whether any of the 50+ projects in the US or the 40+ projects in Canada will proceed.

 

The arguments against proceeding

 

I’m a chronic optimist for the future of the gas industry, but there are many very good reasons why Boards might not sanction new greenfield LNG projects at this time.

 

Cost recovery

 

One of my many projects carried out during the king tide of LNG investment in Australia afforded me the opportunity to benchmark the lifetime break-even costs of various LNG investments around the world. There’s a huge range, from the Qatar projects that break even at $3 to the most recent Australian projects in Queensland, the Northern Territory and Western Australia.

 

The most recent of the LNG projects that look most closely resemble the Canadian projects (large unconventional gas resource with lots of wells, compression plants, gas plants, a long pipeline, and a new on-shore LNG manufacturing plant) were in Queensland Australia. The break even market price (the price of LNG landed in Tokyo that the projects needed to achieve) that covered all the upfront capital costs, the on-going capital costs, the operating cost, and shipping, for a full 20 years, was about US$16 per mmBtu. In comparison, the current spot price of LNG in Tokyo is US$4.50, and the current contract price is $6.50.

 

In my view, none of the Australian projects would have gone ahead with this spread, and any new greenfield project that looks remotely like the Queensland projects is likely to have a similar break even profile, give or take.

 

Efficient markets would tend to favour brownfield expansions, not more greenfield. Then again, the LNG sector has demonstrated that it isn’t entirely efficient.

 

Supply demand imbalance

 

The demand for LNG in the big markets (Japan, Korea, China, Taiwan) has not grown at the same pace of supply, and as a result there’s ample LNG sloshing around the world looking for markets. There’s any number of good reasons why demand is soft, and I point to a recent run of warm winters in the north, and deregulation of some key markets (Japan, for example). Demand is still growing at a healthy clip, almost double the rate of growth for oil, but it’s still well below the growth in supply.

 

And what is the growth rate of supply? It’s about one new 4 million ton LNG train starting up every month in 2016 and 2017, for a total of 90 million tons. A train produces about one cargo every week, so the market needs to absorb some 1200 new cargos of LNG over this time period. That’s a lot. While there’s plenty of regasification capacity to handle that amount, there isn’t the demand. Why add yet more capacity with all this supply available?

 

Like the situation in oil, where OPEC players and the Russians are pumping oil furiously to hold onto their market share, media reports suggest that the Qatari projects are also producing LNG at maximum run rates to hold onto their clientele.

 

 

More price pressures

 

If all this extra supply wasn’t enough, there are moves in the market to adopt more of a spot kind of trade. The market is unlikely to ever look like the oil market in this regard, but spot volumes are still expected to double between now and 2025 to 45% of the total trade. Spot prices are well below the contract price, and adding more spot trade will likely cause the price to fall further as more spot cargoes jostle for customers.

 

Costs down but not enough

 

A very significant portion of the lifetime costs of an LNG project is spent early in its life to erect the plant, install the pipeline and deliver the first round of gas wells. Indeed, accelerating the delivery of that capital by 25% (ie, become more efficient in construction) can lower the breakeven price by as much as $1/mmBtu, according to analysis in Australia.

 

Are the capital costs down in light of the overall slowdown in activity? Yes, absolutely, but not enough to move the overall cost of the projects to meet the market price. Labour costs are down, but not by 50%. Contractors have cut their rental rates for equipment by 50% or more, but all the other costs (for steel, cement, modules, shipping, engineering, specialists) haven’t really changed.

 

The projects outside of the US do benefit from exchange rate movements, but not enough to deliver a dramatic gain in economics.

 

I haven’t been watching the BC labour and housing situation that closely, but these projects require thousands of short term (4 year) workers. It’s doubtful that the BC economy is even close to ready to handle the surge in worker demand and related housing and social pressures that entails.

 

Market uncertainty

 

Actions in Japan are also disrupting the long term stability of the market. METI, the Japanese government agency for the economy, trade and industry, has launched an investigation into whether the destination restrictions associated with most LNG long contracts are anti-competitive. These clauses presently force Japanese utilities to take delivery of purchased LNG and prevent them from trading the cargos to other buyers when circumstances create opportunity to do so.

 

If METI is successful, some Japanese utilities will open up their contracts to renegotiation. Many of the clauses in these purchase and sale agreements are interrelated, and undoing the DES clause might trigger a review of the pricing basis (usually an oil index), or the duration of the contract. Leading Japanese utilities have stated that they will not enter into long contracts for gas, on which these kinds of LNG projects are based. No LNG seller today wants to go into price negotiations if they can avoid it – recent renegotiations by the Qataris and the Pakistanis saw contract prices fall even further.

 

Japan accounts for 40% of global LNG purchasing, so any moves here are disruptive to the market dynamics. Moreover, if Japan is successful, I can well imagine the Koreans, the Chinese and Taiwanese all launching their own challenges.

 

The arguments in favour of proceeding

 

All project proponents have their internal biases in favour of proceeding – after all, growth, careers, jobs and wealth creation are rarely made by saying no. There’s considerable pressure coming from governments, project teams, banks, and contractors to get with the job. Are they right?

I can think of good reasons why a specific project might be approved in this environment.

 

  • A project proponent may be forecasting gas shortfalls within their own portfolio after the supply overhang clears. This could create future supply risks that may be unacceptable.

 

  • A proponent who has invested in a gas supply (typical of the Canadian and Australian projects, and Alaska, but not the US gulf coast), may be feeling pressure to monetize that asset. It generates no return by sitting undeveloped, and shareholders don’t like that. Worse, they may be forced to write down the asset.

 

  • Nations everywhere will be feeling the pressure to meet climate commitments under COP21. Gas still represents the fastest way to maintain energy supply reliability while reducing climate impacts.

 

  • Oil price curves may be forecasting a price move, and it might be sensible to lock in a project before others do.

 

  • With yards empty of work, LNG plant builds are going to be at the low end of construction cost. Buy low.

 

  • With the global economic slowdown, a project may be able to attract a Class A workforce for less than the usual market rate.

 

  • A large and well capitalized LNG project may fundamentally change the risk profile of a project proponent. Depending on the overall portfolio of capital commitments, technology exposure, sovereign risk profile, and contract exposures, this could be a driver.

 

  • Finally, by the time a project that is launched today finally delivers LNG to the market, the oversupply may be clear.

 

As a final thought, big energy companies pay little attention to short term market gyrations. If you believe in the future of gas as a key fuel, then you’d sanction the project.

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2 Comments
  • Greg Bruce
    Posted at 20:23h, 03 October Reply

    Great summary of the investment decision issues facing new LNG projects. When you layer in contract renewals from exisiting long term but aged projects, it becomes even more interesting.

    • Geoffrey Cann
      Posted at 21:26h, 03 October Reply

      Greg – yes, as the long contracts come up for renewal, one can expect the buyers to be pressing for changes to bring the contracts closer to what could be negotiated today.

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