East coast gas markets at a crossroad
Sinclair Currie, Principal and Co-Portfolio Manager
The S&P/ASX Small Ordinaries Accumulation Index finished up 5.8% for the quarter. The mining sector increased by 27.9% while industrial companies posted a 1% return. The aftermath of the UK decision to exit the EU saw the benchmark end the quarter below its highest point. Gold prices soared in response to fears of how ‘Brexit’ might impact monetary policy, Sterling and the Euro.
The disruption of the federal election tempered investor enthusiasm for industrials, particularly consumer related companies and retailers which also had to contend with a ‘late winter’. As is typical for this time of year some companies delivered downgrades to earnings guidance however these were not systemic and consistent with the current scene on the economic stage of lower interest rates, inflation, fuel prices and contained unemployment.
The US dollar gold price increased by 7.3% during the quarter, still well below the highs reached in 2011. In contrast, the declining domestic currency has driven the gold price denominated in Australian dollars to record highs. This has inflated the share prices of gold mining companies such that the two highest weighted companies in the Small Ordinaries benchmark are now gold miners.
Looking forward, reporting season will commence at the end of July, providing substantial news and insights into the health of the individual companies and their respective markets. Investor sentiment remains cautious and averse to uncertainty. This has expanded valuation premiums in names offering greater perceived ‘earnings certainty’, perhaps beyond a sustainable level. Avoiding misperceptions of ‘earnings certainty’ will be a key objective during the coming reporting season.
East coast gas markets at a crossroad
In 2011 we reviewed the gas market on Australia’s eastern seaboard and concluded that there was potential for upward momentum in prices driven by the establishment of a Liquefied Natural Gas (LNG) export hub at Gladstone and the need for domestic customers to secure supply beyond 2018. We take a look at the sustainability of the current market dynamics for LNG and domestic gas prices. We conclude that rather than providing an inflexion point from which prices can only rise, recent developments in LNG export markets places the east coast market at crossroad. The outcomes will impact Australian gas producers, the companies servicing this sector as well as the domestic gas customers.
LNG export capability shifts the fundamentals
The development of an LNG industry at Gladstone will transform the gas market on Australia’s east coast. It provides a link between domestic prices and international demand. It has also resulted in substantial sunk capital investment to deliver the huge volumes of gas required by the liquefaction plants in Gladstone. The below chart indicates the proportion of gas to be exported as LNG relative to the domestic market.
East Australian annual gas consumption and forecast (PJ)
When the Gladstone LNG projects were sanctioned, LNG provided superior yields to those available in the domestic market. The combined capacity of the three Queensland LNG projects is over 25Mtpa of LNG, or over 1300PJ a year which will require a massive ramp up in upstream gas production. With so much export capacity in Queensland being brought online, we believe that a linkage between domestic gas prices and LNG prices is inevitable. This will support price so long as LNG prices are strong however more recently LNG prices have come under significant pressure with signs that the market is oversupplied.
LNG Market – where did the demand go?
We cannot ignore that spot LNG prices have plummeted to a fraction of their peak levels. LNG demand was forecast to grow rapidly driven by economic growth in developing economies, substitution away from coal and a desire of energy importers to gain certainty of supply. This saw a boom in construction of LNG projects, particularly in Australia. Billions of dollars were sunk into plant and equipment and this capital is now seeking a return.
Unfortunately demand growth appears to have failed to live up to prior expectations. This is likely due to moderating expectations for the pace of GDP growth in China / North Asia, economic growth in these regions arising from less energy intensive industries and perhaps also due to better energy efficiency and improving economics of alternatives such as solar power. A report published by the Institute for Energy Economics and Financial Analysis found that
“Australia’s largest 2 export markets, Japan and Korea, are expected to shrink out to 2030 according to those countries energy ministries. The great growth hope, China is seeing its demand satisfied by cheaper and strategically superior piped gas out of Russia and the growth in renewables.”
More sellers than buyers
The weak spot price for LNG indicates there is a surfeit of liquefaction capacity. Some estimates placing current capacity utilisation as low as 75% with capacity surpluses expected to persist through the next decade. Many LNG sales contracts are benchmarked to crude oil prices, yet weaker crude prices form just part of the picture. Surplus cargos of LNG have also driven down spot markets. Further indication of an oversupplied market were reports in early 2016 that RasGas (a Qatar based LNG supplier) revised its contracts with Petronet (an Indian LNG customer). Under this revision, Petronet is said to have almost halved the price it is to pay for LNG and also had penalties waived for failing to purchase the volumes of LNG it contracted.
Certainty, or a contract? A lot rides on these arrangements
The reported RasGas / Petronet renegotiation highlights that administering international contracts is not straightforward and investors should not complacently assume that contract terms equate to certainty. Given the size of Australia’s export markets relative to its domestic market, the scope for deviation in export volumes and prices has the potential to substantially alter the supply fundamentals of the local market – for better or worse. At stake is the profitability of Australia’s gas suppliers, the viability of proposed new projects and the workflow for those companies providing services to the sector. Investors will form their own views as to how likely or improbable and positive or negative these outcomes are, however we insist a broader range of risks associated with changing dynamics in LNG markets now needs to be factored into investment decision making.
1. “Pipe Dream: A Financial Analysis of the Northern Gas Pipeline” p. 25, B Robertson IEEFA May 2016.
2. Ibid. p. 12
3. LNG World News, http://www.lngworldnews.com/petronet-rasgas-agree-new-lng-price-penalty-waived/