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Australian LNG: cost deflation offsets low prices

Medium term outlook remains positive for country's LNG market

Australia’s fortunes have long rested on its ability to exploit and export its vast mining and minerals base. Prolonged demand for fossil fuels and other commodities from Asia-Pacific, particularly China, has provided decades of prosperity and shielded the country from the fiscal hardships experienced in other developed nations.

But while it is on track to overtake Qatar as the world’s largest exporter of LNG, Australia is now facing a series of challenges to maintain growth as depressed commodity prices and slumping demand for its high-priced gas from buyers in Asia-Pacific put pressure on investment.

In response to the slowdown, private sector enterprises have slashed expenditure on upstream exploration as buyers ponder the value of committing to Australian contracts in the face of a regional supply glut and the availability of spot cargoes at much lower prices.

Australian LNG projects under construction

The sharp decline in energy and mining income is feeding through to the economy with the Australian Bureau of Statistics (ABS) also reporting that Australia’s gross domestic product grew by just 0.2% in the three months to June 2015 – the slowest growth rate in three years.

Exploration spend plummets

The ABS has reported that private-sector investment in petroleum exploration across Australia has nosedived since 2014. Western Australia’s offshore sector had a particularly sharp fall and more bad news will come when the ABS releases its end-of-year data in early 2016.

While a reduction in exploration investment is not surprising, what stands out is the speed with which companies have slashed spending. Most marked is the significant drop-off in spending on offshore petroleum exploration in Australia which fell by an estimated 37% to A$441m ($316m) in the second quarter 2015 compared with the previous one, according to seasonally-adjusted ABS data. This puts it close to lows last seen in early 2012 when the global financial crisis was unwinding.

Of this, expenditure on drilling plummeted 41.9% with spend on other forms of offshore exploration down 24.5% in Q2 compared with Q1. The slowdown is even more dramatic if compared year-on-year, with a 59% fall in offshore exploration spend showing up in Q2 figures compared with the same period last year.

Total spend on petroleum exploration fell 31% to A$703m in Q2 compared with Q1, with spend on production leases hardest hit. The Q2 figures show a 54% drop compared with Q1 2014.

In its recent submission to the Australian Competition & Consumer Commission (ACCC)’s inquiry into the east coast gas market where three new LNG facilities are being commissioned in 2014/15, local oil and gas group Santos said petroleum industry finding and development costs in Australia have risen six-fold in the past decade owing to expensive labour and contracting services, plus higher expenses associated with regulation.

Petroleum exploration in Australia

In three years to 2013, Santos noted that total Australian finding and development costs averaged A$4.16/GJ, 2.7 times the average for 2004-07. Developers of major LNG projects have been stung by soaring capex costs in Australia. Chevron’s Gorgon LNG project in WA was due to begin production in late-2014 but is now expected onstream in late 2015. Costs have soared from an initial estimate of $37bn to around $54bn to date but the final tally won’t be known until it starts producing.

WA hardest hit

The investment slump has been particularly acute and sudden in WA where vast offshore reserves of natural gas have attracted international heavyweights such as the US majors Chevron, ConocoPhillips and ExxonMobil and, from Europe, Shell and Total.

Seasonally-adjusted data shows a 47% drop in private sector investment in petroleum investment in WA over the June 2015 quarter compared with the same period last year.

At least six planned LNG export projects offshore WA now look unlikely to be developed and those nearing commissioning look significantly overpriced compared to cheaper spot cargoes into Asia-Pacific as the region experiences a supply glut on lower-than-anticipated demand from China and other buyers.

To incentivise investment, particularly in under-explored areas, WA’s Department of Mines and Petroleum (DMP) has published its strategic plan for 2015-18 focused on prioritising “stakeholder engagement.”

The minister responsible, Bill Marmion, remains optimistic, telling PE that it is important to look past the headline numbers: “Western Australia recorded the smallest decrease in onshore petroleum exploration expenditure. Additionally, expenditure on onshore petroleum drilling activity has only declined marginally by 3.4% nationally,” he said.

Despite challenging market conditions, there are oil, gas and condensate projects committed or under construction in WA valued at A$87bn.

Petroleum exploration in Australia

“Western Australia is in the fortunate position of possessing large conventional offshore gas resources and a very significant shale and tight gas resource potential…. There are still new major projects on the horizon, with Prelude set to be one of the world’s first FLNG projects in operation, and the Browse FLNG project in development. Western Australia is well placed to become a centre of expertise in the ongoing management and service of this new technology,” he added.

Strong Asian demand forecast

The downturn in private investment upstream is a marked change on recent years when Australia enjoyed what is now seen as a ‘once in a generation’ boom for LNG from Asia-Pacific. Now, companies are cutting their workforces, slashing capex and struggling to maintain shareholder value as diving oil prices hit profits and valuations.

But there are signs that a recovery may emerge sooner than anticipated, providing demand for LNG into Asia-Pacific continues to grow as expected into the next decade and pushes prices back up.

According to Arnaud Dubois-Denis, General Manager at BG Singapore Gas Marketing in Singapore, Asia’s gas needs will continue to grow strongly into the coming decade, driven by demand and declining indigenous gas reserves with LNG providing security of energy supply and helping buyers manage their demand uncertainty.

“Asia currently accounts for around 75% of global LNG imports and will continue to be the key driver for LNG demand growth, representing 75% of global LNG imports to 2025 to reach around 360m mt/y by 2025 compared with 240m mt/y today,” Dubois-Denis told media on a recent webcast on Asian LNG demand growth scenarios.

“What will change will be that growth will be underpinned by newer markets like India, China and other Asian markets as well as those in south-east Asia such as Malaysia, Singapore, Thailand, Indonesia, Vietnam and the Philippines,” Dubois-Denis added, noting that growth in south-east Asia will be rapid, placing it second behind China in terms of aggregate imports by 2030.

Cost deflation critical

Seen as a cyclical sector by nature, as energy demand picks up so prices are expected to rebound, meaning Australia will continue to be a key provider of LNG for buyers. But the proviso is competitive export prices and it is here that Australia needs to take advantage of a window of opportunity to cut costs and enhance productivity.

According to Wood Mackenzie’s vice president for Asia-Pacific upstream research Gero Farruggio, efficiency gains and project optimisation will be “critical” to cost improvements in the Australian gas sector going forwards.

“Australia is high on the cost side and the cost deflation we’ve seen here is no greater than the global average so it really needs to work on that. One of the areas is a greater degree of collaboration between operating companies and with the service sector. There really has to be a much more aggressive approach to efficiency gains here than elsewhere. Greater collaboration, working with the service industry and optimisation of these projects and reengineering,” he told Petroleum Economist.

“Capital costs are already falling with rig rates down by as much as 50% in Australia contributing to lower drilling costs. 

“This provides a great opportunity today to explore but this window of opportunity will be short-lived because costs will recover with the oil price,” Farruggio said.

Technological advances

With industry experts forecasting that oil will average around $75/barrel over the next decade, further, costly greenfield LNG projects are unlikely to materialise in Australia for the time being. Instead, brownfield expansions are more likely with floating LNG (FLNG) expected to be deployed on remote offshore gas fields, providing it is proved viable and cost efficient by developers such as the Prelude FLNG facility.

“Advancements in technology and innovation will also be essential to our ongoing competitiveness. Innovative FLNG technology, which enables the cost effective development of remote offshore petroleum, will form an important component of Australia’s future LNG production, evidenced by the under construction Prelude project and other FLNG proposals,” Australia’s outgoing Federal energy minister Ian Macfarlane, told Petroleum Economist.

From a national policy perspective, Australia is also implementing measures to remain a leading destination for attracting capital, helped by a lower Australian dollar and a reduction in raw material costs.

“The cost competitiveness of Australia’s LNG sector will determine how we fare in securing further project investment. To this end, the government is working with industry on a range of measures which include regulatory reform, streamlining environmental approvals, seeking to improve workforce productivity, enhancing skills development, improving migration processes, and promoting new technology and innovation,” Macfarlane said adding that these measures “seek to reduce production costs, ensure access to skilled labour and increase productivity and efficiency”.

While the stock of investment in the sector is declining, there remains the potential for further investment in the future, Macfarlane believes.

“Australia has many world class mineral and energy deposits that can be developed when market conditions permit. However, Australia will have to compete with other resource-rich countries to secure investment. To secure a share of this investment, the Government is implementing measures so that we remain a leading destination for attracting capital,” Macfarlane noted.

While the current low oil price and LNG oversupply is placing pressure on the LNG sector, the minister believes the medium term outlook is positive. 

“Australia is a reputable LNG producer based on its large gas reserves, low sovereign risk, regulatory certainty, proximity to the Asian LNG market, reliability, and extensive contact and market experience,” Macfarlane said. 

Macfarlane has since been replaced by Josh Frydenberg from the state of Victoria. 

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