The $US3.3 billion blow-out in the capital costs of constructing the Exxon-led PNG LNG project is another disconcerting sign that construction costs in the region are eroding the economics and competitiveness of resource projects.
The PNG LNG project, in which Oil Search and Santos have equity interests, said about a year ago that the estimated project cost was $US15.7 billion. Exxon said the cost had ballooned to $US19 billion, although it remained on track to produce first gas in 2014.
The biggest factor in the cost increases was the strength of the Australian dollar, with heavy rainfall, work stoppages and land access also cited as factors. Since the project was given its final go ahead in 2010, foreign exchange impacts on its cost have amounted to $US2.1 billion.
Earlier this year BG Group announced that the cost of its export LNG plant at Gladstone had escalated from about $US15 billion to $US20.4 billion, with currency a major factor.
In June, Santos increased the budget for the Gladstone plant that it is building with Petronas and Kogas by $US2.5 billion, to $US18.5 billion, although it attributed that rise to a pull-forward of capital expenditure.
Origin Energy said in July that the Gladstone plant it is joint venturing with ConocoPhillips and Sinopec remained on track with its $23 billion budget in Australian dollar terms – but that the US dollar costs had risen from $US20 billion to $US23.7 billion.
There is no doubt that the continuing strength of the Australian dollar has taken the entire resources sector by surprise. It was an historical truth that there was a tight correlation between commodity prices and the dollar, a relationship that has broken down post-GFC with the value of the dollar remaining elevated in the face of sharp falls in commodity prices.
While construction in PNG has some specific issues, the pressure on the construction costs for new projects is an industry-wide one that has been particularly acute in this region because of the concentrated competition for limited skilled labour, services and equipment.
While that pressure may abate, as those projects still in the planning phase are postponed or abandoned, there are still close to $270 billion of projects already at an ‘’advanced stage.’’ Close to $200 billion of them are LNG projects.
The three big projects at Gladstone alone account for more than $60 billion of capital and Shell and PetroChina are still progressing towards a final investment decision on a fourth LNG plant. There are also massive amounts of capital being deployed in LNG projects off the WA coast.
The PNG LNG project will come on stream at broadly the same time as the first train of BG’s plant, with the Santos and Origin projects hitting the market in 2015. From the middle of this decade a lot of gas from this region will be flowing into the Asia Pacific market.
While all the projects have contracted customers, some of them also equity partners, and the near to medium term outlook for LNG appears reasonably sound, the spiralling costs and the longer term implication for projects that will generate US dollar revenues from what effectively are Australian dollar cost bases are a concern.
As long as LNG is priced off the oil price that probably still leaves a substantial margin for error and profit – the projects recover their cost of capital at around the $US50 a barrel level for oil – but the energy market is changing and there are noises coming from some of the Asian customers to whom all this new LNG production is targeted that they’d like to see LNG priced more discretely.
The shale gas phenomenon in the US, and its potential to be replicated elsewhere, particularly in China, is a relatively new issue to be factored into LNG equations.
The US has been flooded by its new source of energy, which has caused the gas price to slump to levels that has driven energy coal out of the US domestic market and into Asia Pacific markets, undermining the price of thermal coal for Australian producers whose costs have spiralled to the point where many of the mines are now sub-economic.
There is a question as to whether having suddenly found energy self-sufficiency, the US will allow exports of shale gas. To date the US doesn’t have export LNG terminals that would enable that gas to find its way into the markets being targeted by the Australian and PNG plants, although one terminal is under construction.
If the US were to start exporting LNG targeting higher prices, of course, its domestic gas price would almost certainly rise and the arbitrage between Henry Hub pricing and the oil-related pricing of LNG would close the price gap and the incentive to export.
Nevertheless, the US gas producers do have a prospective, and significant, cost advantage over the Australian producers and one could assume that if the Chinese were able to develop a shale gas industry they would too.
In the long run the inflated capital costs of the Gladstone and PNG projects will certainly lower returns relative to what they might otherwise have been, although they might still generate very sizeable returns.
There is, however, considerable security in being a low-cost producer and the Australian resource sector has lost or is losing that status in just about all commodities other than iron ore, with the dollar playing an increasingly significant role in undermining the competitiveness of the local producers.
There is nothing much that governments or their agencies can do about it other than try to help reign in the other elements of the cost inflation the industry is experiencing.
Gas construction costs dangerously overheating
The PNG LNG cost blowout is another sign of the precarious position major gas projects are finding themselves in. With high construction costs at one end, and cheap US energy potentially flooding the market, the economics are looking shaky.
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