Gas still gold despite Chevron's big bill

Despite a staggering 40 per cent cost blowout, and the looming danger of short-sighted state government-led anti-competition measures, Chevron's Gorgon project, and LNG in general, presents attractive economics.

Chevron’s confirmation of a massive blowout in the cost of its Gorgon LNG project off Western Australia encapsulates the issues confronting the resources sector as it shifts from its frenzied price-driven phase to a more mature and sober stage.

While the massive escalation in the cost of the project wasn't quite as dire as some had forecast – there was some speculation that a project planned to cost $43 billion might end up costing as much as $60 billion – it is, nevertheless, staggering.

Chevron said overnight that Gorgon was now expected to cost $52 billion, a $9 billion or 20 per cent increase in the projected cost. Strikingly, however, the blowout is far worse in US dollar terms which, given that Gorgon, like all big resource projects, will generate US dollar revenues, is the more pertinent number.

A project that was planned to cost $US37 billion is now expected to cost $US52 billion, or $US15 billion – 40 per cent – more. That underscores the dramatic shift in the currency relativities since that period pre-crisis when Chevron committed to Gorgon and the impact it has had on projects viewed through a US dollar lens. Gorgon has been under construction for the past three years and is now about 55 per cent complete.

Chevron said the stronger Australian dollar and changes in the mix of currencies since the project was sanctioned accounted for about a third of the projected increases in US dollar outlays.

There isn’t that much anyone can do about the currencies but Chevron attributed the real core of the increase in costs to labour costs, productivity at the Barrow Island site, logistics challenges and weather.

There is some hope that with the resources investment boom now deflating quite rapidly the intense competition for labour and resources that forced up development costs so dramatically will also wane, although the number of LNG projects still under construction or committed off WA and onshore in Queensland means there is a particular and continuing issue in that sector which demands attention from policymakers and the companies themselves.

It won’t help those projects if the lobbying for "reserving" of gas for domestic use gains traction, or if state governments prioritise onshore investment and state royalties over the most efficient developments and the long-term national interest in creating low-cost and globally competitive projects.

The proponents of reserving effectively want to get access to the gas at significantly less than its market value in what is effectively a new form of protectionism.

The royalty and onshore investment issues are a factor in the WA government’s opposition to Shell’s floating LNG technology, which could radically lower development costs, and its preference for a controversial onshore processing facility at James Price Point.

The more positive news out of Chevron came from its vice chairman, George Kirkland, who made the point that, while the currencies may have moved against the project since it was sanctioned, the oil price has moved even more significantly in its favour, rising 80 per cent over the period. LNG prices are strongly linked to oil prices. He also said the LNG nameplate capacity had increased by 4 per cent a year.

While, in the light of the US shale gas revolution, there has been a lot of debate about the potential impact of that gas on the Asia Pacific LNG market and the pricing of LNG, there is a conviction in the industry that only a relatively small proportion of that gas will find its way into the international market.

There are US domestic political and economic – and geopolitical – reasons why the US is likely to maintain a reserving policy and be cautious about approving export terminals for shale gas-based LNG. At present, approval for only one new terminal, in Louisiana, has been granted although there are about 17 more applications in the pipeline.

Despite some attempts by Japanese buyers to de-link LNG pricing from the oil price, all the long-term supply contracts that underpin the LNG projects having pricing mechanisms mainly related to the oil price so the likelihood of a fundamental change to the pricing structure in the near to medium term is low.

As Kirkland said, despite the cost blowout, the economics of Gorgon and other LNG projects remain attractive. Chevron is also building another $29 billion LNG project, Wheatstone, off Western Australia, which is only 7 per cent complete but is, for the moment at least, on-schedule and on-budget.

The legacy of the mining segment of the resources investment boom – which has ended with a slew of projects being withdrawn from the investment pipeline and left newly-constructed projects with inflated capital and operating costs that have undermined their international cost competitiveness even as the sector’s drivers shift from commodity prices to volume – is instructive.

There are still a number of massive prospective new or expanded LNG projects on the drawing boards or on the verge of final investment decisions and the experience of the mining industry ought to be drawn on to ensure that those projects are not only built but have economics robust enough and competitive enough to weather whatever the LNG market might throw at them over the next decade or two.

Low-cost producers – and until the commodity price boom most of the larger Australian resource companies were low-cost producers – can survive most market conditions.