KGB: David Knox

The Santos chief warns of cost blowouts in the local LNG industry, and says Australia should follow the US model to unlock its gas resources for export and domestic use.

Santos’ chief executive officer and managing director David Knox tells Business Spectator’s Robert Gottliebsen and Stephen Bartholomeusz:

The current $180 billion of Australian projects in the pipeline, discussed at the recent APPEA conference, should go ahead, but the next phase of projects beyond this amount could be under threat due to cost blowouts.

Australia must follow the US model for unlocking its gas resources for export and also for the transformation of the domestic energy use.

There’s no danger a downturn in the banking system will mean Santos won’t be able to fund its current project, or that future Australian gas projects will be under threat, because much of the funding is already available in cash by strong companies and the debt involved is underpinned by very stable lenders.

The fact that the recently built US LNG export port, Cheniere’s Sabine Pass, will operate on Henry Hub based pricing doesn’t seem to represent any long-term threat to the pricing model the upcoming Australian projects are based on.

If Australian state governments try to enforce pricing restrictions as conditions on new projects then companies like Santos will not unlock the resources because it will not be financially viable – but allowing them to go ahead freely will drive prices down.

Stephen Bartholomeusz: David, you chaired the APPEA Conference and the simple theme was that cost blowouts and capacity constraints could threaten this kind of massive pipeline of LNG projects we’ve got underway. You’ve got a $16 billion coal seam gas to LNG project in Queensland, right next door to a BG project which recently announced its costs had blown out by $5 billion. Are you experiencing those same sorts of pressures?

David Knox: I think the key thing, one of the really big messages at this conference, is yes we’ve got $180 billion of projects in the pipeline. They’re actually sanctioned approved projects. The real question is will we be able approve the next phase of projects that go beyond that $180 billion. That’s really where the core focus of the conference has been and it’s really been around our ability to operate effectively, our ability to gain the trust of all the communities and also a request of government, a very clear request of government. In order to invest the future wave we need a stable, fiscal and regulatory environment in which to operate. So, those are the key three fundamental themes that are associated with this conference.

SB: If one of those existing projects in the existing $180 billion pipeline has already had a 33 per cent cost blowout, what hope have we got of that next generation of projects?

DK: I think the key thing is everyone knows that Australia is an expensive place to do business, but equally everyone also knows that extraordinary investments which have happened in this industry have come about because of the rise in Asian prices. The key thing for us to manage is obviously our cost base in Australia, while also staying competitive, so we continue to sell in our case gas, but there are other quantities, but in our case gas into the Asian market. So yes, a number of partners in Australia are under cost pressure and the key thing for us is to manage that cost pressure in such a way that we actually deliver our projects, that they actually work and they actually, ultimately will create enormous wealth for Australia. What we as an industry are focused on is delivering that $180 billion of projects, selling the gas into the Asian markets and creating vast amounts of wealth for all of Australia.

Robert Gottliebsen: David, has your project blown out by 30 per cent in terms of capital costs?

DK: The issue on capital costs is clearly our projects are under pressure as they go forward. In the case of my projects, the easiest for me to talk about, then we have, well three very big contractors; Bechtel, Saipem are building the pipeline and Fluor are doing the upstream. So, we’ve chosen the contracting philosophy whereby we have a lump sum of Bechtel, a lump sum of Saipem and a target price with Fluor. So, we sought to manage the costs in that manner. Obviously, we’ve quoted the projects in US dollars, so some of the increase you see, some of the headline increase you see, it’s because clearly the Australian dollar relative to the US dollar has been very strong. But for a company such as us, which is an Australian company earning money in US and Australian dollars, then in fact that doesn’t actually make any difference to our bottom line, though it does increase the headline prices. And I think you referred to earlier in an earlier question about the BG project, half of their increase came from the fact the Australian dollar has been so strong relative to the US.

RG: David, in terms of those Queensland… those three Queensland LNG projects, in rough terms how far advanced is the physical construction? Are they 10 per cent completed? 25? 50? What roughly… How much of those projects have been… of LNG projects have been completed building wise?

DK: Yeah. BG is probably slightly in front of ourselves and we’re probably slightly in front of APLNG. For our project, we’re approximately at 25 per cent complete, so what I would say is we’ve done one lap of the track, that’s gone well, we’ve got three more laps to go. So, executing those three more laps is going to be excruciatingly important for us. But right now, we’re about 25 per cent complete today which effectively means…

RG: What about the WA projects? I’m talking about those in the $180 billion. How many of those are at their very early stages?

DK: Well, Gorgon clearly has made very good progress. It’s been… I think it was proved to have a couple of years ago and if you look at Barrow Island, it’s made clearly very good progress. Ichthys is much more in its infancy. It’s just recently been supported, so it’s much earlier in its cycle. And Prelude also, which is the shale project also is much earlier in its cycle. But right the way throughout these projects are making progress and they are doing it in obviously an environment where managing costs and managing the schedule is critically important. But what’s really important for the whole industry is that these projects are successful because ultimately it’s about brand Australia. It’s about selling Australia into the Asian market and the Asian market needs that confidence that we can all deliver projects well, we can deliver them safely and we can operate them efficiently once we come online and thereby deliver the cargoes into Tokyo, into Seoul, into Malaysia and China as we’ve all committed to it.

RG: David, when you talk to Australian bank CEOs you discover that they are not forecasting another global financial crisis where the banking system is frozen, but they realise the clear danger and are preparing for it and the recent moves in the stock market are part of that nervousness. What will happen to these big projects if the banking system is frozen and many of the banks who have agreed to fund these projects simply can’t find the money?

DK: Yeah. So, there are probably two answers to that. It depends on obviously who you are and what partner you are. A number of the partners such as Petronas in our case, Total in our case with other big firms such as Shell, now they basically can fund these projects straight off their cashflow from their global businesses, so they don’t need to borrow large sums of money against a particular project. So, that’s one group of companies. A project such as ours, we again we’ve taken great precautions and we’ve been very prudent to make sure that right up front we’ve basically got sufficient funds to fund the whole project right to the end of 2015. Now, that is obviously a combination of equity, shareholders’ money, and also debt, but the debt is all agreed. In our case with very strong institutions. A lot of them are Australian institutions, so you know, the debt is very strongly underpinned by really strong lenders. And in our case, I think the probability of the whole global banking system collapsing is one I don’t think we’re contemplating at this stage, but as I say from our perspective we’re well funded. My company itself today, you know, we’ve got three, $3.5 billion of cash plus the funding from the banks, so that is sufficient to get us right the way through to the end of 2015 when we start to see the revenue really coming through.

RG: David, there’s no suggestion that the global financial system collapses. It’s just that as it happened last time, it freezes for six months and people go on doing their business, but you can’t get money offshore easily. However, there could be some projects amongst the lot that perhaps are not as cashflow based and don’t have their money organised with people who can get through this and they may be delayed.

DK: Look, as an industry once you go to FID which is a financial investment decision, you don’t make that decision until you’ve got the funding that fully supports that decision and all partners obviously insist that other partners have got the wherewithal, the funds in order to take you right the way through the project. So basically the projects are already approved, are fully funded, so if there’s any influence, it would be on the subsequent pipeline, but again most of the oil and gas companies involved globally are very strong players; they’ve got very good balance sheets and they’ve got access to capital.

SB: David, that second wave of projects that you talk about as a subsequent pipeline would roughly more than quadruple the existing capacity of the system. There’s a view expressed at the conference that you presided over that we’re looking at something that’s way too ambitious for an economy our size. Do you have a view on that?

DK: I think it is ambitious, absolutely. You know, if we deliver on this phase of projects, or I should say when we deliver on this phase of projects, you know, we’re going to be matching Qatar in terms of LNG exports. That is an extraordinary outcome. I’d say it’s come about because of strong Asian prices. But we know that this, let’s say another 20, 30, 40 million tonnes of LNG in the pipeline is being considered for sanction. That really will mean that Australia becomes a really serious player in the gas world in Asia. Now, the advantage of that obviously creates enormous wealth for Australians, it creates enormous tax revenues. It also in fact makes a contribution to reducing the carbon footprint both here in Australia but also in these Asian countries, which typically either burn coal or oil, so it also makes a good contribution in that area.

SB: David, traditionally our LNG has been sold at prices that are linked to oil prices. You would have seen that recently approval was given in the States for their first export LNG terminal, I think in Louisiana, Cheniere, which is going to sell on Henry Hub based pricing. Does that represent some kind of threat to the pricing model that we’ve developed these projects on?

DK: Yeah, that’s correct. We believe that Cheniere’s Sabine Pass is going to go forward; it will do 16 million tonnes when it’s at full capacity. Our understanding, generally understanding the industry, is it costs about $8 to take a molecule of gas from Henry Hub and deliver it to Tokyo Bay, so on today that means you could deliver it to Tokyo Bay for about $10.50. The prices on LNG, liquid natural gas, same molecules into Tokyo Bay delivered perhaps from an Australian project is about $14.50. So, clearly there is an opportunity for US exports into Tokyo Bay right now, but of course that makes the assumption, a couple of important assumptions, but the main one is that Henry Hub prices stay as low as two 50. The other issue here is I don’t believe that US exports are going to be a huge contribution of global LNG. There’s a clear indication that the US government would step in, in the event that those exports get too large and at the end of the day I think it’s commonly believed that probably US exports are unlikely to be more than 10 per cent of global LNG demand, which in 2025 will be about 350 million tonnes. So yes…

RG: David, I can endorse that. My understanding is that the US is not going to be a major LNG exporter, as you say. However what they’re doing is to use gas to completely transform their economy. They’re going to introduce manufacturing businesses, they’re going to reduce their taxes to bring money back to develop this, they’ll propel their cars; They are going to become independent of the Middle East. Now, why wouldn’t we do the same thing? I think we had the guy from Incitec saying the other day that they’ll be putting the next ammonia plant in America and we’ll export the product back to Australia and why wouldn’t we do that too?

DK: You’re exactly right. I see no reason why we won’t do it. So, let’s just look at why it occurred in America. What occurred in America was that gas prices started to rise, then the operators in America started to get the drill bit out. As the gas prices rise the number of rigs in America went up to 1600; one thousand, six hundred rigs. They started drilling masses of holes. They unlocked the shale gale, as it’s called, unlocked the shale gas. What happened then were the prices started to fall. And if you look at the number of rigs operating, they’ve started to drop and prices have come all the way down, and they use technology to completely unlock a new source of gas which none of us really anticipated and we never anticipated getting to these levels of prices. Now, on Monday our Minister Ferguson said that Australia has 400 TCF effectively of conventional and gas that’s in sandstone and he said we have another 400 TCF of gas which is in shale. So, what we need to do in Australia is follow the American model. We need to unlock those resources. We need to get the drill bit out. And what will happen is as gas prices rise, industry will start to invest and then as we’re successful, as we unlock the continent, then the gas prices will start to come down. Now, the time scales, you can argue and debate about, but that is an absolutely clear model, so I think America absolutely showed us the way that we should do it. And then of course once you do open the gas at a reasonably low price, yes you can consider things like using it far more for transport, etc, etc and really lowering the carbon footprint.

RG: Because what the Americans did was to stop LNG, not stop completely but curb LNG exports. If we’re going to use that gas domestically, we’re going to have to do the same thing, surely, and follow the American model.

DK: Quite the reverse. What the American model did is they didn’t interfere. They allowed the market to work. They allowed the prices to rise. At one stage they went all the way up to $12. At twelve dollars everyone was drilling like crazy and then the prices came down. We need to do exactly the same thing, rely on the free market, rely on industry to get on with it, encourage them to allow them access to the land. Now, obviously, as I’ve said, the industry has to perform very well there. We have to demonstrate that we earn the trust and respect of the landowners. We will be seeking to do that. We will continue to work on it. We need access to the land and then we need to be allowed to move forward. So, I think the American model is a perfect one. And what that’s going to do of course is absolutely unlock our resources.

SB: David, you’d be very aware though, wouldn’t you, that in Western Australia, in particular, but elsewhere the states are looking at whether they can reserve some of that gas for domestic uses and presumably at prices reflecting today’s domestic gas prices not market related export related prices.

DK: In Western Australia yes there is a 15 per cent reservation policy. That policy comes into effect and when you come up for a development you have to answer the question of demonstrating commercial that you can both export and also supply to the domestic market, but it’s not a price mechanism. As soon as you restrict prices in effect we won’t get the drill bit out because we won’t be able to afford to do it. Gas is not cheap in Australia right now. What we need to do is be allowed to move forward, get the drill bit out, unlock the technology. It’s that that’s going to drive down the prices and I think I’ll go back to the American model. It’s a superb example, one that the industry never anticipated of how when you use technology, when you do it at scale, the results are quite extraordinary. That’s what we need to do if we need to get on with it. If someone said to me David you’ve got to restrict gas and you’ve got to sell it for $4.50, I can tell you it’s going to stay in the ground. It is not going to be delivered to the Australian consumer. But if someone says to me David, you know, I’ll allow you to move forward, I want you to drill, I want you to unlock the resources, of course I want you to do it responsibility, I want you to do it safely, absolutely we’re up for the challenge and I think we can meet it with the extraordinary resources we have in this country.

RG: Where is this gas geographically?

DK: Yeah. Principally obviously the coal seam gas fields have proved to be probably far larger than we anticipated. They’re largely in eastern Australia. In central Australia in the Cooper Basin, then there is an awful lot of shale potentially and there’s an awful lot of what we call conventional gas but it’s basically gas in normal sandstones. Then if we move in the Cooper Basin, there’s also a large amount of shale. And as we move up into the Northern Territory, there’s also lots of shale. Of course in Western Australia there are huge offshore gas resources, but there’s also onshore gas resources. Some of that is in tight rock, some of it in shale.. Australia is very fortunate that it is blessed with really good gas resources, but as they say it’s a very large country and as a result it isn’t cheap to develop these resources and our industry is not that large. We don’t have 1600 rigs; we have more like 30 rigs, onshore rigs in this country or actually probably even less. So, what we need to do is build to scale and by building to scale we will start to drive down the costs and not only then can we continue to compete in the Asian market, but prices in Australia in the long-term will also be able to drop and that will obviously spur the manufacturing sector.

SB: Mike Yaegar, BHP Billiton petroleum division, said earlier this week that he was bringing some of his experts in shale gas from the States to Australia as part of a kind of a… quite an urgent quest for resources. You referred to the Cooper Basin before. You’ve got something like 85 trillion cubic feet of gas in the Cooper Basin, shale gas. Is there a Santos shale gas strategy?

DK: Absolutely, there is and, as we’ve been saying, we’ve drilled our first shale gas well. It’s a dedicated shale gas well. We’ve announced that we successfully fracked that well and in three zones, so that’s gone well. What we’re doing right now is preparing the well to basically see if we can get any gas out of it. If we do, then that will be a fantastic result because this is a vertical well. What we’ll then do is we’ll then go on to drill more in North American style, horizontal wells. Typically and the best that’s been done in the States was in the Eagleford, which took them about 10 to 20 wells to unlock that basin. We are on our first right now, so we’ve got a little bit more of a journey to do, but absolutely we’re committed to doing it over the next two to three years. That will establish as to whether we potentially have a commercial resource here in Australia, but it isn’t going to be cheap gas, first. What we’ve then got to do is really unlock the technology and start to do it at scale.

RG: David, do you envisage a network of pipes up and down the east coast of Australia providing gas to the capital cities?

DK: Well, we already have all the capital cities connected. We don’t have a connection obviously between Western Australia and eastern Australia, but all the capital cities are already connected with gas and it’s good gas penetration. I would envisage over time that that pipeline network will be strengthened. I would also envisage there may be a few additional pipes run, particularly one that might be run north from the Moomba to Sydney pipeline up to the Queensland pipelines, but I think we already have a good network. It probably just needs to be bottlenecky in certain areas and that will allow us to bring the gas into that network and certainly distribute it to all the capital cities, but what we’d also like to do as part of this, we’d also like to start to distribute more of it to local landowners, local towns, so that they really see some real benefits from the gas gains.

SB: David, could you just briefly run us through the economics of shale gas versus coal seam gas versus offshore gas?

DK: Yes. So, one of the key things with gas, not all gas is the same. The key issue with gas is does it contain any liquids, in other words, any hydrocarbon as in the really light condensates. They’re very similar to petrol almost if you actually get it out of the ground. Some gases contain quite a good level of condensate. For example, the Northwest Shelf has good condensates, Ichthys Field has good condensates. In the Cooper Basin where we produce gas, we also have good condensate and that’s actually is what’s allowed us to produce the Cooper Basin and sell it to a $3 to $4 market. It’s not the value so much as the gas, but the fact that we get condensate with the gas which in our case is exported through the Port Bonython plant here in South Australia. But in the coal seam gas area there is no liquids associated with that. It’s just pure methane that comes out of the ground. So, not all gas is the same and you have to be aware of where you get condensate and where you get just clean methane. The other issue with gas is not all gas is just pure methane. Some gas comes with a higher content of CO2 in it, so that’s another factor that you have to handle and that’s another variable. So, you can’t just talk about gas as a homogenous thing. It does depend upon its quality in the ground.

RG: How far would you need to increase Cooper Basin prices before it became a global parity price? Would you double them or triple them?

DK: Yeah. We’ve said that we will be able to unlock the shale gas in the Cooper Basin at somewhere about $6 and that’s what I believe we’ll be able to do. Currently we sell Cooper Basin gas for somewhere between $3 and $4. So, basically that 50 per cent increase allows us to start to get onto the bottom rung and then obviously as we go forward hopefully we’ll be able to sort of start doing that at scale, but that as I say is some way off.

SB: David, we very much appreciate your time and your cooperation.

DK: Thank you very much indeed. It’s been a great conference. It’s been a pleasure to be here. It’s probably been one of the largest conferences ever in Australia, so you know it’s all about just developing the future and delivering our projects right now and I thank you both very much for your time.

SB: Thank you, David.

RG: Thank you.

DK: Cheers.