KGB INTERROGATION: Richard Cottee

Queensland Gas boss Richard Cottee has had a good week, announcing to the market that his 'proven and probable' coal-seam gas reserves are 80 per cent larger than first thought. He gives Alan Kohler and Robert Gottliebsen the details.
Alan Kohler: Richard Cottee thanks for speaking with us. How many LNG export operations do you think will be built in Queensland?

Richard Cottee: This is a very unusual situation for the Australian gas market in the sense that it's actually not market constrained. The demand for LNG is highly elastic. For example LNG demand in China is presently 3 million tonnes per annum and projected to go to about 30 million tonnes per annum by 2020 which in the context of Japan, which at the same time will be 80 million tonnes per annum, shows that obviously the demand's not the issue. The real problem I think is going to be market acceptance because this is the first…this will be CBM and it's the first time that that's actually going to be used for LNG.

AK: What do you mean by that?

RC: Coal-seam gas or 'coal-bed methane' – CBM. It's the same concept. CBM is the American term...we're divided by a common language so we had to invent our own acronym for it.

AK: And what do you mean by market acceptance?

RC: Well there's two prime issues there. Historically LNG started off with what they call some degree of liquids in it because they couldn't strip out the butane and the propane efficiently 20 years ago. They can now, so they've clearly left some of the LPGs – 1 or 2 per cent of the LPGs. Now coal-bed methane is pure methane which is a cleaner fuel from the point of view of greenhouse gases – but vis-a-vis what's presently being traded it has got a slightly lower calorific value. Now that doesn't cause any problems, we believe, with power stations and various others but if you've got town gas in say Tokyo or Osaka that is predicated on a particular quality, then each of the mums and dads there may have to have a slight conversion of the gas heaters and so on to take a different quality…

AK: You're saying that coal-seam methane is not appropriate for domestic use?

RC: I am saying it is appropriate provided you get the right customer who will then commingle it with other energy. Obviously that means you're talking about big customers or if you get into a new market like China, then they will be more likely to want to build at the leaner end… because of the less pollution that the pure gas will provide. Now that's the first problem and I think that's just a matter of negotiation that one.

The second one though is the credibility of coal-seam methane generally as LNG. I always wear a tie to stop people seeing the rope burns around my neck from being hung for trying to bust into the domestic market with this product called CBM. Now that's simply because a power station costs a billion dollars and the ask how reliable is your supply, and so forth. That was a big question two or three years ago, but now it's a matter of absolute acceptance. Now when you talk about LNG you're talking about 190 petajoules for each train, to give you an idea.

The total NSW demand is 135 petajoules so you can imagine that if you've got one-and-a-half times New South Wales demand being delayed by 12 months because of construction delay or other problems, the LNG customers are going to be quite nervous and asking where can they find that gas that they had scheduled to take from the new project.

Now that's half the reason why even with Woodside in the early days it took five years before it could actually get its first contract. The reserve position is going to be fairly important as well. So if you're going to take 190 petajoules, with 20 years' demand you can see that you're talking about 3,800 petajoules has to be there over the 20 years.

Now how much you need before you actually go ahead is an equity decision I guess. So the constraints are obviously going to be reserves and market has to decide which one comes first or second or third.

There's plenty of land. Each train can have the land. The Queensland government's got to treat each one equally so the permitting and so on is going to depend on just how efficient you are. But it's the fundamentals of gas reserves and offtake contracts that's going to determine the first one. With ours, our offtake contract with BG is actually presently legally enforceable and BG is taking all of those risks that I talked about and selling to the customers, the end users on a portfolio basis so they don't have that risk.

AK: Will they take or pay?

RC: Yes with BG its an absolutely enforceable sales contract after we go to feed.

AK: How many operators in Queensland have got 3,800 petajoules?

RC: Well presently we've got that on the 2P basis which is where you normally contract on sales.

AK: That's proven and probable.

RC: Proven and probable basis – no one has that amount of petajoules. Origin has it, but it has already sold a hell of a lot of it domestically so then you go, after Origin, to ourselves with our announcement yesterday or more than 2,370-odd petajoules at 2P and then you get to Santos with around 1,300 petajoules. So you can see there's still a long way to go on the exploration. So exploration and proving up the reserves is going to be a major ask – no one was trying to explore for these sorts of results a couple of years ago because the total New South Wales market, as I said, was 135 petajoules so why would you…

AK: But everyone's got 4,000 or so on possible 3P reserves haven't they?

RC: Yes. We've got 7,000, but what people aren't disclosing is how much you've already got already sold. So if you take our 7,100 and take out the 1,100 that we've sold, we've got 6,000 petajoules of 3P which is more than enough for a single train, plus the Hunter Valley where we're starting on the second train on the 3P basis.

The point is that proving up our CBM reserves actually takes a lot more time. Lower risk but more time. QGC has been exploring basically since September 2006 so we put in $60 million on our growth acceleration strategy in 2006 on the basis that we thought that PNG stood for 'Pipe No Gas'.

We then had the Santos takeover and AGL resolution that allowed us to put another $200 million in this financial year, ending in the next couple of weeks, and now with the BG money we can put in another 230 petajoules so we actually think the reserves are not a major issue for ourselves. It's a question of whether the second train is made at the same time as the first, given our reserve position.

Robert Gottliebsen: Do you think the stock market might have moved a little bit ahead of itself given the reserve situation and the problem of getting customers to accept this?

RC: Yes, stockmarkets are generally always slightly forward looking, but this is such a new product and I think there's not enough understanding. For example when we did our BG deal we concentrated on what we call the four fundamentals in the alliance to ensure that we got an LNG project.

Some of the others seemed to be concentrating more on trying to get the highest number for their gigajoules. We'd prefer to have a suitable offtake contract...We concentrated on getting a party that had actual operating experience and has built plants before that would give us an offtake. Then it was up to us to get the reserves, but given the fact that we've been doing it for over two years untrammelled, and even if we'd known in September 2006 that we were heading towards LNG, we couldn't have spent any more money physically anyway.

RG: Do you think some of the other stocks might have gone a bit too high?

RC: Well I think people are looking at whether the big oil majors are moving in. The really big companies are moving in so the stockmarket is to a degree forward looking. I don't think there's been much analysis done in the ranking. To go back to the first question you asked which I hadn't precisely answered, there could be more than one because it's not going to be market constrained after there's market acceptance – but then you get to the situation of whether you believe you should get between a capitalist and a bucket of money because obviously if you share the jetty and share some of the common facilities you can save a billion dollars on the second train and the costs for the second…

AK: But what's going to determine who gets a plant up?

RC: I actually think it's the fundamentals. I honestly think it's the fundamentals….

AK: Like what. What do you think?

RC: …like reserves, market, offtakes, financing and in the financing experience.. the experience will bleed into both financing and the contracting. The experience...the believability for the customer and the banks that there's a party there that's built these before and therefore in this resource-constrained environment is most likely to come on time and on budget without significant delays and hiccups.

AK: And it looks like there's only going to be two plants that get up, say, then at that point aren't there going to be takeovers?

RC: I think there's already takeovers last time I looked [laughs].

AK: Of the big four, of the big four or five.

RC: Yeah, look, I think there is going to be some degree of either contractual merger of the facilities – that is sharing the facilities arrangements which is I guess some form of merger but it's not an equity merger – or there will be the balance [between equity and facilities sharing]… There is a report out of London saying that they think it will actually exceed oil price parity by about 2015 simply because if carbon pricing goes across the developed world, LNG is actually cleaner for both transportation and power generation than crude oil and it will be coming from more politically stable countries.

RG: Why wouldn't we use this energy in our local power stations, replacing coal and maybe even to drive our cars?

RC: Well we should be and they're not mutually exclusive. At the present time we've got what I call Mugabe economics being applied to natural gas. If you go to the United States as a comparison, Australian natural gas prices in Queensland have been around $US2 per MMBTU [million British thermal units] for the last five or six years.

In the US it has ranged between $4.50 and $12 an MMBTU. The net result of the low pricing is that only 5 per cent of the reserves of coal-seam gas will ever get developed. If you lower the pricing even further say to $US1 you'll get no gas at all. If you allow gas prices to rise to say export parity coal pricing, if you do do that, then you will get more supply coming on because not all coal-seam gas reserves are going to have the same economics. It's the same as any other resource. It will rise to the marginal economics.

At the moment natural gas prices are lower than export parity coal pricing so vis-a-vis any new power stations coming on, if export parity coal pricing goes there, if you build a coal fired power station you will pay a premium to have less efficient power station with a higher pollution basis now that's unsustainable in the long term. Eventually, obviously, all the incumbent power generators are going to be facing higher coal costs when the renewal of their contracts comes about but if you go and allow our fields to a get back export parity… you will then have sufficient to do everything you want. The US for example has about the same sort of coal reserves as we have but 10 per cent of its consumption is coming from coal-seam gas. So there's an enormous amount available for both.

RG: Can you convert those power stations to gas? Those coal fired power stations?

RC: You can but it's not a total conversion. It's called co-firing and so what you do is you actually supplementally burn both coal and gas in there. By far and away the most efficient is to actually build just a gas fired power station, in the long term, and the irony at the moment is that coal fired power stations' pricings are going up faster than gas fired because China is building so many coal fired power stations because it's not within Kyoto. In fact the equation's moving more and more against coal anyway even without carbon pricing.

RG: What effect do you think, say, a $50 a tonne carbon price would have on the total energy equation in terms of gas and coal?

RC: At $50 a tonne you would make it that it's probably equivalent to an export LNG. Let me explain why. There's a lot of people who just don't really analyse the situation correctly. In Western Australia they point out that there's been a sort of rationing because of the per centage to go for the domestic market. But essentially the North West Shelf is a distance of approximately Moscow to London away from Perth but south western Australia is nowhere near the population of the UK, so you're trying to move a long distance with small volumes no matter what happens.

If you're going to compare that to, say, our situation in Queensland, then our acreage has four or five new power stations being built at this time. Darling Downs, two at Braemer and Condamine because that's where the Queensland-New South Wales interconnect is. So if we were asked to produce into our Condomine power station we don't have to do any compression and we have no transportation. Our alternative is to export to the LNG market which is a 380km pipeline into Gladstone and then we have to compress the gas for the pipeline transportation and then we have to liquefy it at Gladstone all of which are extra costs that we have to incur to get into the LNG market. So when you take those costs off and that's the price you'd sell it at, the domestic market is still at a substantial discount to the international energy price simply because coal is where the demand is. I mean the country was developed off coal reserves 200 years ago.

And then if you put a price on carbon on top of that, well then the electricity price will reflect that and gas will get the premium for it and it might be even more economic to use it domestically than the LNG, but then the domestic market's never going to be big enough for the supply in any event.

AK: Are we at the point now where we can say that the Queensland coal-seam gas reserves are equivalent to the North West Shelf?

RC: Yes. Well I think you can say that it's equivalent to Cooper Basin and Bass Strait combined on a 2P basis but just between Origin and ourselves we'd get there. I'm not sure what the 2P reserves of North West Shelf is because I've been concentrating on the eastern seaboard, but you're getting very close I would have thought by the time you've added Origin's 2P numbers to our 2P numbers and Santos's.

AK: Can you get much gas from NSW?

RC: I'll get a little bit technical here. Coal is a hydrocarbon – part of the hydrocarbon chain. So is methane, but any hydrocarbon actually scavenges, if you like, from any hydrogen or carbon atoms and creates a molecular bond so within coal is generally water, H2O and CH4 (methane) and the big daddy is CO2. All in varying quantities. And so you can assume that all coal will have some methane in it. It may be economic or otherwise depending on the pricing and so yes, New South Wales will have methane in its coal and that's why we've had all those mine disasters – the three types of coal mining disasters that have occurred in history. Flooding, there's water in the coal, explosions because of methane, or asphyxiation due to outbursts of CO2.

RG: But it's not in the same quantity?

RC: It's not in the same quantity. For example in our coals where we are, we have less than half a per cent of CO2 so it's very, very low in CO2, with no sulphurs...it varies in accordance with nature and in accordance with what rotting vegetable matter or whatever it was laid down with but by definition it should have some water, some methane and some CO2.

AK: Are you finding that because coal-seam gas is flavour of the month that the business is being infected with spivs.

RC: I think with any bubble that you have – particularly if there's a degree of lack of education of what makes a good coal-seam gas product or what makes a good LNG – you will have that propensity. To make this point I always use what I call the fall of 'dot-communism' when the tech wreck came about...yes there were a lot of very interesting business plans that were financed, but it didn't mean that Microsoft, Yahoo or Cisco were bad investments.

The reason why there is a bubble is there's some fundamental that's driving it and the fundamentals are there, but you often do get a degree of lack of differentiation occurring when there isn't the education in the new product whether it's nickel or dot-com or CBM.

AK: What's a good rule of thumb or good rules of thumb for picking the wheat from the chaff?

RC: On an exploration you should try and find out the three major things.

One is permeability because that affects completion technique. Now permeability is the ease with which gas or water can flow through a solid medium so if you take a sponge and put it underneath a tap, the water will go straight through the sponge. Highly permeable. If you're going to put a steel rod underneath the same water it will go round it. Highly impermeable. So that tells you the ease with which the gas can escape from the coal, so that's therefore very important for completion techniques. The higher the permeability the easier it is for the gas to escape.

The second one is how much gas there is in the tonne of coal and obviously the higher the amount of gas you've got in the tonne of coal the better the prospect looks.

AK: And what should you look for there?

RC: We're sort of saying that if you're underneath about 3 cubic metres per tonne you're not looking too good. If you're underneath ten millidarcies of permeability then it's going…

AK: Millidarcies?!

RC: Yep.

AK: What's a millidarcy.

RC: Oh it's Tony Darcy's younger sister I guess [laughter]. D'Arcy was the French person who was able to work out what permeability was and created a measurement a bit like Boyle's law [for gases] and other stuff that's come about, so a darcy is a big number. And a millidarcy is a thousandth of a darcy. You just need to know that it's a measurement [laugh].

AK: OK, so what's the third thing?

RC: The third is probably just as important – it's called gas saturation. It is a measurement of the per centage of the gas content in the coal compared to the theoretical maximum that coal could hold. In other words it's worked out as a per centage.

If you've got 75 per cent gas saturation then either 25 per cent of what could have been there has escaped to the atmosphere or was never there. If it's got lower saturation it means you're going to have more water to take out before you get your gas and you're going to get less gas out overall because you take the water out to drop the pressure down to allow the gas to escape but your pressure's still the same. If you've got 100 per cent gas saturation you'll get gas out immediately.

And then there's another easy indicator if you haven't got those because it comes from exploration – you should be looking at a depth of coal. Not for coal-mine methane, which is done for safety purposes, but pure exploration. The ideal depth is somewhere between 200m and 800m.

The reason for that is that if it's less depth than 200 metres it's too shallow and therefore the gas will have escaped to the atmosphere and your gas saturations will go down and your gas contents will go down. But your permeabilities will be high because you've got very little pressure on top of the coal. If you go down greater than 800 metres you will probably have fairly good gas saturations and quite good gas content but there's so much overburden on top that the coal has been squashed, like putting a whole host of books on top of a sponge cake. The gas is difficult, on present technology, to extract if the permeability's too low.

AK: I'm not sure companies actually report their permeability and the millidarcies.

RC: They absolutely don't because the rules have been done for conventional gas.

AK: So how does an investor find that stuff out?

RC: Well we've been publishing it because we're trying to educate the market, to try and differentiate ourselves. Obviously how thick the coal is counts as well and how big the deposit is. At the end of the day they're the three things that determine the economics – whether it's economic or not.

RG: Given that this is a new material and there are complexities that are different from normal gas or normal natural gas, there's going to be some quite nasty stock market plays I suspect in the next year or two.

RC: Oh look, I wouldn't presume to tell an interviewer how the stockmarket will go because you've been following it for a long time and you can smell things a lot quicker than I can, I bet. No doubt about that.

AK: On that note we might finish.

RC: OK, thanks very much.

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