Santos’ investor presentation today underscores the conflicting mix of short and long-term influences the oil and gas sector is experiencing.
With oil prices now below $US80 a barrel, the existing oil and gas producers are under some pressure to cut costs and reduce capital expenditures. Santos is no exception, targeting a 9 per cent reduction in unit production costs in 2015 and a 20 per cent cut to capital expenditures, from $3.5 billion ($4.1bn in 2013) to $2.7bn.
While the decline in capex could be largely attributed to the fact that the PNG LNG project was completed this year and its $US18.5bn Queensland coal seam gas-fed LNG plant is about 90 per cent complete, there is no doubt that Santos, along with its peers, is responding to the dive in oil prices.
There is an OPEC meeting tonight at which production cuts will inevitably be discussed as OPEC’s members seek to put a floor under the price. But there is no great expectation that the members will agree to the kind of big and co-ordinated cuts to supply that would have a material impact on the price.
In the near term, the dramatic rise in US domestic gas production, the surge in LNG supply, the weakness of economies in the eurozone and Japan and the faltering growth rate in China appears to have led to over-supply in energy markets. That, and rising development costs, are in turn impacting producers and resulting in new projects being either deferred or shelved.
If sustained, the short-term effects of much lower oil prices will have longer-term effects.
Santos’ assessment of the longer term outlook for the supply and demand for LNG is almost identical to that which Woodside produced earlier this month.
At the moment, because of the impact of US shale gas on global supply, supply and demand are roughly in balance. The level of over-supply is relatively modest. By 2020, even as US shale gas begins to enter the export markets now serviced by Australian LNG producers, a shortfall in supply begins to open up.
By 2025 that shortfall is about 120 Mtpa of LNG a year and 250 Mtpa by 2030. Even if currently unsanctioned US supply were to enter the market, there would still be a shortfall within the contestable (uncontracted) segment of the market of at least 75 Mtpa.
Santos also downplayed the other dimension of the 'threat' posed by US LNG exports, saying that a move away from oil-linked pricing towards the US domestic pricing mechanism, Henry Hub prices, which the Japanese in particular are trying to impose on producers wouldn’t impact delivered prices. Different approaches to pricing offered buyers options in terms of risk rather than price, it said.
Unless there is a relatively rapid rebound in oil prices, it is likely that the lower prices and the balance between supply and demand that they reflect will see LNG projects on the drawing boards -- whether in Australia, the US or elsewhere -- will be put on hold. This essentially ensures a shortfall in supply by the middle of the next decade and perhaps exacerbates it.
For independent, middle-ranked producers like Santos, the disparity between the current industry settings and their likely long-term trajectory represents both long-term opportunity and near-term threat.
If the growth in new supply is interrupted for any length of time then obviously existing projects will ultimately benefit from gas prices that will be higher than they would otherwise have been, potentially much higher.
In the meantime, however, even though its cash flows will be surging – Santos said today that its operating cash flows would double by 2016 if the oil price returned to $US100 a barrel but would still be 65 per cent higher at the new industry consensus of an oil price of $US90 a barrel -- its vulnerability will be increasing. Even at lower oil prices, Santos should experience a structural and significant boost to its cash flows.
Santos’ share price has fallen more than 20 per cent in less than three months, which might explain why there has been revived speculation (which Santos is long used to) of takeover activity.
In some respects its position, and that of other mid-sized oil and gas producers, is analogous to that of Rio Tinto’s, which is now being stalked by Glencore.
In the near term the tumbling iron ore price generated by an increasing over-supply (which Rio, BHP, Vale and Anglo American are fuelling) will impact Rio’s profitability and create vulnerability. Longer term, however, the continued surge in low-cost production will marginalise and drive out higher-cost production, much of it permanently.
In the long term, given that demand for iron ore continues to rise in absolute terms, albeit at a lower rate than in the recent past, the market will be more balanced and the big producers will be the big winners.
It is the window between today’s over-supplied market and the point at which a more balanced market emerges – and the differences in the time horizons of institutional investors and big miners -- that Glencore would appear to be trying to opportunistically exploit.
Santos could just as easily be targeted because the short-termism of institutions means they won’t concern themselves with what might happen to the LNG market structure in five to ten years’ time.