As details of a Shell investor presentation in New York last week reach the market, they add weight to the increasing concerned commentary from Martin Ferguson, Michael Chaney and David Knox that when the first phase of the resources investment boom ends in the middle of this decade the economy will hit a brick wall.
Chaney, National Australia Bank and Woodside’s chairman, referred to it as a "growth cliff" but it almost certainly goes beyond that. The massive investments in the resource sector – there are about $270 billion of projects in train – have sustained the economy while the competition for supply-constrained resources of skilled labour and services and the continuing strength of the Australian dollar are hollowing out the non-resource sectors.
If there is an abrupt end to the resources investment boom – if the additional $230 billion of projects on the drawing boards but not yet committed are abandoned – the consequences could be ugly.
They could be exacerbated by the likelihood that the 2015 crunch point identified by Chaney would probably broadly coincide with a federal election, raising the prospect that desperate politicians might resort to short-term, politically appealing and stimulatory policies that could add to the damage.
Santos’ David Knox earlier this week warned that investment in the LNG sector, which represents about $180 billion of the investment now occurring, could dry up by 2017 unless the economy becomes more cost competitive. There is another $150 billion of potential LNG investment at risk if that doesn’t happen.
At the Shell briefing its executives effectively confirmed speculation that the giant Chevron-led Gorgon project is experiencing a massive cost blowout (from the budgeted $43 billion to more than $60 billion) and also indicated the group was reviewing the $20 billion Arrow coal-seam-gas-fed export LNG joint venture it has with PetroChina in Queensland.
The three export LNG projects already underway at Gladstone in Queensland are already experiencing cost inflation. BG Group revealed earlier this year that the cost of its project had escalated from $US15 billion to $US20.4 billion; Santos has increased the budget for its project (a joint venture with Petronas and Kogas) by $US2.5 billion and Origin Energy, which has a joint venture with ConocoPhillips and Sinopec, has lifted its estimated costs from $US20 billion to $US23.7 billion.
The theme of those references to the Australian projects in the Shell briefing – huge cost blowouts and the deferral of projects – is now a central one within the resources sector.
While much of the cost inflation in the big resource projects relates to the stubborn strength of the Australian dollar, there is no doubt that the shortage of skilled labour and services is having a major impact on project costs.
Ferguson, more pragmatic than the average politician, hasn’t indulged in the finger-pointing the soaring costs have provoked elsewhere, effectively saying that all those involved in the sector – government, unions and management – have created the situation the economy now confronts (although the dollar has remained persistently elevated for reasons largely beyond anyone’s control).
There is too much red and green tape, which adds to costs and results in lengthy project delays. Unions and contractors have exploited the imbalance in the demand and supply for skilled people.
Managements, seduced by the record commodity prices last year and the race to get their projects into the market while the fabulous profits were being dangled before them, have lost discipline.
While Ferguson and business leaders are talking about the need for an urgent effort from all concerned to reduce costs and lift productivity, which might help salvage some of those second-phase investments as the competition for resources cools, is many respects it comes too late.
The Port Jackson Partners’ report commissioned by the Minerals Council earlier this year told a very disturbing story.
The Australian resources sector was, before the resources boom got properly underway, extraordinarily well positioned to ride through any commodity price and demand cycle, with most of the mines at the lower end of the global industry cost curve and with the Australian producers regarded as extremely reliable.
The Port Jackson study found that in the space of about a half-decade that position has been lost. Where 63 per cent thermal coal production used to be in the bottom half of the cost curve, today only 28 per cent are below the global average, including only 15 per cent of new mines. In metallurgical coal the producers now sit around the mid-point of the cost curve and in iron ore only the big established Pilbara miners have retained their position in the bottom quartile of producers.
The plight of the thermal coal producers is dire, given that the shale gas revolution in the US has pushed US coal into the Asia Pacific market and there are other new producers emerging in Asia, Africa and South America. African coal is also an emerging threat to BHP Billiton’s traditional dominance of the seaborne trade in metallurgical coal.
So, we’ve dramatically and structurally increased the cost base of our resources sector even as supply from Australia and increasingly elsewhere is pouring into our traditional markets. When combined with the likely shallower trajectory of growth in China relative to the past decade, the demand and supply equations are being permanently altered.
Resilience built on cost competitiveness, which in the past enabled the Australian producers to maintain or increase volumes almost regardless of where commodity prices were in the cycle, has been undermined by the degree of cost inflation that has occurred and which is now being permanently baked into the economics of those projects still under construction.
The LNG sector, where the majority of the investment has been occurring, is supported by the strong long-term market fundamentals for gas, although the possibility of shale-to-LNG exports out of the US towards the end of this decade, and perhaps large-scale shale gas developments in China somewhat later, mean the producers can’t be complacent about the economics of their projects.
If the economy is to avoid the "growth cliff" that Chaney referred to and the sharp economic slump that would be generated if the resources investment boom ended and there was nothing to replace it, there is going to have to be a concerted and urgent effort by government, labour and capital to drastically improve productivity and regain cost-competitiveness.
That need takes on an even sharper edge with the news that the IMF is considering giving the Australian dollar reserve currency status, which would help underpin demand for it.
An exchange rate that has already been creating acute pressures for the non-resource sectors and is contributing to the escalation in the costs (viewed through the US dollar lens of projects that will earn predominantly US dollars) of the resource projects now being developed and on the drawing boards is likely to remain a key element of the policy challenges that will have to be confronted.