A peaceful gas boom?

For the first time in more than a decade, last week US natural gas prices fell below $2 per million British thermal units, or mmbtu, the obscure unit Americans insist on using to measure gas volumes.

The energy crisis is over. Long live the gas boom, or so the argument goes. There’s some truth to the fervour. Cheap, plentiful gas has created an energy boom and freedom from foreign energy dependence is now a genuine possibility. The triumphant mood in the US contrasts with the gloom of local gas producers.

The poor share price performance of Santos, Woodside Petroleum and Origin Energy suggests investors believe the US gas boom may threaten Australian LNG sales. They may be right. These three companies have some $50bn invested in developments geared towards selling LNG in Asia at prices approaching $20mmbtu. Could cheap US gas really threaten those investments?

It’s possible. Turning excess gas priced in North American markets into LNG priced internationally, US producers could close the yawning gap between local and international gas prices. Selling gas for $20mmbtu rather than $2 must be very tempting, which means greater competition for LNG sales is possible after 2020.

Projects threaten

Should that occur, it is more likely to threaten new projects than existing ones. New supply is a possible threat for Woodside—its Pluto project will provide profitless volume growth this year (see Woodside hits planet Pluto on 18 Aug 11 ($36.87 – Hold)). Browse and Sunrise, two other jewels in Woodside’s crown, are unlikely to be developed this decade, if at all. 

In contrast, Santos and Origin have already sold 20 years of supply under contract. Gladstone LNG (GLNG), in which Santos is a partner, has already made substantial progress and will ship its first LNG in two years.

This project and others like it will transform the company. Production, for years stuck around 50m barrels of oil equivalent (mmboe), will climb to over 80mmboe by 2020. Better yet, with 70% of reserves tied to oil prices and our positive view on the commodity (see The case for oil on 27 Oct 09), new output should generate higher margins, too.

Origin’s push into LNG is equally ambitious. When complete in 2015, the Australia Pacific LNG (APLNG) project will be among the largest in the land. With access to the lowest cost gas in Queensland, Origin should enjoy fatter operating margins than its peers.

Although APLNG may one day become its largest source of profits, it is barely factored into today’s stock price. Construction work is behind its peers but, with fixed price contracts and the best management in the business, such pessimism is unwarranted. The first two trains (or processing facilities) should generate healthy returns regardless of what happens in North America.

Gas prices to rise

The worrywarts are right about one thing, though; US gas prices can’t stay at current levels. They must rise.

There are two ways this might happen. First, loss-making producers stop drilling, thus reducing supply. Alternatively, new markets are found, increasing demand. Applications to export vast volumes of gas have already swamped the Department of Energy but only one has yet been approved.

Gas supply, meanwhile, is starting to fall. Drilling rigs allocated to gas wells have fallen from 75% of total rigs to about 30%. Losses are starting to drive producers away. Chesapeake Energy, one of the largest shale gas producers, is cutting output and other producers are following. Low prices are already starting to eat into supply, which should eventually lead to higher prices.

While US gas prices breach record lows, an opportunity brews in local LNG stocks. Santos and Origin, currently targets of excessive fear, should be buying targets for investors seeking energy exposure. Both stocks are suitable as LONG TERM BUYs for up to 4% each of a diversified portfolio. Woodside remains a HOLD.