Canaccord Genuity energy analyst Johan Hedstrom is tasked with scouring
the Australian oil patch looking for good deals even as prices slip and
slide. In an interview with The Energy Report, Hedstrom minces no words: Pricing
and rig costs are obstacles to taking large profits. But there is a silver
lining to the energy price cloud—Australian gas exports.
The Energy Report: Johan, please give us an overview of the
shape of the oil and gas industry in Australia.
Johan Hedstrom: The Australian oil and gas industry is dominated by
a series of big investments in new liquefied natural gas (LNG) projects. Our
industry is building seven new LNG projects, costing $240 billion ($240B).
The biggest one is Chevron Corp.'s (CVX:NYSE) Gorgon project, which is
projected to cost $55B. The BG Group
Plc's (BRGYY:OTCQX; BG:LSE) Gladstone project in Queensland is now
selling LNG. A couple more LNG projects will go online this year, a couple
more next year, and the rest of the projects will go live in 2017. This
gargantuan investment sector is dominating the Australian energy industry
and—it must be said—driving up costs in the field as energy services are in
great demand.
TER: How is the Australian energy sector affected by global
oversupply and falling prices?
JH: The high level of LNG activity and the competition for energy
services in Australia—plus a high Aussie dollar—means that Australia is
simply an expensive place to operate. If West Texas Intermediate stays at
about $50 per barrel ($50/bbl), it will be difficult for companies to
generate the elevated returns they had projected at high prices. They can
still make money with Brent at about $60/bbl, but not as much as they had
hoped. On the other hand, the industry is irrevocably committed to bringing
the new LNG projects onstream, and the investment is huge. But wherever the
firms can save on expenditures, such as exploration, they do cut back.
TER: Major firms like Chevron are obviously in for the long term.
But do low prices thwart the timely development of these mammoth LNG
projects?
JH: No. Each of the projects will have sold a majority of their
planned gas volumes at prices set for 15- to 20-year contracts. When firms
commit to multibillion-dollar investments, they lock in terms. They were
probably hoping for the oil price to stay high and generate superprofits.
That is not happening, and who knows where oil prices will go during the next
20 years. LNG prices are linked to the price of oil. The pressure on the oil
price means that returns and paybacks are going to be lower and slower than
originally anticipated.
TER: Is there a danger of the cost of production exceeding the possible
profit margin?
JH: Yes. Let me explain: The cash cost of production in the field
is low, and that will generate cash flow. But taking into account the very
high capital cost of developing these LNG projects, leading to high
depreciation and amortization charges, if the oil price stays at $50–60/bbl,
the projects will probably not cover costs of production in the short term.
TER: What does the cutback on exploration mean for junior firms in
Australia?
JH: There are about 45 onshore rigs in Australia. Half of them are
drilling coalbed methane (CBM) gas wells, and they should be OK. Three of the
new LNG projects will source CBM gas rather than conventional gas. The
industry will require thousands of CBM wells to keep the LNG plants in
Queensland going for a number of years. But, at the same time, there is a
cutback in the number of conventional oil and gas drilling rigs due to
falling oil prices.
TER: Anything brewing with shale plays?
JH: The Cooper Basin in central Australia is the most active area
for oil and gas drilling. Quite a few wells drilled in the deeper parts of
the basin were looking for shale gas or, more correctly, tight gas. The shale
programs are now ending or being deferred, partly because of the oil price
collapse, which has tightened cash flows for the companies. Also, the shale
and tight gas results are not encouraging. The Cooper Basin is not going to
be the next Eagle Ford.
TER: Is the Australian energy market aimed at producing for
domestic consumption or for export?
JH: The gas market has been oriented to domestic sales in the past.
Now, with the LNG projects, it is more export-oriented. Not all of the LNG
projects enjoy full reserve coverage for 20 years; they are keen to buy up
any spare gas. Long-term contracts are expiring, and the recalibration to
export is driving up domestic gas prices. A year ago, the domestic gas price
was $4/gigajoule. New contracts in the domestic market are between
$6–8/gigajoule. That is a 50–100% increase in domestic gas prices.
TER: What countries are buying Australian gas?
JH: Japan is the world's largest buyer of LNG, and is Australia's
biggest customer still, but China is signing more of the new contracts. The
global gas market is broadening: New gas buyers include South Korea,
Thailand, Singapore and India. The demand is primarily for power generation,
but there is also industrial and residential utility demand. China and other
Asian countries are trying to increase the gas proportion in their energy
mixes because they have been heavily reliant on coal, oil or nuclear energy.
Each of these energy sources has environmental issues. Gas is not totally
clean, but it is cleaner than coal, and it is certainly cheaper than oil.
TER: Is Australia competing with North American exporters?
JH: There's no direct competition with North America, but LNG
buyers are effectively using the expansion of North American gas production
to put pressure on price negotiations with Australian suppliers. Because of
the lower oil prices, and the high cost structure in Australia, the window of
opportunity to finance yet another LNG project has closed, in my view.
However, we did quite well to launch the seven projects that are on the
boards.
TER: Is now a good time to invest in the junior energy sector in
Australia?
JH: In my opinion, this year is a good time to invest in Australian
oil and gas stocks, including some juniors. The macroeconomic environment
will remain uncertain for the near term, but some firms are better positioned
than others—and they are worth buying today.
TER: Who do you favor in the Cooper Basin?
JH: Drillsearch Energy Ltd. (DLS:ASX) has a $488 million
($488M) market cap. It is a strong oil producer in the Cooper Basin with low
operating costs. Its cash costs are about $25/bbl. After adding on
depreciation and amortization charges at $20/bbl, Drillsearch is making money
at the current price of $55–60/bbl for Tapis crude, which is used for Cooper
Basin oil pricing.
Drillsearch has a solid drilling program with successful reserve
extensions on the western flank of the Cooper Basin. It also has a small gas
business, and has drilled a series of new conventional gas discoveries with a
high content of natural gas liquids—condensate, propane and butane. With
rising gas prices, and fixed contracts to $8/gigajoule for gas and liquids,
Drillsearch is very attractive. The company is financially healthy, and it is
well placed to grow its gas business. The oil side will depend on ongoing
drilling success. And Drillsearch's balance sheet is in good shape, with zero
net debt. It has $150M of debt through a convertible note listed in
Singapore, but it also has $150M in cash and a positive cash flow.
TER: How do companies like Drillsearch relate to the large LNG
development projects? Is Drillsearch an acquisition target?
JH: There is talk about mergers and acquisitions activity in the
Cooper Basin. Drillsearch is not directly linked to any of the big LNG
projects, but it has a joint venture (JV) with BG Group, looking for
unconventional gas in the deeper part of the basin. BG has the first
up-and-running LNG project; it relies mostly on CBM to supply the plant but
has taken a position in Cooper Basin shale gas with Drillsearch. The JV has
drilled four wells, but the results are not exciting and the drilling costs
are high. Interestingly, BG is also Drillsearch's largest owner, with an 8%
shareholding. If BG needs more gas resources, it could move to acquire
Drillsearch, although I do not think that is very likely at the moment. Maybe
down the road a bit.
TER: Do you have a target price on Drillsearch?
JH: Our price target on Drillsearch is AU$1.18/share; it's
currently trading at about AU$1/share.
TER: Who else is active in the Australian oil and gas patch?
JH: Beach Energy Ltd. (BPT:ASX) and Senex
Energy Ltd. (SXY:ASX) are also in the Cooper Basin. Beach is twice the
size of Drillsearch, and Senex is of a similar size but is a smaller
producer. We don't like these two companies as much as we like Drillsearch:
They have less financial flexibility and a less attractive growth outlook.
They also look more expensive on valuation multiples. These three companies
are the Cooper Basin small caps, in effect.
Origin
Energy Ltd. (ORG:ASX) is also active in the Cooper Basin. Origin is a
diversified gas utility, as well as an oil and gas producer, and it is
vertically integrated.
The biggest operator in the Cooper Basin is Santos Ltd.
(STO:ASX). Its share price halved last year because of the drop in the
oil price and cost overruns on its LNG project in Queensland. Santos' balance
sheet is a bit stretched due to the lower oil price and lower cash flows. Total S.A.
(TOT:NYSE) and Petronas (PETRONAS) of Malaysia are JV partners with
Santos in the LNG project, but they are not partners in the Cooper Basin,
which is the gas supply element. Santos could be a takeover target, as could
Beach. Santos' LNG project will go live in H2/15, which is a big deal.
TER: Who would take over Australian companies of this size?
Domestic firms? Overseas corporations?
JH: The Chinese are logical acquirers of these types of companies.
TER: Is China moving away from coal?
JH: China is trying to reduce its reliance on coal. Coal is a very
big part of the Chinese economy and power supply, but pollution is a massive
issue. China's latest five-year plan calls for gas to power a larger section
of the country's energy grid. Worldwide, gas is typically 20–22% of the
primary energy supply. In China, it is only 5%. The government wants to bring
that ratio up to 10% by 2020—doubling the gas variable in the energy equation
during the next five years. It will achieve that goal by increasing LNG
imports from Australia and pipeline imports from Russia and Turkmenistan.
Beijing is also encouraging development of the domestic gas supply.
TER: Are Australian explorers active in China?
JH: An Australian company called Sino Gas
& Energy Holdings Ltd. (SEH:ASX) is in a tight gas play in China. It
went there looking for CBM. It found CBM, but when it evaluated its leases,
Sino Gas decided that the gas sands were better suited for tight gas
production and commercial delivery. Sino Gas has drilled close to 100 wells
in a JV with a Hong Kong-listed company called MIE
Holdings Corp. (01555:SEHK). The JV is booking significant reserves of
more than a trillion cubic feet of gas on a gross basis. It has neighboring
gas fields with partners like Royal Dutch
Shell Plc (RDS.A:NYSE; RDS.B:NYSE). Sino Gas's pilot production is
generating very attractive gas prices up to $9.50 per million British thermal
units ($9.50/MMBtu). Sino just announced a second gas sales agreement,
confirming a similar price level. This is significant because Chinese
government has recently declared a 5% reduction in gas prices due to the oil
price fall. But $9+/MMBtu for gas is very attractive. Sino Gas has stated
that it can produce the gas for an all-in cost of $1.50/MMBtu, so there is a
big margin to exploit.
The next two developmental stages for Sino Gas are vital. It must get a
Chinese-approved reserves report, which should happen later this year. And it
needs governmental approval for an overall development plan (ODP). That
should happen in 2016. Then, Sino Gas will have to fund the development of
hundreds of wells. Once the ODP is granted, Chinese companies will be
entitled to become partners-in-operator with Sino Gas. Sino Gas and MIE will
be diluted when the ODP is granted.
TER: Does MIE bring a capital commitment, or mostly political
influence?
JH: MIE has useful political ties to China. Its capital
contribution supports the evaluation and pilot production testing. It is not
a significant amount of money. The project is in the range of $50–100M. When
the ODP is given, there are two different licensees. China National Petroleum
Corp. (CNPC), which is a large, government-owned Chinese corporation, will
take one of the Sino Gas projects. The other project will go to China United
Coalbed Methane Corp. Ltd. (CUCBM), which was the Chinese government's designated
CBM company. Even though it's not a CBM project anymore, CUCBM has retained
certain rights. The two Chinese companies will take 51% of the overall JV in
return for providing a significant part of the funding.
TER: What kind of timeline are we looking at for that?
JH: We think that the ODP will be given in 2017 or late 2016, and
that development will start in 2017. Production should ramp up in 2018 and
2019.
TER: Is now a good time to invest in Sino Gas?
JH: Yes. The pilot production is ramping up at very attractive gas
prices. The share price has been underperforming all other oil and gas
companies, despite its operations being largely unaffected by the oil price
fall, and the stock is positioned for exciting growth over the next two
years.
TER: Do you have a target price on Sino?
JH: We have a price target on Sino Gas of AU$0.48/share, and it's
trading at AU$ 0.19/share.
TER: Do you have any other exploration and production firms that
you like in the Australian complex?
JH: There is an Aussie company called Sundance
Energy Australia Ltd. (SEA:ASX), which is active in the Eagle Ford shale
of the U.S. We have a couple of Australian-listed companies that focus on the
U.S. Sundance looks very cheap against its Australian peer group, and also
when compared against the U.S. Eagle Ford shale group. Sundance has some of
the better properties in the Eagle Ford, with 33,000 acres. It is doing about
10 thousand barrels per day. It has a good balance sheet. Unlike many of the
U.S. oil and gas companies that have borrowed too much money, Sundance has a
debt:EBITDA (earnings before interest, taxes, depreciation and amortization)
ratio of 1.1. It is undergeared compared to just about every other U.S. shale
company, and it is financially healthy. Its costs are $15/bbl to produce oil.
It is building up its drilling inventory, with 550 drilling locations yet to
drill. Sundance will be increasingly attractive to the majors.
TER: Do you have a target price on Sundance?
JH: The target price on Sundance Energy is AU$1.31/share, and it is
trading at AU$0.51/share.
TER: Thank you for your time, Johan.
Canaccord Genuity's Johan Hedstrom is an experienced energy analyst, having
started his career as a geologist. Since 1984 he has worked in funds
management, stockbroking and independent research. After a period as head of
research at two stock market research firms, he returned his focus to the
research of energy stocks in 2006, and joined Canaccord Genuity in 2013.
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