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?
"The Australian oil and gas industry is dominated by a series of big investments in new LNG projects."
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?
"If WTI stays at about $50/bbl, it will be difficult for companies to generate the elevated returns they had projected."
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.
"The Cooper Basin in central Australia is the most active area for oil and gas drilling."
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.
"China and other Asian countries are trying to increase the gas proportion in their energy mixes."
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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