Monday, July 1, 2013

Why Oil Majors Are Betting Billions on This Unattractive Market

From The Motley Fool
By Sarfaraz A. Khan
Research Assistant: G. Yousuf

Peter Voser, the outgoing CEO of Europe’s leading energy major, Royal Dutch Shell (NYSE:RDS-A), has announced his company’s plans to invest $30 billion in Australia over the next five years. Voser was speaking at the Australian Petroleum Production and Exploration Association conference. However, like other firms operating in the country, Shell is also concerned about rising inflation and increasing costs. In such an environment, the chief executive believes that the government must provide “the right regulatory and tax policies to drive innovation and investment.” Otherwise, Australia could lose about $100 billion in potential investment to other, more business-friendly regions. 
Most of Shell’s investment is focused on liquefied natural gas (LNG) projects. Shell is currently partnering with Chevron (NYSE: CVX) and Woodside Petroleum in Australian LNG projects. Shell has a 25% stake in Chevron’s massive $53.8 billion Gorgon LNG project and a 24.3% stake in Woodside Petroleum’s North West Shelf floating LNG venture (FLNG). Besides these two projects, Shell’s other upstream Australian LNG ventures are the Prelude FLNG project, Wheatstone, Browse, Sunrise and Arrow Energy.
The massive Gorgon project is now 60% complete. Chevron will start engineering and designing works for the expansion by the end of current year. At full capacity, Gorgon will pump 15.6 million tonnes of LNG each year. With the expansion, its annual capacity will increase to 20.8 million tons.
The Prelude floating LNG project in Australia, which will convert natural gas to liquid to be exported to the energy-hungry nations of Asia, is expected to be the first international energy project to use liquefied gas technology. When the project was approved in 2011, Shell gave a cost estimate of between $10.8 billion and $12.6 billion. Its Prelude floating gas rig is currently under construction in a South Korean shipyard.
Meanwhile, Woodside and Shell, after mulling abandoning the development of the controversial $45 billion onshore LNG plant at James Price Point, have signed an initial agreement to develop the Browse project, which will focus on floating LNG. The reason for the change is that the FLNG-Browse project is much more economical. Woodside has a 31% stake in Browse, while Shell has 27%. According to analysts’ estimates provided by Platts, the FLNG-focused Browse project would cost up to $36 billion, which makes it nearly three times bigger than Prelude.
While Shell has taken the lead in developing the world’s first FLNG venture, ExxonMobil (NYSE: XOM) is gearing up to develop the world’s biggest FLNG project off Western Australia. According to Australian Environment Department, the company will make a final decision by 2014 or 2015 and the project could start operations between 2020 and 2021. ExxonMobil plans to produce twice as much LNG annually from the venture as compared to Shell’s Prelude project. ExxonMobil has not given any cost estimates, therefore, I believe it is safe to assume that the project would cost the company significantly more than $12.6 billion.
There are uncertainties regarding costs of projects, which could be one of the reasons why ExxonMobil is not revealing the cost estimates.
Australia: Costs boom vs. LNG boom
Although Australia is on track to become one of the biggest producers of LNG in the world, currently, it is not an ideal place for oil and gas exploration.
Generally, the cost of developing an LNG projects are 20% to 30% higher in Australia as compared to other countries. According to the estimates of Bureau of Resource and Energy Economics, Chevron’s Wheatstone project’s capital costs are around $2.9 billion per million tonnes while a similar project in Southern Africa, the Angola LNG project, has capital costs of less than $1.7 billion per million tonnes.
In fact, the Financial Times has identified that it is the most expensive country when it comes to offshore exploration and production. According to the Business Council of Australia, in remote parts of the region, construction wages are between $120 and $200 per hour, significantly above the U.S. Gulf Coast’s average wage of $68 per hour.
The rising cost is the single biggest concern for energy firms operating in Australia. The region's oil and gas workforce represents some of the industry's highest paid workers in the world. A shortage of skilled labor and the strong Australian dollar are the main reasons behind cost blowouts of several LNG projects.
Chevron’s Gorgon budget inflated by 41% to $52 billion. Similarly, in Queensland, the BG Group and Santos have also faced cost blowouts in their LNG ventures while Shell is mulling abandoning its Arrow LNG project. Last year, Santos upped the budget for its Goldstone LNGproject by 15% to $18.5 billion while BG’s gas export plant in Queensland has seen its cost estimates rise by 36% to $20.4 billion.
Why Invest in Australia?
The current business environment in Australia for offshore oil and gas development is far from attractive.The Australian government needs to take Voser’s suggestions seriously, particularly since they are coming from the head of a firm that is one of the biggest foreign investors in the country. Even locals, such as Woodside Petroleum, are reluctant to give green signal to their ventures. A friendlier regulatory and taxation environment can allay some of the fears of energy firms that are investing billions in Australia. 
However, I believe that despite the financial challenges, oil majors such as Shell, Chevron and ExxonMobil will continue to invest heavily in Australia because of the overwhelming need to constantly find new reserves to remain competitive for the long term.
These companies are even willing to invest billions of dollars in politically challenging regions. For instance, both Shell and ExxonMobil are some of the leading investors in Iraq, which I have highlighted in a previous article. ExxonMobil is even working closely with the volatile semi-autonomous Kurdistan region in Iraq. Similarly, Chevron is betting billions of dollars on Argentina and its oil producer YPF to gain access to world’s second-largest shale oil basin. 
Therefore, Shell, Chevron and ExxonMobil are relatively riskier investments now than they were before as they are willing to take on political and financial challenges to bolster their reserve portfolios.
Benefits outweigh risks
There are also considerable potential rewards here as these riskier investments will improve their reserve-replacement ratios, which will ensure that the companies stay competitive for decades to come. Therefore, the benefits outweigh the risks, especially for Shell, which is one of the leading investors in Australia. The Australia region is considerably less challenging and has abundant natural gas reserves as compared to some developing countries. Moreover, there simply aren't that many places left to explore and the oil companies have few options but to hunt for oil in politically or environmentally challenging regions of the world. 
Shell, Chevron and ExxonMobil are going to move forward with their LNG development, particularly the more flexible FLNG projects. The companies may delay their final investment decisions or abandon some of the onshore projects but through more business friendly policies, the Australian government can offset the problems coming from higher operational costs. 
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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours of this publication. I wrote this article myself, and it expresses my own personal opinion. I have no business relationship with any company whose stock is mentioned in this article