Costs Spiral for LNG Projects

Russia, Iran, and Qatar control the largest natural gas resources in the world — enough to dominate the future business of shipping liquefied natural gas (LNG) to consumers around the world. But of the three, Russia and Iran don’t even show up as LNG exporters in the trade statistics. According to the latest BP Statistical Review, the three biggest exporters of LNG are Qatar, Indonesia, and Malaysia.

Russia and Iran have legacies of Marxist policies and generally have trouble getting along with their neighbors, so they haven’t exactly been fostering the type of environments that attract international investment. And investment is what they both desperately need.

Iran is a basket case, and as long as the clinically insane are running the show, the country is unlikely to attract the investments in technology and capital assets it needs to transform its natural gas reserves into a tradable commodity. But Russia is apparently open to foreign investment, as long as that foreign ownership is limited to small, non-controlling stakes.

Despite all the headlines of Russia confiscating big projects started by international oil companies, the country doesn’t want them out entirely. On July 9, BBC News reported that state-controlled gas giant Gazprom, after discovering how difficult and costly it would be, is sheepishly reapproaching the companies it had kicked out of the Shtokman gas project:

"Russian gas monopoly Gazprom has said it is close to pairing with foreign firms to start developing the world’s largest offshore gas field.

"The comments made by one of the firm’s top executives, Alexander Medvedev, mark a dramatic U-turn from its tough stance last year.

"Last October, Gazprom said it alone would exploit the untapped Shtokman gas reserves in the Barents Sea.

"Signing a deal would be a major boost for any of the overseas firms involved.

"Norway’s Statoil and Hydro, ConocoPhillips and Chevron in the U.S., and France’s Total had all been shortlisted as potential members of a consortium to start pumping gas from the strategically crucial Shtokman field on the ice-free Kola Peninsula.

"But Gazprom dealt them all a huge blow last October when its chief executive Alexey Miller said Gazprom would take control of 100% of the resources.

"The 1,400-square-kilometer field has the potential to become the world’s largest offshore gas field with 3.2 trillion cubic meters of gas contained in reservoirs 2 kilometers below the seabed — itself at a depth of 350 meters.

"The cost of the operation has been estimated at between $20-30 billion, which Gazprom would have to foot if it decided to go it alone.

"Mr. Medvedev [said] Gazprom was in talks with foreign companies to allow them to ‘share in the economic benefits of the project, share the management, and take on a share of the industrial, commercial, and financial risks.’

"This would be through overseas companies taking a stake in the company created to operate Shtokman, while Gazprom will retain control of the license to the field."

To place it into context, Shtokman’s estimated reserves of 3.2 trillion cubic meters translate to about 113 trillion cubic feet, or the amount of gas the entire U.S. economy consumed over the past five years.

This is a smart move on Gazprom’s part because the estimated development cost of $20-30 billion is probably a fraction of what it will ultimately turn out to be. Many projects that resemble Shtokman in scope and complexity are struggling with major cost overruns.

This plays right into the hands of companies like Chicago Bridge & Iron, Foster Wheeler, and the infamous Iraq contractor Kellogg Brown and Root (KBR — recently spun out of Halliburton). The stocks of these companies are expensive for good reason: They’re all big players in the engineering and construction of LNG liquefaction terminals, so their businesses will benefit as this market grows and continues to experience cost inflation.

Despite the fact that it’s proceeding at a slow and expensive pace, the continued growth in liquefaction capacity raises the possibility of the LNG market eventually looking like the oil market does today — with a few players dictating the terms under which they’ll export gas. Rumors of a planned OPEC-like natural gas cartel have even popped up in recent months.

But they are way ahead of their time.

In order for a gas cartel to develop, its members must control huge shares of low-cost global gas production and cooperate to suppress supply. Not to mention the fact that the majority of gas consumption would have to be shipped via LNG — rather than pipeline — so it can be sold to the highest bidder (like the oil industry). The LNG market may not develop to this degree for another 20 years, if ever.

Petroleum Review Sees Cost Pressure in LNG "Megaprojects"

Chris Skrebowski, editor of Petroleum Review, follows the progress of major LNG projects as closely as he follows major oil projects. Drawing from his observations of the Energy Institute’s IP Week conference, Skrebowski explains that the marginal cost of LNG is increasing rapidly:

"Considerable uncertainty remains for projects due to startup in 2010 and later. In the course of a presentation during IP Week, Andy Flower, an LNG consultant, produced a listing of projects that had been expected to get final investment decisions (FIDs) in 2006. This is because no FIDS have been signed off in the last 18 months."

Apparently, a lot of engineering and design work is under way, but companies remain hesitant to fully commit capital to liquefaction projects. Rapid increases in Greenfield construction costs have "reversed all unit costs reductions in the last 20 years. This means new liquefaction trains will have markedly higher unit costs than recently built ones."

Since Asian and European markets will experience growing demand for reliable supplies of seaborne LNG, the regasification terminals slated for construction on the Gulf Coast (primarily by publicly traded Cheniere Energy) may face the prospect of having to pay unprofitably high prices to import LNG to the U.S. "The problem is that the lack of new [liquefaction] projects is now certain to produce a supply shortfall around 2012 [emphasis added]. The time from [final investment decision] to first gas is normally around four years," writes Skrebowski.

U.S. Gas Supply Will Rely More Upon LNG and Drilling Activity

What does a potential shortage of LNG by 2012 mean for U.S. gas consumers? First and foremost, it means that the U.S. must keep drilling intensely on its own land to maintain the domestic gas production its home heating, electricity, and petrochemical industries rely heavily upon.

The big white space in this chart is the portion of U.S. gas demand that’s fulfilled by homegrown drilling. About 80% of gas demand is produced locally, while 17-20% is piped in from Canada (shown in blue) and 3-5% is imported as LNG (shown in red) — mostly from Trinidad and Tobago:

Zooming in to a smaller scale shows the trends since January 2001. Pipeline imports from Canada decline each year during the "spring breakup." When the ground thaws each spring in Canada, it becomes too soft to move around heavy drilling equipment, so production and exports to the U.S. temporarily decline:

But beyond the seasonal swings in gas imports from Canada, an important trend is emerging. I make note of it in the chart above. A growing share of Canadian gas production will be consumed by tar sands projects as production is projected to grow by a few million barrels per day over the next decade; this mined substance consumes a great deal of natural gas as it’s upgraded into useable fuel.

Furthermore, in its quest to cut down on carbon emissions, the Canadian government is pushing for the replacement of its coal-fired power plants with gas-fired plants. So what remains of Canadian gas resources may eventually be piped to domestic power plants, rather than exported to the U.S.

A final blow to U.S. pipeline imports: Gas supplies will continue to be limited as long as the Canadian rig count remains near the bottom of its five-year range. Last Halloween’s decision by the Canadian government to phase out the tax-favored status of energy trusts not only upset scores of income investors; it also dramatically curtailed drilling projects that are vital to sustain oil and gas production — and exports to the U.S.

So despite the fact that LNG imports have grown to satisfy about 3-5% of U.S. demand, this is no reason to expect gas prices to collapse. In fact, this 3-5% figure will have to double and triple in the coming years to compensate for lower Canadian imports.

Lastly, a look at domestic gas production (the maroon section of this chart) shows a flat trend since 2001. This has occurred even as the rig count has soared. So the U.S. will need a healthy, growing domestic drilling rig fleet to avoid shortages in the future:

Rising Drilling Intensity Reveals Need for Rig Fleet Overhaul

As many industry and government sources point out, the U.S. sits on plenty of untapped natural gas resources — especially "unconventional" gas. This is gas that’s "nonassociated," meaning it’s not a byproduct of oil production, and it requires more significant investment in fracturing and pressure-pumping services to start and maintain production. On the bright side, the best operators in unconventional plays experience drilling success rates north of 95%; so it’s more of a manufacturing operation than it is "wildcatting."

But the key aspect to remember about growing unconventional gas drilling activity is that it will require a large rig count and a growing oil field service industry.

In a Feb. 27 Strategic Investment weekly update entitled "Opportunity in Unconventional Natural Gas," I wrote:

"I constructed the following two charts to illustrate this rising trend in drilling intensity. This information is publicly available on the Web sites of the Energy Information Administration (EIA) and oil field equipment and service company Baker Hughes.

"The blue line is the Baker Hughes Natural Gas Rig count in the ‘lower 48’ United States, including offshore basins. By ‘gas’ rigs, Baker Hughes refers to rigs drilling for natural gas in U.S. territory. Out of the total U.S. rig count, gas rigs now comprise about 84% of active rigs, with oil rigs comprising the other 16%:

"As you can see, 10 years of monthly data refute the oft-repeated line, ‘Newly built drilling rigs coming online will lead to a glut of natural gas and cause prices to crash.’ This is cited as a reason why so many drilling and E&P stocks remain cheap.

"The second chart combines the two data sets from the first chart — it’s monthly U.S. gas production divided by the monthly rig count. A simple regression line shows a clear trend running from 3 bcf per month per rig 10 years ago to 1 bcf per month per rig in 2006:

"What conclusions can we draw from this chart? Well, it lends heavy support to the view that drilling demand will more than absorb any increase in the rig population. Most E&P companies are earning huge returns on invested capital at current gas prices. So they will bid aggressively to put newly built rigs to work on their drilling projects.

"Another conclusion? Just maintaining current natural gas production will require a steady uptrend in rig activity (the blue line in the first chart). This can be achieved by building more rigs and refurbishing the huge population of rusted-out rigs left over from the early 1980s drilling boom…

"So disregard headlines about the impending wave of new rigs destroying the drillers’ profit margins. Many will be put to work on unconventional gas projects where break-even gas prices are in the $2-4 per mcf range. Unconventional gas production is very drilling intensive because operators are seeing 60-70% production decline rates after the first year of production from a new well."

So what investment conclusions can we draw from the trends transforming the natural gas industry?

First, growth in LNG trade is important to satisfy demand. Most of the world’s largest gas resources are located far away from major population centers, as you can see by looking at the map of the Shtokman field. There’s no shortage of LNG shipping or regasification capacity at the moment, but there’s a growing shortage of liquefaction capacity. Once the billions are ultimately spent to build out this capacity, U.S. importers may very well have to outbid Asian and European customers for LNG. This makes U.S. gas drilling activity all the more important.

Second, since the existing land drilling industry was largely constructed during the early 1980s oil boom, most of its equipment is nearing the end of its useful life. Lots of new rigs are being constructed, but they’ll be necessary to replace those that are retiring. This trend is long lasting and will favor forward-looking rig operators and equipment companies.

Despite its week-to-week ups and downs, there’s a sustainable boom under way in manufacturing, refurbishing, and operating the equipment necessary to meet the demanding drilling environment of the 21st century.

Good investing,
Dan Amoss, CFA

July 11, 2007