Giving up the Liquid Link

Liquefied natural gas (LNG) represents a $1 trillion opportunity for the province of British Columbia. Billions of dollars will need to be invested into natural gas wells, pipelines, and natural gas liquefaction facilities over the next 25 years to fully realize the value of BC’s massive natural gas reserves. Though it is still a few years before meaningful quantities of LNG will be shipped off the BC coast, energy companies of all types are rushing to position themselves best in the race to take advantage of Canada’s LNG potential.

LNG 101

In order to ship natural gas across oceans, it must be liquefied and loaded onto special boats – it is too expensive to build a trans-ocean pipeline. Cooling natural gas into LNG and shipping it across the ocean is still very expensive, costing roughly $3.80/mcf (thousand cubic feet) for Canadian LNG facilities selling to Japan, a large existing market. Cooling and shipping natural gas to Asia is a very expensive proposition which has traditionally made it uneconomic for producers who could sell at attractive prices domestically. More recently though, the North American price of natural gas has been depressed, and prices in Asia have been very high, over four times the natural gas price in Canada. Canadian natural gas producers have been eying lofty Asian natural gas prices enviously, and the price differential means LNG has very compelling economics.

The Asian Opportunity

In order to sell natural gas in Asian markets, billions of dollars need to be invested in the pipelines connecting Canada’s gas supplies with BC’s west coast, and the LNG facilities to cool the natural gas and load it onto tankers. A project led by Apache, a large American petroleum company, and Chevron, who bought out the project’s other two partners in January, were the first project to receive its export license in October 2011. Originally hoping to have made a final investment decision in early 2012, the decision has been delayed indefinitely, awaiting a long-term oil-linked contract with Asian buyers. Traditionally, LNG contracts signed by Asian buyers (primarily Japan and South Korea) have been linked to the price of oil, as natural gas could in many cases be burned instead. An oil-linked contract would have yielded LNG prices of $16-20/mcf in 2012 as an example (assuming a slope of 0.16).

One of the things an oil-linked contract implies, and one of the reasons that Asian buyers have been reluctant to give one to Chevron/Apache, is a high price. While the exact slope of the oil-link is negotiated, in a 2011 Macquarie report, recent oil-linked LNG contracts occurred at slopes of 0.14-0.16 ($16-$18/mcf average 2012 LNG price). Apache likely believed that they too could replicate those prices for their project, but was rebuffed because their price was too high (natural gas deals with the Russians have likely not occurred for the same reason). LNG buyers were savvy enough to notice that a long-term LNG contract at current prices, would give windfall profits to anyone shipping natural gas from North America. No buyer would be interested in securing massive profits for a seller, especially knowing they are currently accepting lower returns on other projects. While the addition of Chevron as a partner is a boon for Apache’s project – Chevron is a massive oil company, experienced in building and operating LNG facilities and contracting their volumes to Asian buyers, there are indications that Chevron is taking the same negotiating approach as Apache did. In a recent conference call Chevron’s CEO was quoted saying that LNG projects need contracts that are “something close to oil parity or the projects won’t get built.”

BC’s Crowded Coastline

While the Chevron CEO’s comments are likely posturing (a deal could probably be done yielding a wellhead price twice what they need to drill their gas wells), they must realize that time is of the essence for their project. The BC coast is going to become crowded with LNG terminals under-construction toward the end of the decade. Chevron and Apache’s project originally had a 2-3 year lead over competing projects, but delays in signing an appropriate LNG off-take contract has nearly removed all of that advantage. Losing that time advantage hurts Chevron/Apache on two fronts, 1) Chevron/Apache will be competing with at least two other very large LNG projects for labour and materials which will present significant pressures on construction costs, 2) Chevron/Apache will be bringing their LNG to market around the same time as many other LNG projects, weakening their bargaining position on sales price. The longer Chevron/Apache goes without a deal, the more their project is going to cost, and the more competition they will face in the global LNG market place – there are several LNG proposals in Canada, and dozens more in the Middle East, Russia, Australia and even the US. If Chevron/Apache does not want to play ball on price, then LNG buyers will take their business to someone who does.

A Better Strategy

Chevron/Apache need to understand that they are not going to get long-term contract at $16-20/mcf for their LNG project; $12/mcf is much more reasonable. Instead of an oil-linked contract, one linked to natural gas prices in western Canada with a $7-8/mcf premium, could potentially work out to be just as beneficial in the long-term. As LNG projects come on stream, western Canadian natural gas prices should increase as new gas is shipped directly to Asia instead of entering western Canadian markets like it does now.

If Chevron/Apache are so concerned that this type of contract structure will reduce their margins, there are things that they can do to lower their costs. Perhaps the single biggest thing they could do to lower cost is to divest its $1 billion pipeline – Chevron/Apache are the only large LNG terminal owners that are also building their own pipeline to their terminal. All other terminals have brought in a more experienced pipeline company with a lower cost of capital to permit and build their pipelines for them (Pipe Dreams, Fall 2011). By selling their pipeline, a significant capital cost and construction risk will be eliminated. Chevron/Apache will be able to invest the proceeds from the pipeline sale into assets that generate cash flow like oil and gas wells. The other big benefit is that Chevron/Apache will likely also pay less to ship their natural gas from the wellhead to their LNG terminal (due to the pipeline company’s lower cost of capital and more experience at controlling capital costs).

Chevron/Apache need to sharpen their pencils and negotiate a fair contract with Asian buyers if they want to make this project work. Prior to Chevron’s January 2013 arrival, ownership wasted away the projects competitive advantage seeking a windfall that never materialized. The addition of Chevron brings size and experience to the project that the previous ownership did not possess; potential customers will believe this project has greater certainty and will be more likely to provide a contract. Time is of the essence for this project. It would be unwise for Chevron to not use its skills and expertise to advance the project, instead wasting time with the same unsuccessful approach as previous ownership. If they don’t, their project’s customers and therefore economics might disappear entirely.