On February 17, 2014, when British Columbia Minister of Finance Mike de Jong was asked what the industry might say about his government’s proposed liquefied natural gas (LNG) tax, he responded, “Of course they want zero.”
The industry followed in kind. “We’ve been clear that the rate needs to be globally competitive if B.C. is to build an LNG industry, and we’re concerned the top end of the range won’t achieve that level of competitiveness,” Shell Canada Ltd. spokesman David Williams told the National Post.
But a study prepared by Ernst & Young Global Ltd. for the B.C. Ministry of Natural Gas Development shows that British Columbia has one of the lowest combined royalty and tax rates among competing jurisdictions in North America. The tax won’t change that. So, what gives?
It’s a long and cautionary tale.
Whereas in times past, provincial taxes and royalties might have made a material difference to a major project’s outcome, those times are gone.
Geoff Morrison, B.C. spokesman for the Canadian Association of Petroleum Producers, likely said it best: the LNG tax proposal “brings us one step closer to some clarity. That’s encouraging, but it’s more complicated than just the tax.”
The simple fact is that even if British Columbia’s royalties and taxes were zero, it likely wouldn’t be a major determining factor in whether these projects go ahead. The province’s fiscal policies are just the tip of the iceberg.
The natural gas market is going through rapid change, not just in North America, but globally. Who will be left standing when all is said and done is very hard to determine.
U.S. natural gas production is up. Way up. Marcellus producers are muscling out competitors from Texas to Alberta. Pipelines are being reversed. And despite sitting atop a world-class unconventional gas resource of its own in the Alberta Deep Basin and Montney and Horn River formations, Canada can do little to nothing about it.
As Peter Tertzakian, chief energy economist and managing director of ARC Financial Corp., said in a column in the Globe and Mail, “The erosion of eastern markets represents a collapse of a supply chain that for almost six decades had been as predictable as a telephone landline.”
The response in B.C., of course, has been to push for market access to Asia, and that means LNG. But the LNG market is very different from the North American gas market, and those differences matter. Here is how it differs, and what we can be done about it:
1. The LNG market is smaller than you think.
LNG supplies 10% of global natural gas demand. In total volume terms, it is half the size of the U.S. market. Asian delivered volumes account for about 60% of global LNG trade.
2. The LNG market is not a competitive market.
In the LNG market, gas-on-gas competition is not the status quo. Oil-linked long-term contracts are the norm. Prices are not generally disclosed.
U.S. merchant LNG project developers are starting to change this dynamic, with Cheniere Energy Inc. (Nasdaq:LNG) having signed contracts for its Sabine Pass LNG project that are tied to Henry Hub gas prices. The buyers pay a 15% premium to Henry Hub, plus a fixed processing cost. This is the first time that the LNG plant owner hasn’t owned the natural gas value chain back to the wellhead and will rely on gas market supply instead.
So far, LNG proponents and potential buyers in Canada have not entered into a similar type of arrangement, with several buyers preferring an integrated upstream supply chain, where they own everything from the LNG plant back to the wellhead.
3. Developing LNG facilities takes a long time.
Many factors influence the development timeline. On average, regulatory approvals take one year to 18 months. After that, construction averages three to four years for a brownfield site and five to six years for a greenfield site. None of the B.C. LNG project developers has made a final investment decision. All projects, except for Woodfibre LNG, are to be built on greenfield sites. Only the Kitimat LNG project, jointly proposed by Chevron Canada Ltd. and Apache Corp. (Nasdaq:APA), has received all of its regulatory approvals. It is, therefore, highly unlikely that any B.C. LNG project will deliver its first cargo of LNG prior to 2020.
4. Prior to 2020, U.S. exporters are likely to be king.
This supremacy has little to do with a comparative advantage of geography or resource, but rather is due to a colossal over-investment in import infrastructure just a few short years ago.
The United States has 132 million tonnes per year (17.4 billion cubic feet per day) of idle LNG import capacity, built at a time when forecasts were that America would be chronically short of natural gas. Many more were proposed. Many are making their way through U.S. Department of Energy and Federal Energy Regulatory Commission (FERC) approvals processes.
Sabine Pass LNG was the first to go. It is under construction, and its owners anticipate delivering their first cargo sometime in 2015. Freeport LNG Development LP is still waiting for its FERC approval but expects to start construction this year and go live sometime in 2017.
5. Post-2020, B.C. has potential, but cost will be an issue.
Analysis by RBC Capital Markets puts the total integrated supply cost of Canadian projects at between US$11 and US$13 per mmBtu (at a 15% pre-tax internal rate of return, landed in Japan), comparatively more expensive than projects in Western Australia, the U.S. Gulf Coast and Qatar.
With Japanese LNG prices between US$15 and US$16 per million British thermal units (mmBtu), a $2 cost disadvantage might seem like a small thing. It is not. Japan is paying more than any other Asian nation for its LNG, and its economy is paying for it with record deficits. Meanwhile, China is paying between $10 and $12 per mmBtu. The Japanese government and its utility companies have been clear that, going forward, they want to be paying LNG prices that are much closer to China’s.
6. Australia’s high cost history could well be B.C.’s future.
Australia is a vast country with a small population. It has had to build LNG projects in remote locations with little or no supporting infrastructure. There is hypercompetition for in-country resources, in particular for skilled labour. In other words, it is just like B.C.
Australia is in the middle of building seven projects at once. In their efforts to gain a first-mover advantage, developers there played a game of one-upmanship, outbidding each other for labour and supplies and refusing, until late in the game, to work together on shared infrastructure. The whole thing was further exacerbated by competition from the mining sector, which was experiencing a boom of its own and also looking to source local labour and supplies. As a result, costs have gone through the roof.
As a consequence, according to analysis undertaken by Brian Songhurst, a research associate with the Oxford Institute for Energy Studies, the Australian LNG projects will go down as some of the most expensive LNG projects in history.
7. B.C.’s proposed tax is likely less important than foreign exchange and gas price fluctuations.
A lower Canadian dollar can cut both ways. On the one hand, much of the big equipment that is used to build an LNG facility is procured offshore and paid for in U.S. dollars. On the other, local labour costs are paid in Canadian dollars. The overall impact on project economics depends on the split. Meanwhile, project developers will be doing everything they can to avoid natural gas price increases (also priced in Canadian dollars) and price volatility.
8. B.C.’s proposed tax is likely less important than what Russia does.
Asia, in particular China and India, has alternatives to Canadian LNG. This includes inland gas resources from Russia and various central Asian republics, such as Turkmenistan, and LNG projects, most notably Yamal LNG. So far, Russian and Asian buyers have had difficulty coming to terms, but if differences could be resolved, the market for any LNG, from B.C. or elsewhere, will be significantly reduced.
9. A robust and competitive Canadian natural gas market that includes LNG is not preordained.
International oil companies, most notably Royal Dutch Shell PLC (Nasdaq:RDS) and BG Group PLC (Nasdaq:BRGXF), are in the middle of shedding assets and cutting costs. It doesn’t take a rocket scientist to anticipate that even if they are committed to B.C. LNG over the long run, these projects may be cancelled or delayed.
If this happens, then a plausible scenario could be that facilities backed by either or both Petronas (Nasdaq:PNAGF) and CNOOC Ltd. (Nasdaq:CEO) would be the only ones to go ahead in the near term. In their filings with the National Energy Board, both of these companies indicated that they planned on using their own proprietary gas reserves, sourced from their subsidiaries and/or investment partners. They do not plan on sourcing gas from the market. If this future becomes the reality, independent producers will have little or no access to Asian markets through B.C. export terminals.
Geology knows no borders, and yet the Canadian debate is functioning as if it did. The focus is on how provincial jurisdictions might maximize their own benefits and not how they might reorient their natural gas infrastructure across the Western Canadian Sedimentary Basin so that producers can take advantage of the best that both the North American and Asian markets have to offer. It’s not B.C. versus Alberta, it is Canada versus the world.
Western Canada’s shale and tight gas resources are mostly in northeastern B.C., distant from the Pacific Ocean, with the Rocky Mountains in between. There are no connecting pipelines and (perhaps understandably, given the alternatives) few people have chosen to live where the wells or LNG facilities are likely to be.
The solutions, if not simple, are relatively well known. There are the familiar strategies of outsourcing the construction of large industrial equipment to Singapore and Seoul, but it needs to go beyond that.
Skilled-labour training needs to start now, and supporting infrastructure needs to be planned for and shared, to support the long-term economic benefits that LNG facilities have the potential to provide.
The global natural gas market is changing, and B.C. is well positioned to take advantage of these changes. If only it would start talking about the right things.
