Image 20150915 16968 r7ahep.jpg?ixlib=rb 1.1

Woodside’s failed Papua New Guinea power play shows the growing desperation in the gas sector

Woodside has been hoping to tap into cheaper gas reserves in Papua New Guinea. AAP Image/Kim Christian

Woodside’s failed Papua New Guinea power play shows the growing desperation in the gas sector

Woodside’s failed A$11.6-billion acquisition of Oil Search Ltd is a sign of both desperation and wider trends in the oil and gas industry.

Woodside’s interest in Oil Search is based on the fact that the latter is one of several companies, alongside ExxonMobil and Santos, who are jointly developing gas with the Papua New Guinean government in PNG.

Typically, a business strategy for an oil and gas company is to seek projects in regions with stable governments, to minimise their risk. What is evident from Woodside’s interest in Oil Search’s onshore gas activities is that it is seeking much cheaper and easier-to-extract assets, at the expense of the political stability that is usually a requirement.

PNG is seen by many as a risky partner – it has by many measures been a fragile state since gaining independence from Australia in 1975.

Linking oil to LNG

At the dawn of the international trade of liquefied natural gas (LNG) in 1958, when the first shipment was sent between Lake Charles Louisiana and the UK, setting a price for this new commodity was difficult. It wasn’t until 1964 that the commercial trade in LNG began, when the CAMEL project shipped gas from Algeria to the UK and France.

The high costs of entry and the small number of suppliers meant that a suitable contract price for the long-term supply of LNG was set with reference to the prevailing oil price.

The price of LNG in the Asian market is set by an index link to the oil price known as Japanese Customs-Cleared Crude (JCC, also called Japanese Crude Cocktail). This oil-indexed price is largely driven by the potential to substitute oil for gas into Japan’s fuel supply. The oil index linked S-Curve contract regulates prices to protect consumers during periods of high oil prices while also protecting producers during low oil price ranges.

Japanese S-Curve Contract prices. Adapted from Global Natural Gas Markets Overview: A Report Prepared by Leidos, Inc., Under Contract to EIA (www.eia.gov/workingpapers/pdf/global_gas.pdf)

This S-Curve pricing model is what attracts oil and gas companies to Asian markets. With a $5-6 price spread between the average production cost plus transport and liquefaction of conventional onshore gas like the resources of PNG, an arbitrage opportunity is always enticing. The contract has also been a driving force for the export of US natural gas to Asia, especially when oil prices are high.

Benchmark Natural Gas Prices. Energy Information Agency, US Department of Energy

Saudi Arabia’s weapon of choice

Global oil prices have now dropped by more than half since June 2014, when Saudi Arabia forced up production in a bid to push out expensive US shale oil and gas producers from degrading their market share – a move that could be described as predatory behaviour similar to that of The Standard Oil Company in the late 1890s.

This overt use of oil supply has driven down US oil production and shut down more than 50% of US oil rigs, thus achieving one of its goals of marginalising US shale oil.

Global oil prices dictate acquisitions

Global oil and gas companies are always searching to diversify their portfolio of cheaper conventional resources, regardless of the prevailing oil price. During periods of high prices the hunt is on to find new reserves from previously undeveloped countries. Low construction costs and minimal royalties will offer the lowest marginal cost of additional gas.

Conversely, when oil prices dive, the expensive and risky operations of exploration and development are passed over for acquisitions of undervalued assets that have already either begun production, or have at least proved up their resources.

This is certainly the case with Woodside seeking to acquire the stake of Oil Search in PNG’s natural gas sector. It offers a cheaper, more conventional source of natural gas, which is both onshore and relatively easy to extract when compared with Woodside’s own current operations in Australia.

Furthermore, its offer for Oil Search’s shares in the PNG joint venture at a significant discount to their long-term potential revenue further demonstrates the urgency involved in the prospective deal.

Woodside is a cashed-up and well-oiled operation, with low levels of debt and a notoriously risk-averse management. The decision to shelve the onshore processing facilities at James Price Point (near Exmouth in Western Australia) was largely driven by concerns over the cost of construction and the higher Australian dollar, and it opted instead for the relatively new processing solution offered by a Floating Liquefied Natural Gas (FLNG) facility co-developed with a multinational oil conglomerate of Shell, BP, Petro China and Mitsui-Mitsubishi. These concerns are particularly poignant now, given this relatively sudden move to acquire a stake in PNG gas.

Furthermore, while the original intention of the FLNG plants was to break even in the short term and healthy return above 15% on the outlook things are still not looking good for the northwest Australian development.

In desperate times, oil majors have sought out lower-cost, riskier developments. In this case, PNG is not a safe bet. With a largely unstable political system and deep-seated corruption, PNG has been long derided as the next failed state in the region.

Furthermore, all developing nations with a sudden influx of foreign capital are subject to the Natural Resource Curse, which can result in declining domestic manufacturing and weakening economic conditions. PNG is no exception.

But this is one side of the corporate deal. The other exposes the revenue given to the PNG government for their resources. The development of PNG’s natural gas resources by its partners (Shell, Exxon and Nippon Oil) has brought a cash injection to the region. This has given the PNG government a unique position to recover a high share of profits from their ownership of Oil Search.

In summary, it’s clear that energy companies will accept risk to reap the rewards from mining natural resources. The conversation needs now to turn to who is really benefiting from these activities.