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Government of Western AustraliaDepartment of Mines and Petroleum

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Email: derek.perez@dmp .wa.gov.au

Dr MONahan MLAChairEconomics and Industry Standing CommitteeParliament HousePERTH WA 6000

( Dear Dr Nahan

PARLIAMENTARY INQUIRY - DOMESTIC GAS PRICES

Thank you for the opportunity to make a submission to the Committee's inquiryinto domestic gas pricing in Western Australia.

In relation to the development of gas resources in Western Australia theDepartment's primary role is to encourage andfacilitate responsible exploration,development and production of petroleum resources including those in theadjacent offshore area, in a timely fashion, for the long-term benefit of allWestern Australians.

The Department also has a role in the administration and collection of petroleumroyalties under State and Commonwealth legislation. Royalties collected foronshore projects are retained by the State Government, while offshore royaltiesare shared between the State and Commonwealth in accordance with therelevant legislation.

The Department does not have a direct role in overseeing issues relating todomestic gas pricing except to the extent that it relates to the collection ofroyalties. Within this context the focus is on the upstream price of gas ratherthan the range of prices that apply to the retail end of the domestic gas market.

The Department is also represented on the State's Strategic Energy Initiative(SEI), specifically in relation to developing a range of policy options to addressissues impacting on the future outlook for the supply and demand for primaryfuels in Western Australia.

As part of its input to the SEI the Department has undertaken an analysis of theoutlook for the supply and demand for domestic gas over the next twenty yearsand identified those options that may assist in addressing a possible shortfall insupply relative to projected demand.

Mineral House 100 Plain Street East Perth Western Australia 6004Telephone +61 892223333 Facsimile +61 892223862

www.dmp.wa.gov.auwa.gov.au

ABN 69410335356

Submission 18 - Department of Mines and Petroleum

The Department is of the view that the fundamental issue facing WesternAustralia is to ensure a sufficient and diverse supply of gas as part of a broaderprimary energy mix. However, although increasing the supply of gas wouldreduce the upward pressure on domestic gas prices, the Departmentacknowledges that the increasing cost to develop new fields and linkagesbetween the domestic market and the LNG market will also playa role in futuregas prices.

The attached discussion responds to gas pricing issues specific to theCommittee's terms of reference. The Department's current outlook on supplyand demand for gas in the domestic market, and its interrelationship with theLNG industry, are also discussed as this will have important impacts onupstream gas pricing.

The information provided is in confidence and is not intended for publicdissemination.

Yours sincerely

Richard SellersDirector General

2 July 2010

000173.derek.perez.docx - Perth Release Classification: - Addressee Use Only

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Submission to the Parliamentary Inquiry - Domestic Gas Prices

Introduction

Information on domestic gas pricing in Western Australia is difficult to acquiredue to the commercial sensitivity of the data and is held in strict confidence bysuppliers.

The bulk of domestic gas sales are tied into take or pay contracts which vary inquantity (less than 10 TJ/day to over 100 TJ/day), price variation provisions andlength of contract (which have been known to vary from 2 years to 25 years).Anniversary dates, quantities and renewal timing of these contracts affect thecalculation of average prices for domestic gas in Western Australia and it isimportant to , keep these factors in mind when comparing prices with otherjurisdictions.

Further, when seeking to understand gas pricing the issue of particular interest isthe likely direction and magnitude of change of expected future prices. That is,as the economy grows and the demand for gas increases what are the likelyprices consumers will face, and what impact will any upward changes have oneconomic growth.

As with most commodities a significant indicator for the direction of domestic gasprices is the future outlook for the domestic supply and demand. In addition,given Western Australia's current reliance on gas supplied from LNG projects,the timing and volumes to be made available from these projects is alsoimportant, as is the opportunity cost of providing domestic gas as opposed toselling the gas to LNG customers.

The discussion below first considers the current level of gas prices in WesternAustralia, other jurisdictions and its possible relationship to LNG prices. This isfollowed by the Department of Mines and Petroleum assessment of the currentdemand and supply outlook for gas in Western Australia. Based on this analysisit would be anticipated that future gas prices will be significantly higher than pastcontract prices.

Gas Prices in Western Australia

A range of gas prices exist in the Western Australian domestic market. Thewholesale prices available to major consumers of gas reflect the upstream priceof gas plus transportation costs. In the retail market the price of gas reflects notonly the wholesale price but the underlying costs of the retailer.

In addition, reported gas prices largely reflect historical contracts for gas ratherthan recent gas price contracts. Information about specific contracts iscommercially confidential and consequently publically available data is anaverage of old and new contracts.

The average wholesale price of domestic gas in Western Australia is currentlyaround $3.50/GJ. This compares with the retail tariffs faced by businesscustomers in the metropolitan region of around $19.00/GJ (at 6.77 cents per

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unit). Based on these prices the upstream price of gas represents only about 20per cent of the retail price (in this example). On this basis a doubling in the inputprice of gas to the retailer would, if fully passed on, lead to an increase of lessthan 20 per cent to the retail price.

Retail tariffs are outside the scope of activities undertaken by the Department ofMines and Petroleum and as such the remaining discussion will focus onupstream gas prices.

While current average gas prices of around $3.50/GJ reflect historical contractsindications are that recently negotiated new contracts for gas have increasedsignificantly. For example, anecdotal information from industry suggests thatthe gas price in the recent Woodside/Alinta agreement is in the range of $8/GJto $10/GJ.

Based on a Report in the Australian (January 2009) the deal between Santosand Citic Pacific for the provision of gas from the Reindeer field was based onan initial price of US$7.80/GJ (for first three years based on oil price ofUS$50/bbl) and a price linked to oil thereafter (an oil linked price would be aboutUS$14.00/GJ based on oil price of US$90/bbl).

The outlook for the supply and demand of gas to the domestic market(discussed further below) would suggest that as older contracts expire, and newcontracts are entered into, the average domestic price will increase towards aprice more in line with LNG netback1 prices (currently in excess of $7.00/GJ onnetback to Japanese LNG price), with some suggestions that the price will begreater if in the future producers take thenetback price as an input price todomestic gas processing plants.

It should however also be noted that even for gas not directly linked to LNGmarkets, such as the recent deal between Citic Pacific and Santos, suggestionsare that the price of gas is being indexed to oil prices (as is LNG).

Comparison to Prices in other States

There are a range of upstream prices in Australia both between and withinStates. This largely reflects the particular contracts between producers andconsumers.

For the December quarter 2009 prices in Queensland ranged between $2.48/GJ(Molopo) to $5.74 (Arrow). Nexus in Victoria realised prices of $3.41/GJ,whereas the AEMO reported that Victorian average daily spot prices for thefourth quarter of 2009 was $1.55/GJ.

1 Netback price is the LNG delivered price less costs associated with transport, liquefaction,regasification etc.

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A$/GjAverage Natural Gas Prices

---------------fl-_+_~

5 .00 ---.----------.------...-.--..--.---.-..- --.-....---.-------

4.75

4.50

4.25

4.00

3.75

3.50

3.25

3.00

2.75

2.50

2.25

2.00It) It) It) U> U> U> U> ..... ..... ..... ..... co co co co en en en cn

~0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0l!: Q.. .:. .!. l!: Q.. .:. .!. l!: Q.. .:. .!. l!: Q.. .:. .!. l!: Q.. .:. .!.

~G> G> IlJ

~Q> G> IlJ :::l CI> G> IlJ :::l G> G> IlJ

~CD Q> t'O

(J) 0 ::E (J) 0 ::E ~ (J) 0 ::E ~ (J) 0 ::E (J) 0 ::E- WAdomgas - East Coast domgas

Source: Argus Monthly LNG, EnergyQuest and DMP

The graph above attempts to average out these various contracts to give anindication of the relative prices between Western Australia and the East Coast.However, Western Australian prices are likely to rise due to the current supplydemand outlook and Western Australia's linkage to world LNG markets. On theEast Coast similar issues may arise, particularly in Queensland, with thedevelopment of LNG projects from their coal seam methane reserves.

Comparison to LNG Pricing

As with domestic gas prices a range of prices exist in our regional LNG market,both in terms of spot and long term contracts, and in terms of destination (Japan ,Korea, China etc). The majority of traded LNG is based on long term contracts.The details of which are confidential. Published LNG prices are a reflection ofthe terms of these contracts at the time they became effective and are anaverage over all contracts.

By far the major consumer of LNG in our region, and the world, is Japan.Historically long term contract LNG prices paid by Japanese consumers havebeen linked to oil prices via the S-curve formula (conceptually this is illustratedbelow). In Japan the relevant oil index is the Japan Customs-cleared Crude(JCC). Although the exact formulae used in long-term LNG contracts areconfidential, utility traders say they tend to take an average of three months ofthe JCC, lagged by a month. Using published JCC crude and LNG prices since2004, a slope of about 0.11 (~arity is considered 0.1485) and a constant ofabout 1.25 gives a fairly good fit .

2 http://www.lngpedia.com/japanese-Ing-contract-prices-yet-to-reflect-oil-plunge/

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Conce tuall GPrice Indexa ion toCrude Oil S...Curve Ap red in Some of

Ja an's Long-te rn Contracts

JCCQ'I Price(US$JbarreI)

'o\u''C : Davi \ ooel ~ ' -. riat

On this basis, and assuming a long term average oil price of US$80/bbl, thecurrent netback price for domestic gas in Western Australia would be in thevicinity of $A7.15/GJ, depending on the exchange rate.

Supply and Demand Outlook for Domestic Gas

With an overwhelming volume of domestic gas consumed by the mining,manufacturing and electricity generation industry, future growth in demand isdependent on the extent to which new projects are developed and/or expanded.Precisely forecasting future growth in domestic gas demand is therefore difficult,with significant demand increases usually dependent on the go-ahead of only ahandful of large mineral processing or manufacturing projects. The lumpynature of investment in these projects, changes to project status and timing canresult in significantly different gas consumption forecasts.

The methodology adopted by the Department to determine its gas demandscenarios was based on aggregating the projected energy demands of knownState projects over time, with some allowance for the probability they willproceed. The supply of gas was determined by summing existing supplyagreements (State Agreement gas from Northwest Shelf and Gorgon projects),and anticipated gas from the development of new fields either for domestic gas(as in the case of Macedon and Reindeer), or for LNG with a 15 percentreservation applied.

The chart below illustrates the notional outlook for gas supply and demand forWestern Australia based on the above methodology. A complete description ofthe assumptions and analysis underpinning this chart are provided inAttachment 1.

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Y, !!lOlllOU101410 161016

Western Australian Domestic Gas Demand and Supply Out look (TJID) (a) (b)

400

200 - -----------------------•••--

TJ /D

2.200 rr======::;--------------r========;-~

1.200

Hi m w poly K ,n!do"W2:000 =~::PIYhUJt0 400T)/d

by1 016 .

1.600 Worn> lOllHo/yanI/Sp w IOUBra..... 1023

1,600 5cwt>orou;h lOB

1,400

(

2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2025 2027 2028 2029 2030

- l ow dem.md - Reference demand - High demand -lowSupply - - - High Supply I~Iot. ,

(I ) OJomlnd p r~j Kti :t1 S cUI :lo n krIown major TI S:::lu r: t l l :t:lr Pr.::I}lttJ ..n~ ~:luMS ,::ric••ff t :u. GISc:) nlun"'l;:J't1~ urd ¥ tr. . r".r¥lca s:.".ri;lb projt :t~ t o , raw by3 .5 ," p l r Yllr OV-Il' t ht: out look p. nod

(b) SU;::JI:J !y fOrtt lst s t n. don In ;:;..,npet~ti ill sourt.s.. Su ppty fT'omprojt ::tssud' I S Plub IMd \Vhl l tst on , sub j.::tto tOtnnw rda lviabiit.y.

Source: Department of Mines and Petroleum

As with any projection there is a level of uncertainty in estimating future demanddue to the lumpy nature of the growth in domestic gas consumption. Further,approaching an analysis of the domestic gas market in the way described above,although providing a more quantitative understanding of the situation, canoverstate the demand outlook and understate supply. This is because it does nottake into consideration changes in gas prices. Aggregating all possible demand(for gas) irrespective of price, results in latent or notional demand beingdetermined. In order to understand effective demand an analysis of the impactof various prices on demand outcomes needs to be undertaken. That is, fromthe demand side price plays a part in bringing supply and 'effective demand' intobalance. However, in terms of supply, in Western Australia price plays a lesssignificant role for reasons outlined below.

A higher price of gas will act to curb demand to a point where supply andeffective demand are in balance. However this will be at the expense of somedomestic economic growth. It is clear that for the low supply scenario (in thegraph above) there will be a growing shortage of gas supply over notionaldemand from 2012 to 2030. That is, the growth in notional demand will betempered by higher prices and so the effective demand for gas is likely to belower. However, it is clear that under the low supply scenario, of around 1,200TJ/day from around 2020 demand would exceed supply at even the mostmodest levels of economic growth and consequently gas demand growth.

This analysis highlights that the primary concern with respect to gas in WesternAustralia is the supply of gas, with price largely reflecting an excess of demandover known supply. This is however not the complete story with respect to thedomestic price of gas which also relates to the interaction of the domestic gasmarket with the LNG export market.

As can be seen from the supply side trends, Western Australia is heavily relianton obtaining domestic gas from existing or proposed LNG projects, either

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through commitments under State Agreements, or through the States GasReservation Policy. The domestic price of gas is likely to have only a marginalimpact on the supply of gas from these projects due to the scale and risk ofdeveloping LNG projects. In essence the focus of LNG projects is to developLNG markets and contracts, not the domestic gas market.

Nature of the LNG Industry and the Supply of Domestic Gas

By contrast with oil, developing LNG projects requires specialised facilities ' forliquefaction in the exporting country and regasification in the importing country,linked by a fleet of specialised ships. Committing to an LNG export facilitywithout having secured a buyer(s) (with import capacity and adequate transport)represents an enormous risk. Consequently, LNG projects are only undertakenafter meticulously planning from the development of the gas field to the gasdistribution grid in the importing country.

To reduce the risks and enormous costs involved in financing an LNG project($43 billion for Gorgon) a number of participants are usually involved in a jointventure arrangement (although the contribution of each participant in the jointventure is substantial). This further encourages projects to reduce risks as muchas possible by locking in buyers, import capacity, and transport before finalinvestment decision is made. As a consequence the LNG market is dominatedby long term bilateral contracts which are usually put in place at projectinception.

Average incremental domestic demand growth for gas in Western Australia in ayear represents about one percent of the output from a project such as Gorgon.As such, it is likely that from the perspective of a specific LNG joint venture,incremental domestic demand, irrespective of price, will be largely irrelevant inbringing on the supply of gas required to establish an LNG project.

Exacerbating this situation , the long term (10 to 20 years) nature of LNG supplycontracts, creates the possibility for the majority of the gas supply, from aparticular project, to be contracted away prior to the incremental domesticdemand becoming effective.

In addition, the growth of the overall LNG market in Western Australia is verylumpy leading to a lack of liquidity in the domestic gas market. For example, theonly new LNG projects since the original Northwest Shelf are Pluto and Gorgon,with the timing of any other projects uncertain. Consequently, the concern is thatthe mismatch between the lumpy development of LNG projects and the'relatively' gradual growth of domestic demand for gas may become exacerbatedby gas being locked up in long term LNG contracts.

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Measures to reduce Price

From the analysis above the main issue confronting Western Australia is thesupply of gas, with price largely reflecting a possible lack of supply, althoughexposure to the LNG market is also a factor. The broader issue of primaryenergy security is being examined by the Department as part of its input to theStrategic Energy Initiative.

On the supply side the Department has been working to facilitate thedevelopment of onshore unconventional gas as a means of increasing supply. Inthe U.S. unconventional gas production, which was just beginning 20 years ago,is now producing 400/0 of total gas supply. This has put downward pressure ongas prices in the U.S.

In Western Australia the development of unconventional gas is initially expectedto be more expensive than historical conventional gas prices but about the sameas new contract conventional gas. Conventional offshore sourced gas costshave risen because the easier, cheaper fields have already been developed andnewer fields are more expensive to develop.

The Department is also involved in facilitating the development of undergroundcoal , gasification (UCG) to syngas. UCG has the potential to significantlyincrease the utilisation of a coal resource by gasifying currently uneconomic andotherwise un-mineable deep or thin coals. The development of coal gasificationtechnologies, with associated carbon capture and storage, is also beingexamined as part of the Collie-South West C02 Sequestration Hub concept.

The use of coal both directly, and indirectly via the production of syngas, can beviewed as a means of either, reducing overall demand for conventional gas, orincreasing the supply of substitutes. Although to some extent this would reducethe domestic demand pressure on conventional gas supplies as noted earlierthis is only one factor in determining future gas prices.

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