Exxon's Weapon of Gas Destruction

By LIAM DENNING
Wall Street Journal
June 25, 2009

ExxonMobil has a loaded gun pointed at the U.S. natural-gas market -- and it isn't the only one.

The ammunition is liquefied natural gas. Exxon is scheduled to start up another three LNG projects in Qatar this year. They will produce more than 3.0 billion cubic feet per day of natural gas and freeze it for transportation. Europe and Asia are potential markets. But the U.S. could be a magnet for LNG cargoes, despite not really needing it -- a paradox that spells low prices.

LNG is joining up the world's hitherto largely regional natural-gas markets just as demand is faltering. Declining natural-gas production in countries such as the U.S. and U.K., and rising energy prices, prompted LNG production and receiving terminals to sprout on coastlines around the world.

Two things have turned this scenario on its head. One is recession. The other is the development of unconventional natural-gas resources in the U.S., leaving it over-supplied for now. Several Wall Street analysts expect inventories to reach the maximum capacity of around 3.9 trillion cubic feet later this year.

So why would anyone ship LNG to the U.S.? In part, it's simple economics. Many projects were sanctioned and financed when lower natural-gas prices prevailed.

In Exxon's case, valuable liquids also produced in its Qatari projects take the market breakeven price of the natural gas itself "towards zero," says Deutsche Bank analyst Paul Sankey. Factoring in processing and shipping costs, that gas can be landed in the U.S. for less than $2 per million British thermal units, reckons Noel Tomnay, head of global gas at Wood Mackenzie. The current Nymex price is about $4.

Competing markets also look oversupplied. Wood Mackenzie estimates annual demand in Asia east of India will rise by 1.3 trillion cubic feet by 2015. New projects targeting the region and close to final investment decision amount to more than two trillion cubic feet of capacity.

In Europe, the prevalence of long-term pipeline contracts limits the size of the market up for grabs. Wood Mackenzie estimates about 4.9 trillion cubic feet of discretionary piped and liquefied natural gas per year will compete for a market half that size over the next three years.

The U.S., with its large, liquid natural-gas market, will be a natural destination for this surplus LNG. As a cap on prices, this effect of globalization in the natural-gas market is great news for customers.

In a buyer's market, though, higher-cost sellers suffer. A big increase in low-cost LNG supply would displace some U.S. natural-gas production. The average U.S. field requires a Nymex natural-gas price of $7.79 per million BTU to earn a 10% return on capital, according to Jonathan Wolff at Credit Suisse.

Yet, as Mr. Wolff points out, natural-gas drillers' capital expenditure is still outpacing cash flow, as it has since 2006. The number of operating natural-gas rigs actually rose last week.

Increasing globalization means a bigger range of factors affect U.S. natural gas and the fortunes of its producers. An extended spat between Russia and Ukraine this winter, for example, would help draw more LNG cargoes towards Europe.

Barring this, prices and drillers will likely remain under pressure. A question haunting the sector is why majors like Exxon have not rushed in to scoop up distressed companies sitting on large U.S. natural-gas reserves. The answer may be that, with more LNG pointed at already weak markets they can afford to take time, and take aim.

Write to Liam Denning at liam.denning@wsj.com