with Jeff Dowling, Australia Partner and Oil and Gas Sector Leader, Ernst & Young Australia
In the 2009 Ernst & Young Business Risk Report for oil and gas, access to reserves, uncertainty around energy policy, and price volatility were listed as the main risks facing the global industry. Given the events of the past six months in Australia, what would you say is the new, uniquely Australian risk paradigm facing oil and gas companies in this country today?
The major risk paradigm in Australia and Western Australia (WA) is the regulatory environment and the potential changes in the resource rent tax that could evolve. We already have a petroleum rent tax which is applicable to offshore resource reserves other than the Northwest Shelf Venture which operates under a separate framework. Uncertainties remain as to whether the government intention to include onshore coal seam methane (CSM) under an extended PRRT regime applying to onshore projects will eventuate. There are significant doubts as to how the whole tax regime will evolve and if indeed it will evolve.
The Labor party is in power at the moment and wishes to continue to pursue the extended petroleum resource rent tax (PRRT) and broader MRRT. The Coalition is against an extension of the resource rent tax regime in any way. There is a lot of uncertainty with respect to where it will land in the medium term.
What you will find is that many of the companies involved in the industry have projects in potentially different tax regimes. Some will have a project in the Northwest Shelf, another offshore project which is also intended to be subject to the extended PRRT, and perhaps involvement in CSM in Queensland where different rules could apply to it. There is still a lot of uncertainty. This uncertainty has considerably changed the risk profile with respect to some developments .I do not think there will ultimately be a deal breaker. I believe that any changes to the tax regime will likely be passed on to the consumer one way or another whether it is a domestic or international consumer. But it will cause uncertainty and it will change projects’ development timeframes until people get a better understanding of how they can bring these projects on.
Leading up to the Henry Tax Review, did Ernst & Young foresee an event like this happening? Was this part of the “worst-case scenario” of your various models?
I do not think many saw this coming because there was no consultation process with industry prior to it being announced by the previous Labor government after the Henry Tax Review had provided its report. Since then it has principally been a process of private negotiation which resulted in the revised announcement prior to the election. It has not been a particularly visual process at the government level in terms of industry being able to get involved. That may well change, however. The new Labor government has said that they will more actively consult with industry and stakeholders will be able to put their views forward. This has started with the formation of the Policy Transition Group and their release of an Issues Paper and consultation program.
What was the proposed super profits tax’s impact on Ernst & Young’s operations? How did you adapt to the wave of companies looking for clarity on the tax’s implications on their business?
There was a narrow, communication on how the RSPT would be calculated. It basically suggested a 40% tax on profits above the bond rate. Based on that limited amount of information we assisted companies in trying to assess their tax position whether for an existing project already operating or a development project and what that might look like. We assisted in interpreting the tax consequences of that announcement on their projects and then tried to help them work that through their business modeling, cash flow models, and project valuations. All of that was based on very scant information. Companies were struggling for a clear sense of what it meant for their business.
Generally, we saw the market taking the worst-case scenario of what it might mean. It was a difficult time for companies to try and make proper sense of the implications, particularly if they had a suite of projects across various potential jurisdictions.
The revised MRRT and extended PRRT regime announced on 2 July and the release of the Issues Paper have assisted in somewhat narrowing the scope of uncertainty, though it still exists today, however. We do not know what the ultimate make up of any new resources tax regime will look like, or whether it will even pass into legislation. Those uncertainties still exist.
Is there any difference in terms of fiscal clarity between April 30, 2010 and October 1, 2010?
There is no difference. While there is some additional direction being provided, there is still no clarity as to the final outcome. Not just with oil and gas, but across the entire resources industry in Australia, there is still that uncertainty as to how this will work its way through the negotiation and legislative process. That is the difficulty companies are facing at the moment. Oil and gas companies are reaching final investment decision on many projects. When you have a significant uncertainty it will clearly affect your ability to make those decisions. The result will be that it will likely delay decisions until there is more certainty.
If we can turn our attention, please, to CSM in the east which is drawing a lot of attention and investment from many of the major oil and gas companies. Will 2011 be the year for mergers and acquisitions (M&A) as driven by this new asset?
Looking specifically at CSM in Queensland, there are effectively four consortia all trying to build LNG trains in Gladstone. It is unlikely that there will be four separate developments. I think the market’s view is that two developments will get up. The reason being, the more trains you can build at once, the economies of scale kick in much faster and the return on investment is so much greater. Natural economics and return on investment will drive M&A at the project level in some form or another in Queensland. I think the industry anticipates that there will be two consortia. and these consortia will effectively build one or two HUBS in Gladstone.
Who do you opine is best positioned to lead the consortia?
To answer that properly requires a very strong insight into the portfolios of each of the major companies. The global players want to be positioned in CSM because it is a new source of gas. BG, ConocoPhillips, and Shell are all significant players in the Queensland CSM space as they are in the conventional gas space. They want to be players in CSM. I do not think they are likely to give up their interests in the projects. But they may bring some of their interests together with others and form a larger joint venture purely driven by the economics of the development of the infrastructure to liquefy the gas and export it. How that eventuates depends very much on the majors and where the projects sit in their global portfolios.
What about for the junior companies? Are you anticipating many of them getting acquired simply because they lack the financial wherewithal to monetize their assets on a profitable scale?
That would probably be one of their key strategies – to get their projects to a certain value and then get taken out by one of the majors who already have the infrastructure in place to liquefy and export the gas. That would be a clear strategy for a junior and very consistent with the strategies adopted by smaller resource companies in Australia. One of the major components of the resource value chain right across Australia is for juniors to get assets to a point of value and then sell them to a larger corporation to develop.
You also have to realize that if some of these consortia come together, they will have substantially large gas reserves. They might not necessarily need the reserves of a few junior companies to sustain their projects. At a commercial level, I think the main game at the minute in the CSM space is the rationalization of the four consortia. That will depend on who has the offtake agreements in place.. Then it becomes an economics question based on whether they will get better returns by joining with another consortium and jointly developing a liquefaction facility. That can be done a number of different ways – joint venture, unitization, or even a separate company that just owns a plant and tolls the gas for each of its constituent shareholders.
Market exuberance in mid-cap CSM companies is driving up their valuations. However, CSM-to-LNG has never been done before so there are inherent risks involved. Is this exuberance justified by all of the investment from the majors and the confidence they are instilling in the market?
That is typical of how a market values an emerging opportunity. The gas is there, in the coal seam. It is not as risky as exploration in unexplored acreage. It may not be proven out because it takes a lot of drill holes to prove it over these massive coal seams. The reserves that are eventually proved will not be proved up front but will be proved up as the projects mature.
The markets take the view that these juniors potentially have significant additional reserves. I suspect that the market anticipates that CSM in Queensland will be a really powerful and strong industry once developed. At the moment you would suspect that long term world demand for gas and where the gas sits in Australia will make both Queensland and WA significant suppliers to Asia.
What is the business portfolio role of oil and gas for Ernst & Young in Australia and the role of Ernst & Young Australia within Oceania?
Our Oceania and Asian practices are now fully integrated. Effectively, in Asia-Pacific we have created three hubs to service the oil and gas industry: WA, Singapore, and Beijing. We are rapidly developing one in Queensland to support the CSM industry with a lot of support coming from WA since that is principally where our oil and gas capability resides in Oceania at present.
The way we see our practice developing to support the growth of the industry is to replicate how the industry has developed HUBS across the Asia Pacific region. An upstream business in WA and Queensland, a trading business and marine support services business in Singapore, and a specialist full service OGAS business to support the NOC buyers in Beijing, greater China and the rest of ASEAN. We have evolved into three hubs with oil and gas specialists across our disciplines in those three locations to provide a seamless service between the producers, buyers, traders, and support services.
The reason we have taken a hub approach is to replicate what our clients do in developing their hubs for oil and gas. In our case it is hubs of expertise to service the industry. We do not want to have little pockets of people spread throughout the region. We are trying to align ourselves in the same way that our global clients align. Shell is a very good example of this. Shell has relocated its upstream business in Oceania to Perth. They also have a trading hub in Singapore and they are interfacing with customers – the national oil companies – in Beijing. All of the global majors are doing the same and we are replicating our business model accordingly.
What would you like to grow for Ernst & Young in the Asia-Pacific oil and gas industry?
We are very comfortable with our position in oil and gas in Oceania. What we want to do and the whole purpose of our Asia-Pacific integration is to build a stronger and tighter relationship with our Chinese and Asian firms so that we can service clients in a seamless way. Our business model is a totally integrated partnership across the region. We then have a natural commercial reason to work as one. That then assists us in being able to take our upstream expertise into Asia and assist clients in growing and thus provide our Australian expertise into a much larger market.
Are there any final messages that you would like to convey to our readers about Ernst & Young?
Oil and gas in Australia is a really exciting place at the moment. There are so many things happening and it is giving WA an enormous amount of exposure to the world. We are the most isolated capital city in the world. Besides the financial benefits to the community and the country that come with oil and gas, the industry is really putting Perth, Western Australia, on the map in a global sense. That is one of the great benefits of what is happening with oil and gas at the moment – it is profiling WA and the city of Perth to the world. It is also bringing a lot of expatriates into WA and assisting in making our community far more global and cosmopolitan. The oil and gas industry being a global industry is really helping drive that cultural change in our society and it is a benefit that should not be underestimated. It is really changing Western Australia.
Australia does seem to be the right place and right time for oil and gas. Our colleagues in Brazil informed us that at a recent trade fair there was a lot of talk and attention devoted to Australia. International eyes are indeed fixed on this country.
Australia needs to be conscious of Brazil. Admittedly, I do not know a lot about Brazil other than what I have heard from my global colleagues but Brazil also presents a lot of Oil & Gas opportunities to the world. It is welcome and open to global companies to develop these opportunities. Australia, by its fiscal regime or the words of its leaders, cannot give the impression that we are not as open. Developments will naturally flow to the countries that are welcoming. That is not to say that proper sharing of the profits of resource developments across our society is not the right thing to do. But let’s first make the profits before we worry about how to share the profits. Let’s make the cake before we try to cut it up.