Why Santos’ David Knox is bullish on LNG

It is rare to find leading analysts covering an industry to be completely at odds with the chief executive of the major player. That’s why you will find the KGB interview with Santos chief David Knox, to be published later today, so fascinating.

Knox says his massive Queensland coal gas and Curtis Island LNG plant is a winner. The analysts, led by Macquarie, say Santos is unlikely to cover the cost of capital on the Curtis Island/Queensland coal gas venture and they give the Santos shareholder stake a token value.

The Knox KGB interview was undertaken just before the recent conflict in Iraq broke out – a situation that is bullish for oil and gas prices and may block the remarkable plans of Shia-dominated Iraq and Iran to treble oil output by 2020. This would damage the position of Sunni-dominated Saudi Arabia and would reduce Australian oil and gas prices. This is part of the background to the events in Iraq, which are likely to see the Middle East map redrawn (The fallout from the Middle East's deadly oil game, June 11).

In terms of Santos, Macquarie and the analysts point out that the Russian gas contract with China equals Australia’s total output and the Russians can almost double production and deliver that higher production at a low marginal cost. Although Australian LNG producers have long-term contracts, history tells us when a major exporter reduces the price it creeps into all pricing. The Santos project is high on the global cost curve and is vulnerable. And certainly any new contracts must be at the Russian price level. Australia’s enormous costs of construction mean that it will be priced out of the market in terms of new projects. Macquarie rates the Santos stakes in the Cooper Basin, WA and Papua New Guinea much more highly than its Queensland operation.

As you can imagine, I questioned Knox closely on these issues. In essence his assumptions are totally different to the analysts’.

First, Knox believes that there is going to be an enormous rise in China’s demand for gas and so the Russian gas contract will be just part of a very large mix. China will not want to be too dependent on Russia, and even though the Russian price delivered to Beijing is lower than Australian LNG, it is not that much lower.

Knox says that because the demand growth will be so large there will be new contracts available and Australia can compete when extending existing operations – so-called ‘brownfields’ expansion.

The Santos chief says that construction costs are set to fall 20 to 30 per cent as the boom subsides. He did not mention it but the Australian government’s actions to break up the cartel-style agreements between big builders and unions must be helping.

So who is right? I am an admirer of David Knox and I certainly hope he is right. And I suspect he might be right because China needs to breathe better air, and gas can deliver. But if Knox is right, coal will take another hammering.