In early December, Marathon Oil (MRO) announced a $5.2 billion capital budget for 2013 and ConocoPhillips (COP) plans to invest $15.8 billion in the next year. But the biggest announcement came from Chevron (CVX), which will make investments of $36.7 billion in 2013, which is 12% more than its planned budget for 2012--$3.3 billion allocated for its affiliates. About 90% of $36.7 billion will go towards upstream crude oil and natural gas exploration and production, while 7% will go towards downstream operations. These investment numbers are being inflated due to changes in the structure of the world economy since many of the projects currently under development were started.
A case in point is Chevron's massive Gorgon LNG project in Western Australia, the biggest natural resource project in Australia that aims to create one of the largest LNG facilities of the world. As anticipated, Chevron has announced that Gorgon will now cost about $52 billion, which is 40.5% more than its 2009 estimate of $37 billion. Initial LNG production targets from the facility have also been delayed from late 2014 to the first quarter of 2015. The rise in cost is attributed to several factors-- particularly the rising labor costs, weather delays and the strong Australian dollar. The USD-AUD exchange rate has climbed from $0.69 in early 2009 to $1.04 on 10th December. The country's currency has been growing stronger due to high demand for its raw materials, such as coal and iron-ore, from the energy hungry Asian economies.
The project is still somewhat profitable-- even with these cost over-runs -- due to oil prices, on which revenues will be based because Chevron has pre-sold so much of Gorgon's future production at past oil prices, which have also increased considerably, as indicated in the chart below. Moreover, the project's annual capacity has been increased by 4% to 15.6 million tons.
The problems with the large Australian LNG projects are industry wide and not just focused on Chevron. Other firms that are working on LNG projects in and around Australia-- such as the BG Group's Queensland Curtis LNG project and Exxon Mobil's (XOM) PNG LNG project-- have all increased their cost estimates citing similar reasons to Chevron's. Despite the rising oil prices offsets, Macquarie analyst Adrian Wood pointed out that the internal rate of return for the five large Australian LNG projects have fallen from 14.9% to 11.7%. Moreover, the changing market dynamics-- such as the Japanese firm Kansai Electric signing foreign LNG contracts that are based on U.S. domestic gas prices rather than the conventional oil price-based formula-- is making Australian LNG less lucrative in an increasingly competitive market.
These cost blowouts, coupled with new pricing formulas emerging in the market, mean that Chevron's investment is not going to be as lucrative as it was in 2009. If the price of Brent Crude (BNO) drops sharply -- not a likely scenario in our view -- projects like Gorgon could become albatrosses quickly. The Australian Dollar will likely maintain its current range between $0.98 and $1.05 to the U.S. Dollar as long as the Reserve Bank of Australia is not forced to adopt a zero-interest-rate policy similar to the Federal Reserve.
Although the Reserve bank of Australia has cut the interest rate -- for the fourth time this year-- to 2009 global financial crisis level of 3%, it is still one of the highest in the developed world. The brewing and bursting residential housing bubble may force the RBA's hand, however. The Australian government bond remains popular among sovereign investors as foreign ownership of these bonds has reached a record 76% this year. That is also becoming a crowded trade which can push things out of balance quickly. Nonetheless, there is very little Chevron can do except continue with its investment. As long as the cost structure for Gorgon does not deteriorate from here, the medium-term cross-currents for Chevron are solid as the Aussie Dollar will only strengthen appreciably from here on general U.S. Dollar weakness due to massive QE. This will push up oil prices faster than the AUDUSD cross, in effect offsetting or even improving Gorgon's profitability.