Australia's LNG Challenge: Russell

With commodity prices slumping, the local currency slipping and manufacturing jobs disappearing, Australians are starting to question whether they've backed the wrong economic horse.

The country's wealth and unbroken 24 years of economic growth have largely been built on exploiting natural resources and the happy coincidence of being close to China just as its demand for iron ore, coal and other minerals exploded.

But with China's growth slowing and many commodities in structural oversupply after resource companies over-estimated future demand, Australia finds itself facing some uncomfortable issues.

Liquefied natural gas (LNG) neatly encapsulates the problems facing Australia.

A combination of international and local companies have invested about $200 billion in the past few years to massively expand Australia's LNG capacity, building eight new projects.

This will more than quadruple Australia's output of the super-chilled fuel to over 80 million tonnes per annum, in the process overtaking Qatar as the world's largest producer and leaving regional rivals Malaysia and Indonesia far behind.

But much like iron ore and coal, it now appears that the demand forecasts for LNG that underpinned the projects were optimistic, and producers are likely to find it increasingly difficult to source buyers, especially for the part of output that isn't tied to long-term contracts.

Even the cargoes delivered into long-term contracts won't deliver the revenue that companies probably expected they would, given they are oil-linked and crude, in common with other commodities, has slumped and the outlook remains soft.

Asian spot LNG prices <LNG-AS> climbed to $8.10 per million British thermal units (mmBtu) in the week ended July 24, but this is down almost 20 percent from the start of the year and 60 percent from the record high of $20.50 reached in February last year.

While major LNG investors such as Chevron (CVX), Exxon Mobil (XOM), Royal Dutch Shell (RYDAF) and Australia's Santos wouldn't have expected prices of around $20 per mmBtu to sustain, they could reasonably have forecast around $12-$14 as a long-term price when they were making investment decisions in the past five years.

NOT ALL BAD NEWS
While the slump in LNG prices has no doubt weakened the economics of the projects and increased the length of time it will take to make positive returns, there are still positives.

Despite weak demand growth this year, longer-term forecasts are still bullish for LNG, even if they have been tempered from the wild exuberance of previous years.

ANZ Bank expects LNG usage in Asia will grow by 40 percent in the next decade on rising demand for cleaner energy.

This would allow Australia's LNG exports to triple to an annual value of more than A$50 billion ($36 billion), making the fuel the country's biggest export earner, overtaking current number one iron ore and second-ranked coal, the bank said in a report released July 23.

But rising LNG exports are also a double-edged sword for Australia as while they deliver export earnings and royalty taxes for the government, they will also cause the price of domestic natural gas to rise to levels linked to international prices.

This means domestic wholesale natural gas prices may almost double, which could lower aggregate profitability of gas-dependant manufacturers, such as chemical and metals, by 20 percent, according to ANZ.

While the bank says this means manufacturers must adopt strategies to mitigate higher gas prices, in reality this is likely to lead to further hollowing out of the industrial base.

The decade-long, China-inspired commodity price boom from 2004 onwards resulted in the Australian dollar surging to a record high of around $1.10.

In turn this put enormous pressure on import-competing industries, with the most obvious casualty being vehicle manufacturing, with the local units of General Motors, Ford and Toyota all announcing an end to manufacturing by 2018.

While lower commodity prices caused the Australian dollar to slip to $0.7290 in early trade Monday, the risk is that the LNG export boom once again renders industries uncompetitive, and once factories close they tend to close forever.

There are also no major LNG projects likely to be built after the current wave, given the poor outlook for prices and increased supply from the United States and potentially Canada, meaning the workers currently building plants will struggle to find new jobs.

PROJECT PIPELINE EMPTIES
This is also the case in iron ore, where the mining giants BHP Billiton (BHPLF) and Rio Tinto (RTNTF) have largely completed their expansion plans and are now seeking to cut workers in a bid to lower costs in response to low prices.

In coal, the same dynamic is at work, with serious question marks now being raised over whether the new projects in the Galilee Basin in Queensland state will actually proceed.

India's Adani has stopped development work on its planned A$10 billion Carmichael coal mine in the Galilee, increasing speculation it's preparing to walk away from the 40-million tonne a year project.

Australia also appears increasingly out of step with its global peers on climate change, with conservative Prime Minister Tony Abbott lauding coal while decrying wind farms as "visually awful", and ordering a government clean energy financing agency to stop funding wind and solar power.

However, the headline-grabbing issues don't quite encapsulate some basic realities.

Australia is the world's largest exporter of iron ore, and will most likely reclaim its top spot in coal from Indonesia in the coming years.

It will become number one in LNG within three years and while green activists may not like these commodities, demand for them is likely to remain robust for decades to come.

In the meantime, Australia is also likely to benefit from increased demand for agricultural products, as well as from export-orientated industries such as tourism and higher education.

It's worth remembering two things from Australia's recent history.

In 1980, former Singapore prime minister and elder statesman Lee Kuan Yew said Australians risked becoming the "poor white trash of Asia." His warning that reform was needed to open up and innovate the economy was heeded and instead of falling behind the Asian tigers, Australia managed to increase living standards.

At the height of the technology revolution hailed by former U.S. Federal Reserve chairman Alan Greenspan as a new economic paradigm, Australia was ignored by investors as an old economy, dominated by mining.

The tech wreck of 2001 and the rise of China brought the old economy back into vogue, but the challenge for Australia is once again to navigate the turbulent waters of the commodity cycle.

By Clyde Russell