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Western Australian Domestic Gas Prices

Submission by Alcoa of Australia to the Parliamentary Inquiry

July 2010

Submission 24 - ALCOA

WA State Parliamentary Inquiry - Submission by Alcoa of Australia

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Contents

1. Executive Summary .............................................................................. 2

2. Background .......................................................................................... 5

2.1 Alcoa in Western Australia ................................................................... 5

2.2 Contribution to WA Energy Infrastructure ............................................. 6

2.3 Aluminium and Alumina Demand ......................................................... 8

2.4 Competitively Priced Energy is Critical for the Alumina Industry .......... 9

2.5 WA Natural Gas Supply and Demand ................................................ 10

2.6 Natural Gas Globally .......................................................................... 10

2.7 Conclusion .......................................................................................... 13

3. The price for Natural Gas in Western Australia .................................. 13

4. Price Comparisons ............................................................................. 14

4.1 International Prices ............................................................................. 15

4.2 Alcoa’s Middle-East Case Study ......................................................... 15

4.3 East Coast Gas Pricing ...................................................................... 16

5. LNG Pricing ........................................................................................ 18

6. What Can be Done to Reduce Prices ................................................. 20

6.1 Energy Security Policies around the Globe ........................................ 20

6.2 Reservation Policy .............................................................................. 22

6.3 Retention Leases ................................................................................ 24

6.4 Promote the Development of New Gas Supplies................................ 25

6.4.1 Gas Basins .............................................................................. 25

6.4.2 Targeted Gas Exploration ........................................................ 26

6.4.3 Unconventional gas ................................................................. 27

6.5 Promote Competition .......................................................................... 28

7. Conclusions and Recommendations .................................................. 29



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1. Executive Summary

Natural gas is vital to the Western Australian economy. For mining and mineral processing operations natural gas has been the dominant energy source with pipelines feeding the industrial hubs into the south-west, mid-west and north-west of the state. Natural gas is also the main source of energy for electricity supply to the state. Historically, competitively priced natural gas has been a source of competitive advantage for exporting industries in Western Australia and one of the reasons for locating their businesses in the region.

Alcoa of Australia (“Alcoa”) is a vertically integrated aluminium producer with alumina refining processes in the south-west of Western Australia, aluminium smelting and rolling operations in Victoria and rolling operations in New South Wales. Energy is integral to each of Alcoa’s operations.

In Western Australia (where natural gas is Alcoa’s principle energy source) Alcoa has a long history with the development of the natural gas supply chain. Alcoa’s requirements for natural gas underwrote the early development of the Perth Basin followed by the North West Shelf in parallel with the development of the Dampier to Bunbury Natural Gas Pipeline (DBNGP). In 2004, Alcoa partnered with Alinta to develop gas- fired cogeneration power stations at Alcoa’s Pinjarra and Wagerup alumina refineries which now supply up to 15% of the state’s electricity requirements. Today, Alcoa is a 20% owner of the DBNGP and is continuing to invest heavily in new sources of gas supply, already committing $40 million to help explore the Canning Basin and up to $100 million to develop unconventional gas sources in the Perth Basin.

Alcoa has become very concerned about the sharp increase in price for natural gas in Western Australia. Not only does it significantly increase the cost of living and doing business in Western Australia, it erodes one of Western Australia’s competitive advantages.

Alcoa welcomes the Parliamentary Inquiry into domestic gas pricing and looks forward to the recommendations from the committee.

Gas Prices in Western Australia are Rising Significantly

Alcoa sources its gas supply directly from producers in the north-west of the state, however does from time to time purchase gas from producers in the Perth Basin. Historically, WA gas prices have been in the A$2-4/Gigajoule (GJ) range and have been relatively stable with low levels of pricing volatility.

Alcoa has significant market experience in Western Australia and has been trying to source gas supply for the expansion of its Wagerup refinery as well as incremental growth and for future contract roll-off. Whilst these



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discussions are confidential, Alcoa confirms that producer expectations have significantly shifted away from historical pricing. Given the growing number of Liquefied Natural Gas (LNG) export projects which link LNG price to oil price it is also not surprising that producers would be looking more closely at the domestic gas price and increasing its linkage to oil price. This would put gas price expectations in the range of A$8-16/GJ depending upon oil price and the exchange rate. At these prices, expansion of Alcoa’s refining operations in WA won’t occur and Alcoa will have to look at other energy sources such as coal to substitute gas contract roll offs for existing operations.

Prices for new gas in Western Australia are more expensive than Eastern Australia

The Eastern Australian wholesale gas market is characterised by:

Over 100 companies involved in gas and oil exploration and around 35 gas producers.

The six major producers supplied around 71% of the domestic market in 2008/09.

Santos and BHP Billiton each supplied around 17%, followed by Esso (12%), Woodside (12%), Origin Energy (9%) and Apache Energy (5 %). The next tier of players in terms of market share include BP, Chevron, Beach Petroleum, Shell and BG Group.

The main gas hub into Victoria is through Longford, where wholesale pricing has been in the range $3.85-$4.20/GJ (source: Energy Advice), however spot gas prices are more in the range $2.00-4.00/GJ (source: AEMO).

Gas Prices are Determined by Regional Markets.

Whilst export gas markets (LNG) are seen as the alternative market for gas producers in Western Australia, exporting industries located in Western Australia look more broadly at the energy costs of competitor countries. Competitor countries often have other competitive advantages such as lower costs of labour and capital. Recently, Alcoa Inc announced the development of its Ma’aden JV project in Saudi Arabia to build an integrated bauxite mine, alumina refinery, smelter and rolling facility. Saudi Arabia has the advantage of very low energy prices, low labour and low capital costs. Western Australian projects like Alcoa’s expansion at Wagerup will have to compete with this and other global projects for future capital.

LNG links Western Australia more closely with the energy poor countries of Asia, where energy costs are very high. Prices for LNG delivered into Asia are often linked to the oil price, however the strength of the linkage depends on when the contracts were negotiated. Some cargoes into Asia



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have oil prices capped at US$30/bbl limiting delivered gas prices to <US$3/GJ, whilst more recently cargoes could be selling under long-term contract for US$11-18/GJ. In Western Australia, at these prices Alcoa would need to consider alternative energy sources such as coal.

Action is Needed in Multiple Areas to Reduce Domestic Gas Prices

Alcoa strongly supports the State Government’s desire for a state energy strategy. The benefits of having an energy strategy include providing investment certainty (both downstream and upstream), allowing for more efficient allocation of resources, and positioning the government and industry to respond to the challenges of climate change. Alcoa believes the following elements are critical in any state energy strategy.

i) Recognition that the ongoing availability of competitively priced natural gas to domestic users is a significant competitive advantage for the state and is of fundamental importance to the state’s economy.

ii) Development of new domestic gas supplies through targeted exploration and the reservation of gas produced from fields targeted for LNG development.

iii) Removing some of the regulatory burden to ensure efficient development of the necessary infrastructure to bring on new gas supplies.

iv) A commitment to work with the Federal Government to ensure more rigorous reviews of natural gas Retention Leases.

v) Encouraging the Federal Government and the ACCC to ensure that competition in the wholesale gas market is maximised through individual selling arrangements for new projects.



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2. Background

2.1 Alcoa in Western Australia

Alcoa is Australia’s leading alumina producer and has driven the development of the aluminium industry in this State for over 40 years.

Alcoa operates the world’s largest integrated alumina refining system in Western Australia comprising:

Facility Production Capacity Jobs

Kwinana Refinery 2.1 million tpa

4200

Kwinana Port 3.6 million tpa

Pinjarra Refinery 4.2 million tpa

Wagerup Refinery 2.5 million tpa

Bunbury Port 6.5 million tpa

Huntly Mine 18 million tpa

Willowdale Mine 7.5 million tpa

Alinta Cogen Unit One 140 MW 15

Alinta Cogen Unit Two 140MW 15

Alinta OCGT Unit One 175 MW 10

Alinta OCGT Unit Two 175 MW 10

DBNGP 900 TJ/Day 240

These operations produce over 8 million tonnes of alumina a year, or around 13 per cent of world demand, making the state the world’s largest producer of alumina.

Alcoa accounts for 8 per cent of the state’s exports, with exports to the world’s fastest growing economies, including China. The alumina industry generates over $3 billion a year in exports for Western Australia.

The industry makes a significant value-adding contribution to the state. Alcoa supports local communities through employment, training, support for local businesses and sponsorships.



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Alcoa provides direct employment for over 4000 people in WA (employees and contractors), predominantly in regional areas. Over 1100 West Australian tradespeople have also been trained by Alcoa through its apprentice program.

Alcoa spends over $1 billion a year on wages, royalties and local businesses in the state. Alcoa’s operations create over $1.7 billion in direct and indirect value-adding.

In 2005 Alcoa invested to expand its Western Australia operations with a $580 million Pinjarra refinery upgrade. Alcoa has actively considered expansion of its Wagerup refinery; however this is now on hold due, in part, to the lack of long-term domestic gas supplies.

Alcoa’s bauxite reserves can sustain current capacity for more than the next forty years ensuring continued contributions to the state economic well being.

2.2 Contribution to WA Energy Infrastructure

Alcoa is a major contributor to state energy infrastructure enabling the growth and sustainability of local and regional communities.

Alcoa’s operations in WA started in the early 1960’s. The primary fuel source at that time was fuel oil. Fuel oil was relatively low cost and was the typical fuel for alumina refineries globally. Fuel oil was shipped into Alcoa’s Kwinana port for use at the Kwinana refinery and railed to the Pinjarra refinery.

In 1971 gas flowed from the Perth Basin gas fields into Alcoa’s newly constructed Pinjarra refinery and its operations at Kwinana. With oil price shocks in the 1970’s and 1980’s Alcoa realised that in order to remain competitive and grow its business in WA it required a more stable priced fuel source.

In the 1980’s Alcoa’s requirement along with the State Government underwrote the development of the North West Shelf gas fields and development of the Dampier to Bunbury Natural Gas Pipeline (DBNGP). In 1984 first gas flowed down the DBNGP into Alcoa’s refineries at Kwinana, Pinjarra and the newly constructed Wagerup refinery. Since this time Alcoa’s operations in WA have continued to grow, underpinned by cost competitive gas supplies (see Figure 1).



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Figure 1: Alcoa’s alumina production in WA in millions of tonnes per annum. First gas supplies flowed into Kwinana and Pinjarra in 1971 and into Kwinana,

Pinjarra and Wagerup in 1984.

Alcoa currently accounts for around 40 per cent of the gas supplied to the South West of the state and about 25% of the state’s total gas requirements.

Alcoa joined a consortium to buy the Dampier to Bunbury Pipeline for $1.8 billion to release the pipeline from receivership and to enable expansions of the pipeline in a timely manner to meet domestic requirements. The consortium has committed a further $1.8 billion to expand pipeline capacity since its purchase in 2004.

Alcoa’s operations have also supported the development of other gas production operations, such as the original development of the Perth Basin and Parmelia gas pipeline, Beharra Springs, Tubridgi, Griffin and the fields associated with the Varanus Island, that have made a significant contribution to the state’s energy market.

In 2007 Alcoa contracted with Arc Energy (now known as Buru) for the supply of gas from gas exploration in the Canning Basin. Alcoa also made a $40 million pre-payment for these supplies. This innovative arrangement underwrote exploration of this relatively underexplored frontier basin. Recently, Mitsubishi has provided further support for exploration in this region committing up to $150 million.

In 2008 Alcoa formed a Joint Venture with Latent Petroleum to appraise and develop tight gas in the Warro gas field in the Perth Basin. If successful, this will be Western Australia’s first gas field based on tight gas.

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Alcoa partnered with Alinta Energy to build gas-fired cogeneration power plants at Alcoa’s Pinjarra and Wagerup refineries. The plants produce both electricity and heat from the same fuel source, delivering significant energy efficiency and greenhouse benefits.

Each cogeneration unit at the Pinjarra refinery supplies 140 megawatts of power, enough to provide the power needs of 90,000 households. With Alinta’s open cycle gas turbines at Wagerup, Alcoa hosts 15% of the State’s electricity needs. Energy is supplied to WA households and businesses directly through the South-West grid. Alcoa’s own refineries are already the largest cogenerators of energy in Australia. Alcoa’s cogeneration capacity could be expanded by up to 1000 MW to supply environmentally friendly power to the SWIS. Power supplied from these units would have a thermal efficiency of 75%, which is superior to alternative combined cycle gas or coal fired electricity generation.

2.3 Aluminium and Alumina Demand

The global demand for aluminium is expected to grow at 3.7% pa, more than doubling current requirements by 2030. This will be driven predominantly by growth in China (see Figure 2) but also by the increased use of aluminium in applications (particularly transport) which improve energy efficiency due to the light weight nature of aluminium.

Figure 2: Global primary aluminium consumption (Source: CRU)

The production of alumina and aluminium is energy intense, so Alcoa is continually looking to improve energy efficiency in it operations, not only through technology and process improvements, but also through the use of lower carbon fuel sources. Alcoa recently built a smelter in Iceland which is powered by hydroelectricity. This new smelter produces around 10% (350,000 tonnes) of Alcoa’s aluminium output. More than 60% of



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Alcoa’s aluminium production globally comes from electricity produced by hydro.

Global expansion in alumina production through greenfield and brownfield refinery expansions will be required to meet the significant demand expected for aluminium. The state’s ability to globally compete for this growth will depend on certainty over long-term competitively priced energy supply.

Alcoa recently announced it has formed a joint venture with Ma’aden, the Saudi Arabian Mining Company, to develop a fully integrated, world-class aluminium industry in the Kingdom of Saudi Arabia. The complex will utilize critical infrastructure, including low-cost power generation (see section 4.2)

To date Alcoa has a great track-record of growing and expanding its operations to meet global needs with a 5% pa year on year growth since 1972 (see Figure 1).

2.4 Competitively Priced Energy is Critical for the Alumina Industry

Alcoa is the state’s single largest user of natural gas and access to competitively priced energy is critical for the future success of Western Australia’s alumina industry.

The alumina industry is energy intensive, with the cost of energy representing 20-30 per cent of production costs.

Alcoa’s existing operations in Western Australia need to compete globally. Access to reliable and competitively-priced energy is therefore critical for the ongoing competitiveness and sustainability of Alcoa’s operations in Western Australia, and any future investment by Alcoa in the state.

Uncertainty over the price and availability of gas will have a direct impact on the state’s attractiveness as an investment destination for the global aluminium industry, compared to national and global locations (see Figure 3).

Figure 3: World Alumina Production (Source: International Aluminium Institute)

Africa North America

Latin America

AsiaWest EuropeEast Europe

Australia



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2.5 WA Natural Gas Supply and Demand

There have been many analyses provided on the supply and demand fundamentals for the WA natural gas market. Alcoa has formed its own view on the supply and demand outlook for WA based on its knowledge of the Western Australian gas market (see Figure 4). Alcoa has taken a relatively conservative view on growth between now and 2020, in part due to the lag effect of the global financial crisis. Previous studies assume that NWSG JV and Apache JVs will keep producing gas at current levels well into the future. Alcoa believes that most of the existing John Brookes, Harriet and Reindeer reserves will be exhausted by 2020 – the only material volume to remain contracted is for the Burrup Fertilizer plant. NWSG has continued to contract LNG supplies beyond 2020, however Alcoa understands that their longest term domestic contract concludes in 2020. As a result Alcoa in its analysis reduces the volumes being made available to the market from both the Apache JV’s and NWSG JV.

This analysis clearly shows that there is a significant shortfall by 2020.

Figure 4: Supply and Demand Outlook for WA Domestic Gas (Source: Alcoa)

2.6 Natural Gas Globally

Australia has less than 2% of the world’s natural gas reserves. Australia has 89 trillion cubic feet (TCF) of proven conventional reserves most of which is found in Western Australia (see Figure 5). To put this into perspective, the USA alone uses 25 TCF per annum.

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Much of the world’s natural gas reserves are held by national oil companies (NOC) controlled by the governments of the country holding the reserves (see Figure 6 and Figure 7). Australia and the USA are the only two countries that have open access principles in which international oil and gas companies (IOC) have full access to the reserves. This makes Australia an attractive destination for IOCs.

Figure 5: Global distribution of natural gas reserves – Australia has less then 2% of the world’s reserves.

Figure 6: Global distribution of natural gas reserves – Only 8% of world’s natural gas reserves are available to international oil companies on a full access basis.



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Figure 7: Global distribution of natural gas reserves – Australia and the USA are the only two countries that allow full open access to their oil and gas reserves.

With the development of LNG, gas is becoming increasingly more of a globally traded commodity (see Figure 8). The major trade routes are from Russia to Europe, Canada to the USA and the Middle-east into Asia.

Figure 8: Global trade routes for natural gas (billions of cubic metres) (Source: BP Statistical Review 2009, Oil and Gas Journal)



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2.7 Conclusion

Mining and minerals processing industries like Alcoa play a vital role in the Western Australian economy and their competitiveness depends on long-term competitively priced energy supplies.

Australia has less than 2% of the world’s natural gas reserves and is one of only two nations that allow full open access to its oil and gas reserves, making it very attractive for international oil and gas companies.

Any reduction in the availability of gas for domestic use, or a significant increase in price for domestic natural gas could result in:

Reduced competitiveness of important refining and manufacturing export industries, such as the alumina industry, with flow-on impacts on employment, economic activity, investment and development.

The loss of greenhouse-friendly cogeneration opportunities. The State currently offers significant potential for gas-fired cogeneration. The loss of such opportunities will significantly undermine the state’s efforts to reduce greenhouse emissions and respond to climate change.

The need for increased use of significantly more greenhouse-intensive fuels such as coal or oil. While renewables and emerging technologies may become available in the future, they do not provide a practical near-term alternative to gas.

A significant rise in the cost of natural gas and electricity to residential and small business users, negatively impacting household incomes and standards of living.

3. The Price for Natural Gas in Western Australia

The WA gas market is broadly broken into two sectors, the wholesale sector and the retail sector. At the wholesale level companies directly contract with producer groups, whilst at the retail level aggregators like Alinta and Synergy supply gas supply to households and small and medium sized businesses.

Wholesale gas sales have been dominated by NWSG which has a 70% market share and the Apache JV’s which have a 30% market share. Historically, the WA wholesale market has been made up by long-term contracts; many of these are legacy contracts from the foundation North West Shelf Gas agreements.

Under the original agreements which had gas and transportation bundled together, there was the duel notion of coal competitive gas and oil competitive gas pricing structures, depending on how the gas was to be used. Alcoa’s refining process uses natural gas for its powerhouses to produce steam and electricity and fuel for heat in the calcination process for producing the final product alumina. Natural gas for calcination was



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considered to be oil competitive whilst the power stations were seen to be coal competitive. As a result Alcoa originally had a dual pricing structure for its gas supply, partly linked to oil price and partly linked to coal price. During the 1990’s a new contract was negotiated, the price and pricing formulae are confidential. This contract is due to terminate during 2020.

The majority of Alcoa’s gas supply is sourced from the state’s north-west. Alcoa has contracted for gas since the early 1980’s and has had several gas supply contracts over this period. The terms and conditions of each contract are confidential.

In WA there is no transparent price for gas supplies and gas prices are determined at the time the contract is negotiated. The main factor that has traditionally influenced price is competition. Until 2006 there had been healthy competition between individual north-west gas suppliers and between north-west suppliers and Perth Basin suppliers resulting in prices which were competitive and stable.

Alcoa’s observation is that the historical price for domestic gas in Western Australia pre-2006 was in the range A$2-4/GJ, however post-2006 pricing expectations started to rise dramatically. Whilst Alcoa is not entirely sure of the significance of 2006 there are a number of factors that might have been at play:

Gas supplies from NWSG were largely contracted. Problems with East Spar and the Apache JVs long-term

commitment to Burrup Fertilisers, limiting gas availability from Apache.

Oil prices were on the rise and were significantly higher than the historical average, creating a gap between domestic prices and LNG pricing for gas.

Alcoa has been in discussions with a number of suppliers for the supply of gas post-2006. Whilst these negotiations are confidential, a broad observation is that there is an increased trend towards wanting to link gas price to oil price and terms and conditions are significantly less flexible than historical contracts.

Linking gas price to oil price significantly increases the volatility of gas prices and depending upon the degree of oil price linkage, can significantly increase the price. For example, a gas price linked to oil at 14% of the oil price would give a gas price of $US14/GJ at a $100/bbl oil price or US$9.80/GJ at a US$70/bbl oil price. This volatility and significant increase in the price of gas is of significant concern to Alcoa and other gas users in Western Australia.

4. Price Comparisons

Whilst Alcoa understands the Inquiry is seeking to examine price differences between the east coast and west coast of Australia (in



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particular Victoria), for exporters like Alcoa price comparisons with global competitors are also relevant.

4.1 International Prices

To date there is no global pricing for natural gas and prices tend to be more regionalised (see Figure 9). Prices in North America and Europe are determined by local supply and demand factors and are traded through hubs such as the Henry Hub in the US or Zeebrugge in Europe. However, natural gas sold into Asia as LNG is sold under long-term contract and is linked to oil prices (see section 5 for further discussion on LNG pricing.

Figure 9: 2009 pricing in A$/GJ – Natural gas is priced regionally.

4.2 Alcoa’s Middle-East Case Study

The Middle-east, which has some of the world’s largest reserves of low-cost natural gas, is using this competitive advantage to foster the establishment of large new industrial bases, helping to diversify its economy.

Alcoa has a long history of working with companies in the middle-east. Alcoa entered into a 20 year contract with the Saudi Basic Industries Corporation for caustic soda supplies which, coupled with low cost energy supplies, helped underwrite the development of their chlor-alkali plant. Alcoa has also had similar experiences with the Qatar Vinyl Company.

Alcoa recently announced it has formed a joint venture with Ma’aden, the Saudi Arabian Mining Company, to develop a fully integrated, world-class aluminium industry in the Kingdom of Saudi Arabia.

South AmericaA$2.70/GJ

EuropeanA$7.00/GJ

Middle-eastA$0.80/GJ

RussiaA$2.50/GJ

ChinaA$11.00/GJ*

Henry HubA$4.50/GJ

IndiaA$2.40/GJ

MalaysiaA$4.60/GJ

* In China industrial users pay as low as $4.50/GJ



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In its initial phases, the joint venture will develop a fully integrated industrial complex of significant scale, including:

A bauxite mine with an initial capacity of 4,000,000 metric tons per year (mtpy);

An alumina refinery with an initial capacity of 1,800,000 mtpy; An aluminium smelter with an initial capacity of ingot, slab and

billet of 740,000 mtpy; and A rolling mill, with initial hot-mill capacity of between 250,000 and

460,000 mtpy.

The refinery, smelter and rolling mill will be established within the new industrial zone of Raz Az Zawr on the east coast of the Kingdom of Saudi Arabia. The complex will utilize critical infrastructure, including low-cost power generation, as well as port and rail facilities developed by the Kingdom’s government. First production from the aluminium smelter and rolling mill is anticipated in 2013.

Capital investment is expected to be approximately $US10.8 billion, subject to the completion of detailed feasibility studies and environmental impact assessments.

Whilst the price for energy for this project is confidential low cost long-term energy supplies was a key factor in Alcoa’s investment decision.

4.3 East Coast Gas Pricing

Unlike the Western Australian market, the east coast market has multiple supply points and multiple suppliers (see Figure 10 and Figure 11).

On the east coast there are over 100 companies involved in gas and oil exploration, but only around 35 produce gas. The six major suppliers supplied around 70 per cent of the domestic market in 2008/09.

Santos and BHP Billiton each supplied around 17 per cent, followed by Esso (12 per cent), Woodside (12 per cent), Origin Energy (9 per cent) and Apache Energy (5 per cent). The next tier of suppliers in terms of market share includes BP, Chevron, Beach Petroleum, Shell and BG Group.

Historically most gas is bought and sold on long-term bilateral contracts for terms of 10 to 20 year between gas producers and wholesale gas buyers, producers and transporters, and transporters and wholesale consumers. These contracts often have periodic price review mechanisms.

Victoria is the only state where there is a formal short-term trading market. In other jurisdictions, system balancing is physically managed by system operators (such as GMC and REMCo); as a result outside of Victoria there is a lack of market transparency and little public domain



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information regarding levels of uncontracted gas supply, demand, price and other commercial variables.

Alcoa understands that the price for gas from Longford, is the main supply hub for Victoria, is in the in the range $3.85-$4.20/GJ (source: Energy Advice), however spot gas prices are more in the range $2.00-4.00/GJ (source: AEMO).

Figure 10: Location of gas producing basins in Eastern Australia, the four main basins are the Cooper in South Australia, the Surat-Bowen Basins in

Queensland and the Otway and Gippsland Basins in Victoria.



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Figure 11: Location of gas pipeline which reticulates gas to from the producing basins through to the various demand hubs.

5. LNG Pricing

The pricing mechanism into Asia has evolved over time (see Figure 12). It has been reported that early contracts negotiated with Asian buyers, while linked to oil, had floor and ceiling prices at US$20/bbl and US$30/bbl respectively. This has resulted in long-term (25 year) contracts from Australian sellers into Asia providing gas at around US$3/GJ delivered.

Contracts negotiated over the last 5 years have been more closely linked to oil and do not have floors and caps on pricing. At US$70/bbl oil these contracts can command prices as high as US$12/GJ. With growing competition from the numerous LNG projects being developed globally, buyers are reportedly resisting this full linkage to oil price and have been successful in negotiating weaker linkages, particularly at higher oil prices.



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Figure 12: Asian LNG pricing mechanism linked to a mixture of different oil indices often referred to as the Japanese Customs-cleared Crude (JCC)

LNG net back pricing is often used to compare pricing at different points in the supply chain. For example, if you wanted to compare LNG prices from different producers and you wanted to remove the price of shipping then you would simply net-off the price of shipping, this would give you a price of gas leaving the LNG liquefaction terminal. Of interest to this Inquiry would be the price of gas entering the LNG liquefaction process. This would remove the price of shipping and liquefaction and should be a zero opportunity cost between domestic gas and LNG (i.e. the price at which a supplier should be indifferent if the gas goes out as LNG or domestic gas). In assessing price in this way, care is needed to ensure that price does not get confused with cost.



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Figure 13: A hypothetical model showing the margin on LNG and domestic gas. Domestic gas at oil based pricing provides a much greater margin.

Figure 13 shows what will happen if WA domestic gas buyers are faced with oil based pricing for gas. There is a significantly greater margin on domestic gas compared for the same gas sold into Asia as LNG. In addition Alcoa believes domestic gas pricing should be further discounted for the reduced risk profile, given the lower capital investment required compared with LNG.

6. What Can be Done to Reduce Prices

6.1 Energy Security Policies around the Globe

It could be argued that between now and 2030 energy security and global warming are two of the biggest issues that nations across the world face. Clearly, there needs to be a balance between enabling energy poor countries to continue to develop and sustain their economies, whilst at the same time recognising that energy rich nations should be able to use their energy supplies as a source for competitive advantage.

Energy security has many definitions, however Alcoa views energy security in terms of securing its existing investments and as a key enabler for further investment. For Alcoa, this is a combination of long-term certainty around volume and price that ensures the existing operations are viable and can expand to meet world demand. An important piece of energy security is the creation of a framework that can provide confidence and investment certainty for the long-term.

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In January 2007 Alcoa engaged Curtin University’s Area of Research Excellence in Oil and Gas Management to provide an understanding of how other countries manage their energy resources (see Table 1).

The research found that, in energy rich countries, policies have been put in place that either reserve or create priority access to oil and gas reserves for the domestic market.

Table 1: Summary of policies used by other energy rich countries to ensure that energy is available domestically. (Source: Curtin University)

Country Policy Comments

USA 1. Strategic Petroleum Reserve

2. Royalty in Kind Program

Indonesia Domestic Market Obligation Reserves a certain proportion of oil and gas produced for domestic use

Algeria Satisfaction of Domestic Gas Needs

Producers cover domestic gas needs as a proportion of overall production.

Tunisia Domestic Market Obligation 20% for oil. Priority to domestic market for gas.

Malaysia National Depletion Policy Domestic production limits for oil and gas.

Timor-Leste Domestic Market Obligation Option for government to purchase from producers their proportionate share in national production, up to 25 per cent, in case of “national need” for crude oil and natural gas liquids.

Russia Oil and gas sectors declared strategic, with foreign ownership limited to 50 per cent.

With regards to the Sakhalin II Production Sharing Agreement, priority of supply is to domestic market for royalty and production



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share from state, and subsidised domestic pricing.

Venezuela Gas associated with oil production (91%) is reserved to the state

Saudi Arabia

The Saudi Gas Initiative (mark II)

Opens non-associated gas exploration and production to foreign companies via targeted projects, such as power generation, desalination and petrochemical plants, which will further develop the domestic gas market.

Qatar Moratorium on new gas projects for 3-4 years announced in 2005. Treating gas reserves carefully to extend production life of fields.

6.2 Reservation Policy

In 2004, in response to a call for submissions by the then Department of Industry and Resources (DOIR) about WA Domestic Gas Policy, Alcoa provided a detailed submission. Today, Alcoa believes that its rationale for a domestic gas reservation policy remains unchanged. Some of the key conclusions from that submission were:

Given the importance of domestic gas supply to Western Australia and evidence showing that in the medium term gas supplies will be constrained, then the State Government should implement a regime to reserve a portion of all offshore gas for domestic use.

The regime must be equitable, with a consistent portion (15 to 20 percent) of all offshore gas reserved for domestic use.

The regime must be field specific, with gas reservation obligations applying to each particular gas field, so that there is a commercial incentive on producers to deliver reserved gas to the domestic market.

The regime must be flexible, with trading of reservation obligations allowed in the case of fields that cannot be economically developed for domestic supply and provided domestic supply of gas from the transferee field is guaranteed.



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The regime must be universally applied to all offshore reserves of gas.

The regime must be supported by additional policy initiatives. In particular, Commonwealth Government engagement will be required and access should be made available to upstream gas gathering, processing and trunkline infrastructure on fair and reasonable terms.

Following on from this and other submissions, the Government of Western Australia developed a policy allowing for the State to reserve up to 15% of a gas field for domestic use. Whilst this policy has been criticised by some sections of industry, it is not dissimilar to the policy that was put in place in the early days of investment and development of the North West Shelf Gas project, which of course supplies nearly 70% of the state’s domestic natural gas supply.

Alcoa believes that a key recommendation to the committee is for the government to develop a more detailed and comprehensive reservation policy that provides clarity and certainty around the expected commitment for both proponents of new gas projects and potential buyers or users of the natural gas. In 2009, the Domgas Alliance addressed some of these more detailed issues:

Certainty

Domestic gas obligations should be made unconditional and not subject to highly subjective “commerciality” escape clauses.

The policy should be consistently applied to discourage individual projects from claiming “special exemptions” and treatment.

The obligation should be to “supply” domestic gas, as opposed to “market”, “make available” or “offer to sell” domestic gas. In the event of any resources shortfall in a project or field, domestic gas supply should be accorded priority over LNG export.

The reservation policy should be made an express condition in the granting and renewal of all gas exploration permits, retention leases and production licences.

Specific leases or tenements should be set aside and granted only on the condition of exclusive domestic gas development.

Flexibility

Producers should be given sufficient flexibility on how they would meet domestic supply obligations.

Producers should be encouraged to adopt the most efficient means of meeting domestic supply obligations - either by supplying domestic gas from the relevant field or, where it is not commercially viable to do so, by supplying domestic gas from other fields.



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Growth

The domestic supply commitment should expand with any future growth in project gas reserves, production or LNG exports.

Timeliness

The obligation should be applied as a percentage of reserves and production, as opposed to a fixed volume. Producers should be required to supply domestic gas prior to or at least no later than start-up of LNG production.

Alcoa believes that it is not sustainable or reasonable to expect supply at any cost and inevitably a project must be commercially viable in order for it to provide the gas domestically. An assessment of commercial viability should, however, not rely on what alternative price a proponent might get for gas as LNG, but instead should cover the incremental cost of gas production at a rate of return that reflects the lower risks associated with domestic production. If LNG is viable then it must be questioned why domestic supply would also not be viable given the much lower operating and capital cost to supply gas into the domestic market.

6.3 Retention Leases

More stringent management of retention leases offers another means of ensuring long-term gas supplies for the domestic market. Tighter management of retention leases without a reservation policy will only lead to more rapid commercialisation of LNG.

Retention Leases are awarded for gas discoveries that might at the time be considered uncommercial. The applicant needs to demonstrate that the resource is not currently commercially viable, but is likely to become viable within the next 15 years. The initial term of a Retention Lease is five years and it may be renewed, provided it still meets the required commerciality criteria. When the discovery is deemed to be commercial, the Retention Lease must be converted to a Production Licence. At any time during the five year term the government can request a review of the commercial viability of the field in the lease area.

Offshore Retention Leases are managed jointly by the State and the Commonwealth Government, whilst near to shore and on-shore Retention Leases are managed by the State.

In April 2008, the DomGas Alliance provided a submission to the Commonwealth Department of Resources, Energy and Tourism in support of its review of Retention Lease policy. Alcoa supports a number of the key recommendations to improve the rigour in which Retention Leases are assessed.



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In the first instance, reserves held under Retention Leases should be assessed to determine whether they are capable of supplying the domestic market on a commercial basis.

A public, on-line registry of State and Commonwealth retention leases should be established. The registry should provide clear indications on the current status of a particular Retention Lease application, or the status of the process; as well as identify Retention Leases coming up for review.

There needs to be a public announcement when the Designated Authority begins its process of review.

The general parameters or assumptions used by the Designated Authority to test “commerciality” should be publicly determined. This could be achieved by publishing an assumptions or data book identifying key factors such as prices, local demand, rate of return, expectations on capital and operating costs.

6.4 Promote the Development of New Gas Supplies

Western Australian domestic gas supplies are heavily concentrated with only two producer groups supplying 98% of the State’s gas. In addition, incidents in 2008 with the state’s two only off-shore gas gathering hubs raised concerns about the reliability of the state’s natural gas supplies.

Alcoa strongly supports the development of new gas supplies to help promote competition as well as provide the necessary diversity of supply which in turn increases the reliability of the natural gas supply chain.

Alcoa believes that in addition to strategies for satisfying the state’s gas needs from LNG based projects, the emphasis should be on finding and developing new sources of domestic gas supplies through targeted exploration and development of unconventional gas supplies.

6.4.1 Gas Basins

Natural gas in WA is predominantly produced from the off-shore Carnarvon basin with small volumes being supplied from the on-shore Perth basin. Significant amounts of exploration have been focussed in these regions over the last 20 years. More recently, discoveries in the Browse basin in waters in the far north of the state are proving to be a potential new source of supply.

Most recent exploration in the Browse and Carnarvon basins has been focused on discovering large fields capable of supporting LNG development. Many of these larger fields are further from shore, in deeper water, contain impurities such as carbon dioxide and nitrogen and tend to be less rich in condensate. This makes these fields more expensive to develop and require greater economies of scale to commercialise. The northern and southern parts of the Carnarvon basin, which are closer to shore, still provide opportunity for the discovery and development of fields that could be suitable for the domestic market.



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The onshore Perth basin represents an area from the south-west of Perth and extending north through to the mid-west of the state. The Perth basin also extends into the off-shore areas along this strip. Much exploration and production activity has been focussed around Dongara and this area supplies ~20TJ/day of natural gas supply into the south-west. Recent exploration by Origin and Australian Worldwide Exploration has demonstrated that this region continues to be a source of new natural gas finds (albeit relatively small).

The on-shore Canning basin has been sparsely explored over the last 30 years and to date there have been no commercial discoveries of natural gas. The Canning Basin represents an area of significant opportunity containing structures that, if gas-charged, may contain multi TCF’s of natural gas. Much of the area is very remote and there are significant challenges in mobilising drill rigs into this region. There are also a number of different geological settings requiring different types of drill rigs depending on the depth of the target. Active explorers in the Canning basin include Buru Energy and New Standard Exploration.

6.4.2 Targeted Gas Exploration

Looking at ways of promoting exploration is one of the key steps in generating new supply for the domestic market. Th high cost of exploration will always be a constraint and so in an area as large as Western Australia it is important for the State to ensure that exploration is well targeted. This raises the question as to what areas are best to target.

Emphasis needs to be given to those domestic fields that naturally have an economic advantage. Alcoa believes the following could represent a guide as to the types of areas to target:

1. Needs to be relatively close to shore or located on-shore. 2. Likely to have a resource in the range of 100 BCF to 2 TCF. 3. Likely to contain only low levels of impurities. 4. Has a high likelihood of containing condensate. 5. Located close to infrastructure.

Policy initiatives to incentivise or facilitate exploration in such areas may deliver significant benefits to the Western Australian economy and public.

Government already provides support to exploration companies by the coordinating of information and providing precompetitive geological data as well as access to petroleum data required to be lodged as part of work program activities. Alcoa would like to see a review undertaken to ensure that such data adequately supports the exploration of domestic suitable gas fields.

Given the remoteness of areas within basins such as the Canning Basin, access to these areas with large equipment such as drill rigs is a significant challenge. This challenge has to be managed by the explorer.



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These explorers are often small in size and don’t have the capability to fund some of the infrastructure requirements to gain access to these remote areas. Alcoa recommends the State Government work in partnership with explorers to define and fund some common arteries that could be developed to open up access to these remote areas.

Another challenge facing Western Australia is the availability of suitable types of drilling rigs, particularly for on-shore exploration. In the USA there are currently 1600+ drilling rigs. Most of these were in full operation during the height of drilling in September 2008, however at the low point (in July last year) only 665 were in operation; today the number is 920. Access to idle rigs could represent a significant opportunity for Western Australia, however apart from the costs of transporting these rigs to W.A., there are significant regulatory hurdles with respect to standards, making it even more costly and difficult for these rigs to enter Australia. Alcoa encourages the government, again in partnership with industry, to review the regulatory hurdles that might exist in bringing these rigs into Western Australia.

6.4.3 Unconventional gas

Western Australia potentially has large amounts of unconventional gas. This is often referred to as tight gas or shale gas. Unconventional gas is gas which accumulates in either tight sands or shale and cannot be brought to the surface by drilling alone. Fracture and stimulation techniques must also be applied in order to allow the gas to flow to the surface. These techniques carry with them additional technical risk and significant expense.

Unconventional gas shows promise, with two large tight gas fields already having being identified - Whicher Range in the far south and Warro in the mid-west of the state. In addition, AWE recently announced that it is investigating the potential for shale gas at its Woodada gas field.

Unconventional gas development requires significant capital investment throughout the life of the field in order to recover the gas. Many holes need to be drilled and the cost of each hole is more expensive than conventional gas. In 2009, the State Government, recognising the difference in cost of exploration and development between conventional gas and tight gas, provided a reduction in the royalty rate from the normally applicable 10% down to 5% to help encourage development. The government is to be congratulated on taking this positive measure.

In the USA unconventional gas represents about 25% of domestic gas supplies. As a result there has been significant development and the techniques used are quite mature. Western Australia by comparison has no producing unconventional gas fields. The development of unconventional gas becomes more economic due to economies of scale and advances in technology and application of the technology.



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In Western Australia there is additional front-end risk with unconventional gas projects, with new technology having to be brought into the state, difficulty in getting up-front economies of scale and limited competition amongst service providers.

As a result Alcoa sees an opportunity for increased synergies amongst proponents of tight gas to help reduce some of the front-end risk that will be part of developing tight gas in Western Australia. Whilst this is likely best coordinated by industry participants, government may have a role in promoting information exchange.

6.5 Promote Competition

As discussed in the previous section, significant competition can be gained from the introduction of new gas supplies. In addition, competition can also come from the tension created between joint venture partners if they are made to sell gas separately. Australia is one of the only countries in the world that still permits joint selling of energy supplies.

Alcoa is opposed to joint selling for new projects in the Western Australian natural gas supply market for the following reasons:

1. The Western Australian natural gas supply market now has the characteristics of a market necessary to support separate selling, with multiple buyers, additional sellers, short-term gas trading and balancing and storage arrangements in place.

2. There are practical ways to resolve perceived issues with separate marketing (gas balancing can be performed using stored gas in the Dampier to Bunbury Natural Gas Pipeline for example).

3. Additional costs associated with separate marketing are not material relative to the added cost to users of increased gas prices from a lack of competition.

4. Whilst proponent projects may provide a public benefit it is equally important to assess the public benefit provided by value-adding companies like Alcoa who rely on a competitive natural gas supply market.

5. Allowing joint marketing further hinders the development of the market’s liquidity.

As part of any long-term energy strategy Alcoa believes that separate selling of natural gas will be a key enabler to a more competitive energy market in WA. Whilst the Trade Practices Act governing joint selling is a Federal Act administered by the ACCC, the state should work with and encourage the Federal government to ensure that joint selling for any new projects does not become a permanent feature of the WA domestic gas market.



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7. Conclusions and Recommendations

Alcoa considers that energy security is the biggest challenge facing Alcoa’s business in Western Australia. Given the significant resource potential available to Western Australia, long-term competitive energy supplies also represent a significant opportunity if managed well.

Alcoa is a significant contributor to the Western Australian economy and has used its energy requirements to help underpin the state’s energy infrastructure, as well as bring to market supplies that may have taken much longer to develop. As a result the state has gained significant benefit.

Alcoa is significantly concerned about the price of long-term supplies of natural gas in Western Australia. Alcoa has had firsthand experience with the rising cost of gas prices and this has had a significant impact on the prospects for Alcoa’s growth in Western Australia.

Key Conclusions:

The price of gas post-2006 has risen significantly and is now at price levels greater than the east coast of Australia and greater than many of Australia’s competitor countries.

There is a significant increased margin between gas sold into WA, priced at oil price parity, and LNG sold into Asia.

There are significant growth opportunities for Western Australia for the alumina industry. To meet the significant demand expected for aluminium, this will require global expansion in alumina production through greenfield and brownfield refinery expansions. The state’s ability to compete globally for this growth will depend on certainty over long-term competitively priced energy supply.

Australia has less than 2% of the world’s natural gas reserves. Australia has 89 TCF of proven conventional reserves most of which is found in Western Australia. To put this into perspective, the USA alone uses 25 TCF per annum.

Much of the world’s natural gas reserves are held by National Oil Companies (NOC) controlled by the governments of the country holding the reserves. Australia and the USA are the only two countries that have open access principles in which international oil and gas companies (IOCs) have full access to the reserves. This makes Australia an attractive destination for IOCs.

To date there is no global pricing for natural gas and prices tend to be more regionalised. Prices in North America and Europe are determined by local supply and demand factors and are traded through hubs such a Henry Hub in the US or Zeebrugge in Europe. However natural gas sold into Asia as LNG is sold under long-term contract and is linked to oil prices.



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Research shows that in energy rich countries policies have been put in place that either reserve or create priority access to oil and gas reserves for the domestic market.

Key Recommendations:

Recognise that the ongoing availability of competitively priced natural gas to domestic users is a significant competitive advantage for the state and is of fundamental importance to the state’s economy.

Improve the State Government’s existing Gas Reservation Policy to create greater certainty, flexibility, growth in commitment as reserves grow and delivery of the gas in a timely manner.

Apply the retention lease review with more rigour, which should, in consultation with key stakeholders, include the development of an assumptions book to be used when determining commercial viability thresholds.

Target exploration for domestic gas fields. A criteria needs to be developed to help focus exploration efforts on fields best suited for the domestic market. An over-arching principle should be that these fields would deliver a competitive advantage to the domestic market.

Review the adequacy of existing data systems to encourage the development of domestic gas fields.

Review existing regulatory regimes to reduce the barriers to entry for drill rigs from overseas.

the State Government to work in partnership with explorers to define and fund some common arteries that could be developed to open up access to remote areas for further exploration.

In Western Australia there is additional front-end risk with unconventional gas projects. Some of this could be mitigated by government playing a role in promoting information exchange.

The State should work with the Federal government to ensure that Joint Selling for any new projects does not occur.


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