Gold and uranium the only bright spots

YOU don't have to be a Rhodes scholar to understand that, over the past 12 months, global financial markets have experienced some of the most severe and destabilising events ever seen. Huge amounts of wealth have been destroyed as the local market declined about 53 per cent from its November 2007 high, driven by de-leveraging induced selling.

The resulting chaos in both debt and equity markets has flowed on to lower global economic growth, delivering weaker commodity prices. Base metal prices have fallen to below their marginal cost of production in most cases, while the outlook for bulk commodities has also darkened. Recent strengthening of gold and spot uranium oxide prices present rare bright spots on a bloody field of battle.

The gold price now trades at around $A1,200 an ounce, offering attractive operating margins to local producers, further supported by declining capital and operating costs, as both skills and services become more freely available.

Through all this it is worth remembering that, over the long term, equities still offer the best place for savings. Investment in Australian shares has proven to deliver a far superior return than, say, government bonds.

Over time, base metal prices follow a cyclical path, exhibiting a regular three to four-year peak-to-peak cycles. Previous peaks in 2000, 2004 and 2007 offer guidance to new peaks in 2011 and then 2015, which should be preceded by a return to economic growth in OECD nations.

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The age of peak oil production is now upon us. Inevitably, much higher prices for oil and energy can be expected as we pass into the next decade. Briefcase estimates that global oil and condensate production is likely to reach a maximum value by 2012 and will begin a rapid decline during the next decade.

The impact of this major turning point will be muted during 2009 by weaker demand growth. Demand for oil is likely to remain static during 2009 as industrial production declines, while expanding production of condensate from newly established large gas fields will soften the impact of declining oil output.

The implications for your portfolio are obvious. Investment in companies with long life oil and gas assets in politically stable locations will perform extraordinarily well during the next cycle and onwards through 2010 and beyond.

Australia is in a favourable position to weather negative impacts flowing from the current global economic weakness. China and India, two of the world's most dynamic growth centres, are among Australia's major trading partners, which should ameliorate negative impacts of global economic weakness flowing around the world during 2009.

On top of this trade support, we see a $12.4 billion economic stimulus being put in place by the federal government, as well as coordinated economic stimulus throughout the G20 nations.

Interest rates are falling, which should stimulate and reduce the cost of borrowing.

In Washington, a new administration is working to restore confidence in that nation's shattered financial system, with better regulation and more visibility.

Ultimately, any short-term hiatus in new resource project development will result in limits to supply, once economic growth recommences. Supply restrictions by 2011 are likely to result in rapid price rises for most commodities. Gold could easily trade up to $A1,600 by late 2009, as the US dollar recommences a secular decline in value.

The oil price will remain weak through 2009, but OPEC's supply control may limit further weakness.

Ultimately the oil price will rise substantially in real terms, rendering investment in producers at today's depressed levels, a once-in-a-lifetime opportunity.

Along with other energy opportunities, the price of uranium will move higher as supply constraints bite and new nuclear power plants are brought on-stream during the next decade.

Industrial materials and metals are likely to experience a long period of low prices, influenced by a three to four quarter period of negative or low industrial production growth within the OECD. However, inventories remain relatively low and supply side adjustment has begun, which should stabilise prices at the current low levels, ahead of recovery in 2010.

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Annual general meetings (AGM) are a great time to catch up with management and get an update of company progress. The last couple of weeks in November get very hectic, with multiple meetings, all producing conflicting meeting times, but Briefcase attended as many as possible.

LNG Ltd's AGM was an upbeat affair. The company is progressing towards a final investment decision by late 2009 at its Gladstone liquid natural gas (LNG) plant, in partnership with gas supplier, Arrow Energy. In addition, LNG Ltd hopes that it is in the final stages of signing up a gas off-take agreement. LNG Ltd is relying on the as yet un-named gas customer taking a 40 per cent interest in the planned 1.5 million tonne per annum LNG project and will also underpin LNG Ltd's retained 40 per cent interest with both debt and equity support.

Gas supply partner, Arrow Energy, has agreed to support its 20 per cent equity in the $US500 million project, which the partners plan to fund on a 50-50, debt to equity basis. Failure to secure such a funding/off-take partner would set back LNG Ltd's ambitions severely.

LNG Ltd plans to use its patented OSMR LNG process, which offers considerable capital cost advantages. For a start, the site is already clear and has relevant permits to proceed. The project has access to an existing load-out jetty, with only a small amount of dredging and additional spending required to service an LNG off-take facility.

LNG Ltd's capital cost estimate is a low $US500 million, including $US40 million of owner's costs. This capital cost is about 40 per cent of comparable costs for conventional LNG plants, largely because of the services and site already in place, but also because the use of coal seam gas (CSG) does not require liquid separation or LPG production facilities, since CSG is mostly methane, with a small amount of carbon dioxide and has no associated condensate.

LNG Ltd is banking on an off-take partner guaranteeing to buy the project's entire LNG output at the wharf, on a sliding price scale. For example, at an oil price of around $US40/bbls, Briefcase estimates that the gas will have a value of close to $US6.50/1,000 cubic feet (Mcf), but if oil is $US120/bbl, gas is estimated to be sold at around $US8.50/Mcf.

The off-take partner will stump up cash for its 40 per cent interest in the project and LNG Ltd is negotiating for its $US200 million commitment to be fully supported by the incoming off-take customer. LNG Ltd expects to be reimbursed for its costs on the project so far and will receive developer's fees at critical stages of the project development.

With about $12 million of cash holdings, plus cash coming in for fees, the company will be well funded through final engineering design. The company is hopeful that it may be able to proceed without recourse to additional equity, but Briefcase believes that prior to plant completion in 2011, at least an additional $20 million may be required.

LNG Ltd's OSMR process allows great operating flexibility and does not need to operate at full capacity. The project could start up by processing as little as 70 million cubic feet (mmcuft) per day of gas and ramp up to full capacity use of 250 mmcuft of gas per day as Arrow increases gas delivery capacity. The OSMR LNG production process is highly energy recuperative, offering an energy efficiency whereby only 6.8 per cent of total gas is consumed in the process, against about 9.1 per cent for standard LNG plants.

Arrow and LNG have plans to replicate this plant once the first stage is up and running and Arrow is estimated to have access to up to 35 trillion cubic feet (Tcf) of CSG, with just 2 Tcf required to supply this project for 20 years.

- Peter Strachan is the author of subscription-based analyst brief StockAnalysis, further information can be found at Stockanalysis.com.au