Market Watch

Unconventional gas’ has lower greenhouse gas emission intensity than other fossil fuels and as such, will form an important part of the transition to a low carbon economy. Environmental and social issues are emerging as part of this transition and while some of these issues are being managed effectively, others are presenting more of a challenge to the industry and to the communities affected.

Hydraulic fracturing or ‘fracking’ has been used in the conventional oil and gas industry for some time and, with the development of horizontal drilling techniques, has enabled the development of shale gas assets, especially in the US. Fracking involves pumping water under pressure, with sand and a mixture of other chemicals, to open up fractures within the rock. It aims to improve the gas recovery rates from the shale or coal seam. While fracturing is required for shale gas developments, it is not necessarily required for coal seam gas. The pressures needed for fracking for coal seam gas tend to be less than those needed for shale gas. This is due to the lower depth of coal seam gas developments and the nature of coal compared to shale.

Environmental issues relating to unconventional gas

Groundwater disposal

The dewatering of coal-seams to facilitate the production of coal seam gas can create a significant amount of groundwater which needs to be disposed of. Reverse osmosis plants is a preferred option, so this water can be reused to supplement industrial and/or domestic water supplies.

Impact on systems and resources

In order to manage and mitigate the impact of groundwater, the levels and quality of groundwater should be comprehensively monitored – both during and after coal seam gas operations. Groundwater impact models should also be updated throughout the operation.

The use of high quality water

In areas where water resources are scarce or in high demand, such as in parts of the US, the sourcing of large volumes of high quality water for fracking has been controversial. As such, there is a growing expectation that fracking should use poorer quality water and collect and reuse flow back water. Any fracking flow back water that will not be reused should be appropriately treated and disposed of.

The use of chemicals

In the US, the potential toxicity of fracking chemicals has been a significant issue. There has been community concern around the lack of disclosure of chemicals being used, or the use of the potential carcinogen BTEX. Australian companies have committed to disclosing which chemicals are used, and have also committed to not use BTEX in fracking operations.

Potential cross-contamination of groundwater systems

Potential cross-contamination of groundwater systems –which can result from poorly completed unconventional wells or from improved conductivity from changes to geological faults from fracking – have raised concerns.

To avoid fracking in high risk-faulted areas, we believe that 3D seismic surveys should be used prior to fracking. In addition, there is a need to construct and complete wells to the highest quality in order to minimise groundwater cross-contamination.

Fugitive emissions

Cold venting of gas during work-overs or exploration, poorly constructed wells and poorly maintained compressors and gas and water gathering systems may lead to significant fugitive methane emissions. These issues can and should be addressed through the use of ‘green’ well completion techniques and collection systems.

Underground coal gasification

Underground coal gasification, which involves the partial combustion of coal underground, is considered by some as an unconventional gas technique. We believe that underground coal gasification has significantly more environmental risks than either shale gas or coal seam gas. Neither the Responsible Investment Leaders funds nor Sustainable Funds invest in companies involved in underground coal gasification.

We believe key environmental issues can be managed

While there is a range of environmental issues that need to be addressed for unconventional gas, we believe that the key environmental issues can be appropriately managed through baseline monitoring, impact assessment prior to development, use of best available technology, ongoing review and reassessment of future impacts and adaptive management.

Social issues relating to unconventional gas

The social issues relating to unconventional gas are possibly even more challenging to manage than the environmental issues.

Conflicts in land use

Much of the development of unconventional gas, and in particular coal seam gas in Australia, has occurred in areas that have had either little or no association with the oil and gas industry. This has caused conflicts in land use and changes to local communities.

While these changes may have benefitted some, for others they have caused economic and social problems. In addition, government regulation regarding access to land for exploration and development of unconventional gas has not been regarded as appropriately recognising landholder rights.

Due to poor community and landholder consultation practices by some players, a lack of trust for coal seam gas and shale gas companies has developed. This is particularly the case with early players in coal seam gas in Australia and a minority of shale gas players in the US.

The over-riding of perceived landowner ‘rights’, inadequate compensation and a power imbalance in negotiations has led to a backlash against some unconventional gas developments. Some companies have not been sufficiently transparent or respectful of stakeholders, leading to a lack of trust not only for the particular companies involved but for the industry as a whole.

Finding a way forward

It is inevitable that as the unconventional gas industry develops, it will change the nature and character of some areas. The planning and approval process should balance the potential costs and benefits that may accrue at a local, regional and national level, and the industry needs to recognise that these costs and benefits will be different at each level. It is also critical that the planning and approval process is transparent, open and comprehensive to enable all stakeholders to participate. Unconventional gas companies need to engage with impacted communities and work with them to minimise and manage potentially negative social impacts that may occur over both the short and long-term – listening to and being responsive to the issues raised by stakeholders.

Some unconventional gas companies have gone beyond what is required by law and committed to respecting landholders who refuse coal seam gas developments on their land. In addition, they have provided appropriate support to landholders during negotiation, recognising that in many cases landholders do not have the time or resources to be able to negotiate landholder agreements on an equal footing.

Some social aspects are difficult to manage, such as short-term impacts on social services in regional communities. This can be the result of a large influx of people during the construction phase of a development. Again, it is critical that companies liaise with local communities and government service providers to minimise adverse impacts.

Finally, there are some impacts that are difficult to reconcile. While companies may be able to minimise the potential aesthetic impacts of developments, there may be a more negative impact on the character of the landscape. In these cases, any change may be considered unacceptable to some, while others see the opportunities. Where there is a natural tension in the community, it will be critical that the planning and approval process is transparent and that the company builds trust and works with all of the stakeholders in the community.

Important note: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided.

Despite the US Federal Reserve looking to hike cash rates in the next few months, the path to significantly higher rates is likely to be slow. Reflecting this, bond yields are still only marginally above their all-time lows and yields in other asset classes are not offering much either.

We expect 2015 to mark the fourth consecutive year of positive performance in equity markets. But in a low-growth environment, investors are wondering just how much longer this equity run can continue. In Australia the corporate landscape remains soft, with negative earnings growth from equities for the past three years, and it’s unlikely to turn positive until 2017.

So in this environment, what should investors be doing? In a way it’s back to basics. There are two known ‘knowns’ in investing – the equity risk premium (ERP) and portfolio returns benefit from diversification.

Equity risk premium

There is overwhelming data that tells us of a premium over cash and bonds from investing in equities. While over very long periods the excess return of shares over bonds has varied, since 1900 the realised ERP has averaged more than 4.5% for the US and close to 6.0% for Australia. We are mindful of starting point biases and it is our assessment that the appropriate equity risk premium going forward, for developed market equities, is somewhere between 3.5% and 4%. For Asian and emerging market shares it is slightly higher – between 4.5% and 5.0% – reflecting greater volatility.

Markets are also cyclical, so entry points matter. However, if we look at equity valuations today there are few signs of extreme stress. While the US market looks almost fully valued, other markets such as Europe, Japan and Asia continue to offer attractive value.

With cash rates and bond yields likely to remain low, and even with single digit equity market returns, investors will continue to be compensated for risk and equities should remain an asset class of choice.

However, looking forward we can’t ignore the fact that equity market risk has increased as the valuation buffer has reduced. Up until the GFC, Australian investors had for many years benefitted from the resilience and outperformance of Australian equities. However, Australian shares have underperformed global markets over the past five years and this is likely to continue with growth being subpar, the banks remaining under pressure to improve balance sheet strength and continuing headwinds from the commodity sector. Global economies are also sensitive to shocks that can turn anaemic growth negative and, even in an environment where credit growth improves and business and consumer spending contributes to stronger than expected economic growth, this is likely to give rise to inflation concerns in the current accommodative monetary environment.

Diversification

So let’s turn to our second ‘known’ – the power of diversification. Diversification is all about trying to diversify away from equity risk, which is typically the biggest risk in most portfolios. It seeks to identify and invest in assets/strategies that are uncorrelated to equity risk – specifically risks that are related to economic growth and its impact on company earnings.

The most obvious diversifier comes from investing in government bonds. In the event that economic growth falls, typically you see cash rates lowered, which reduces bond yields and increases capital value. The longer the maturity or duration of the bond, the more price-sensitive it is to changes in the bond yield. Despite the current low level of yields, bonds will outperform equities in the event of a significant correction, providing some offset to losses.

Currency is another important consideration given the Australian dollar’s propensity to underperform in falling equity markets, hence boosting returns from unhedged international equities.

Property and infrastructure – both listed and unlisted – have some correlation to economic growth but are also linked to supply/demand factors, inflation and cash rates, and so can perform differently to equities.

Private Equity is affected by economic cycles but is also influenced by the underlying manager’s capability in turning around and extracting value from businesses.

Accessing value-add or active management in the market is another important diversifier to equity markets. While we recognise that there are some markets where the ability to source excess return is difficult, such as in the US equity market, there are other markets like Australia where there is strong evidence of the ability to add value.

Finally, you can invest in a portfolio which takes active decisions with regard to asset class weights within the portfolio. This is called Dynamic Asset Allocation. This could mean moving the amount held in various asset classes within a narrow range, taking tilts to underlying countries/currencies/fixed interest markets/asset classes or more actively changing the allocation between asset classes to significantly change the risk profile of your portfolio, and therefore the factors that are likely to drive performance.

Portfolio construction to maximise returns

In the current environment, investors should be evaluating the level of diversification across investments/portfolios. Portfolio construction is a specialised skill that can maximise investors’ returns – even in challenging markets. This was witnessed in the latest September quarter when, despite sharp falls in equity markets, diversified funds only realised between one quarter and one third of the drawdown. There are a range of multi-asset vehicles available to investors that cater for differing risk appetites. In an environment where the ability to benefit from easy wins is behind us, and with the expectation that conditions will remain challenging, it makes sense to invest in a professionally managed solution.

Important note: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided.

Statement by Glenn Stevens, Governor: Monetary Policy Decision

At its meeting today, the Board decided to leave the cash rate unchanged at 2.0 per cent.

The global economy is expanding at a moderate pace, with some softening in conditions in the Asian region, continuing US growth and a recovery in Europe. Key commodity prices are much lower than a year ago, reflecting increased supply, including from Australia, as well as weaker demand. Australia’s terms of trade are falling.

The Federal Reserve is expected to start increasing its policy rate over the period ahead, but some other major central banks are continuing to ease monetary policy. Volatility in financial markets has abated somewhat for the moment. While credit costs for some emerging market countries remain higher than a year ago, global financial conditions overall remain very accommodative.

In Australia, the available information suggests that moderate expansion in the economy continues in the face of a large decline in capital spending in the mining sector. While GDP growth has been somewhat below longer-term averages for some time, business surveys suggest a gradual improvement in conditions in non-mining sectors over the past year. This has been accompanied by stronger growth in employment and a steady rate of unemployment.

Inflation is low and should remain so, with the economy likely to have a degree of spare capacity for some time yet. Inflation is forecast to be consistent with the target over the next one to two years.

In such circumstances, monetary policy needs to be accommodative. Low interest rates are acting to support borrowing and spending. While the recent changes to some lending rates for housing will reduce this support slightly, overall conditions are still quite accommodative. Credit growth has increased a little over recent months, with credit provided by intermediaries to businesses picking up. Growth in lending to investors in the housing market has eased. Supervisory measures are helping to contain risks that may arise from the housing market.

The pace of growth in dwelling prices has moderated in Melbourne and Sydney over recent months and has remained mostly subdued in other cities. In other asset markets, prices for commercial property have been supported by lower long-term interest rates, while equity prices have moved in parallel with developments in global markets. The Australian dollar is adjusting to the significant declines in key commodity prices.

At today’s meeting the Board again judged that the prospects for an improvement in economic conditions had firmed a little over recent months and that leaving the cash rate unchanged was appropriate. Members also observed that the outlook for inflation may afford scope for further easing of policy, should that be appropriate to lend support to demand. The Board will continue to assess the outlook, and hence whether the current stance of policy will most effectively foster sustainable growth and inflation consistent with the target.

Enquiries:

Media Office
Information Department
Reserve Bank of Australia
SYDNEY
Phone: +61 2 9551 9720
Fax: +61 2 9551 8033
E-mail: rbainfo@rba.gov.au

Statement by Glenn Stevens, Governor: Monetary Policy Decision

At its meeting today, the Board decided to leave the cash rate unchanged at 2.0 per cent.

The global economy is expanding at a moderate pace, with some further softening in conditions in the Asian region, continuing US growth and a recovery in Europe. Key commodity prices are much lower than a year ago, in part reflecting increased supply, including from Australia. Australia’s terms of trade are falling.

The Federal Reserve is expected to start increasing its policy rate over the period ahead, but some other major central banks are continuing to ease monetary policy. Volatility in financial markets has abated somewhat for the moment. While credit costs for some emerging market countries remain higher than a year ago, global financial conditions overall remain very accommodative.

In Australia, the available information suggests that moderate expansion in the economy continues. While GDP growth has been somewhat below longer-term averages for some time, business surveys suggest a gradual improvement in conditions over the past year. This has been accompanied by somewhat stronger growth in employment and a steady rate of unemployment.

Inflation is low and should remain so, with the economy likely to have a degree of spare capacity for some time yet. Inflation is forecast to be consistent with the target over the next one to two years, but a little lower than earlier expected.

In such circumstances, monetary policy needs to be accommodative. Low interest rates are acting to support borrowing and spending. While the recent changes to some lending rates for housing will reduce this support slightly, overall conditions are still quite accommodative. Credit growth has increased a little over recent months, with growth in lending to investors in the housing market easing slightly while that for owner-occupiers appears to be picking up. Dwelling prices continue to rise in Melbourne and Sydney, though the pace of growth has moderated of late. Growth in dwelling prices has remained mostly subdued in other cities. Supervisory measures are helping to contain risks that may arise from the housing market.

In other asset markets, prices for commercial property have been supported by lower long-term interest rates, while equity prices have moved in parallel with developments in global markets. The Australian dollar is adjusting to the significant declines in key commodity prices.

At today’s meeting the Board judged that the prospects for an improvement in economic conditions had firmed a little over recent months and that leaving the cash rate unchanged was appropriate at this meeting. Members also observed that the outlook for inflation may afford scope for further easing of policy, should that be appropriate to lend support to demand. The Board will continue to assess the outlook, and hence whether the current stance of policy will most effectively foster sustainable growth and inflation consistent with the target.

Enquiries:

Media Office
Information Department
Reserve Bank of Australia
SYDNEY
Phone: +61 2 9551 9720
Fax: +61 2 9551 8033
E-mail: rbainfo@rba.gov.au