COP ConocoPhillips

MELBOURNE, Australia—Six years ago, Big Oil was so confident in the outlook for global energy demand that it bet tens of billions of dollars to turn part of a remote Australian island known for its breeding grounds of rare sea turtles into a vast gas-export hub.

Now, the Chevron Corp.-led Gorgon plant has become emblematic of how quickly the assumptions that underpinned giant energy bets world-wide have been shaken by falling energy prices.

On Tuesday, Chevron said it had started producing liquefied natural gas—natural gas cooled to a liquid form so it can be transported by ship—from the Gorgon project and the company expects to send its first cargo to customers in Asia next week. However, the plant is becoming operational at a time when investors are more skittish about the health of China's economy, amid an oversupply of major commodities.

Last month, Chevron, which owns nearly 50% of Gorgon, was among 10 U.S. oil companies whose credit ratings were cut by Standard & Poor's due to the oil-price rout. Another of Gorgon's big investors—Exxon Mobil Corp.—had its triple-A corporate rating placed on watch by S&P for a possible downgrade.

Many experts say Gorgon, now estimated to cost $54 billion to build versus an original budget of $37 billion as site construction progresses, offers a scant return on the huge investment with energy prices at current levels. Oil prices were at around $60 a barrel—and rising—in September 2009, when Chevron, Exxon and Royal Dutch Shell PLC signed off on the project's construction. That is roughly 60% above where oil prices sit now.

Gas sales from LNG projects in the Asia-Pacific region such as Gorgon are linked to swings in oil prices, meaning returns on investment are more vulnerable to volatility in commodity markets than export-oriented facilities in the U.S. In 2015, LNG prices in Asia roughly halved.

Energy companies say shareholders will benefit from a guaranteed revenue stream from Australia, backed up by a stable regulatory regime. Chevron estimates gas output from Gorgon will last at least 40 years. Also, Chevron and its partners have locked Asian customers including China into deals linked to oil prices that last up to 20 years, meaning they must pay for natural gas supply whether they need it or not.

"We expect legacy assets such as Gorgon will drive long-term growth and create shareholder value for decades to come," John Watson, Chevron's chief executive, said. Spokespeople for Exxon and Shell, which own about 25% of Gorgon each, declined to comment.

Last year, China's LNG imports fell 1% as the economy cooled. At the same time, rapid growth in North American shale-gas production sparked fears of a global energy glut that is likely to take years to clear.

"We're looking at a world of significantly lower returns compared to the old days of the LNG industry," said Michelle Neo, a Singapore-based analyst at energy consultancy FGE.

Gorgon is Chevron's biggest global bet on LNG and it will produce up to 15.6 million metric tons of LNG a year, plus enough gas to generate electricity for 2.5 million Australian homes.

Gorgon, along with seven other gas-export facilities in Australia and neighboring Papua New Guinea, promised to help redraw the energy map by moving the epicenter of the global gas trade away from the politically volatile Middle East. About $180 billion was committed by companies including Chevron, ConocoPhillips and France's Total SA to Australia's gas-export industry between 2009 and 2012.

As well as concerns raised by the impact of falling prices on margins, onshore LNG projects are costly because they require refrigeration tanks and a network of transportation pipelines, while in many cases sea channels need to be created for LNG tankers to arrive at ports and load up.

In addition, Gorgon's checkered record since starting construction has undermined confidence in its returns.

The project "is the poster child of rampant cost inflation gone wrong in the Australian LNG industry," said Neil Beveridge, a Hong Kong-based senior analyst at Sanford C. Bernstein. He estimated that the project's overall cost could come in at close to $60 billion, or roughly $4,000 a ton of capacity—about twice the current break-even estimate based on current prices.

Gorgon's construction on isolated scrubland off Australia's northeastern coastline coincided with a parallel investment boom in other resources such as iron ore and gold.

The result was that Chevron had to pay more to hire people—from pipe fitters to welders—while the construction frenzy helped to drive up the cost of raw material imports such as steel. A strengthening Australian currency inflicted more pain for Chevron, which had calculated its costs in U.S. dollars.

Barrow Island's status as a government-protected nature reserve since 1910 also brought complications. Chevron and its partners had to comply with strict environmental conditions, ranging from shrouded lights to avoid disturbing the nighttime mating of marine turtles to some of the world's toughest quarantine procedures to cut the risk of invasive species being brought in by workers.

Chevron expects the project to add a little more than 200,000 barrels a day to its production when fully operational. That compares with the company's output of 2.67 million barrels a day in the final three months of 2015. Gorgon and another Australian LNG project, known as Wheatstone, together accounted for nearly half the US$15.4 billion that Chevron invested in oil and gas in 2014.

However, such LNG projects will welcome long-term cargo revenue and analysts recognize their future potential, despite current price concerns.

"If you look from the point when the investment decisions were taken, back between 2009 and 2011, then the project economics are pretty marginal and have suffered," Giles Farrer, a research director at consultancy Wood Mackenzie Ltd. in London, said. "[But] if you look at the point where we are now, the projects are going to deliver fantastic revenue."

Write to Robb M. Stewart at robb.stewart@wsj.com

(END) Dow Jones Newswires

March 08, 2016 09:05 ET (14:05 GMT)

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