Natural Gas Comes of Age

William Powell, Editor, Platts International Gas Report

Demand is growing worldwide for clean-burning natural gas, as Western supplies are being drawn down and new reserves found in distant parts of the globe. Technology like pipelines and LNG is available, but can the established market and political structures respondand at what price?

THE GAS INDUSTRY HAS FOR DECADES adhered to certain set patterns in its supply arrangements, deriving mainly from the proportionally high cost of producing and transporting energy as gas rather than a liquid, and the related nature of its marketingin Europe and Asia if not in North America.

The established market structuressuch as the state-owned exporters agreements to supply regional monopolies in Europe and Asiahave resisted change. Now though, a potent mix of politics, market forces and shifting supplies has put a question-mark over many of the old assumptions.

That gas for most markets is being brought from further away is one cause for concern: security of supply implies energy sources close to demand with shorter transit routes involving fewer countries. For example, the UK enjoyed secure supplies until as recently as the early years of this decade: there was strong demand growth from the power-generation sector but there were also major new fields, such as Britannia, being brought on stream and even an excess of gas available for export. Now annual production appears to be in terminal decline, of around 8%, and there are no big known reserves left to develop.

But now spot trade is dragging liquefied natural gas cargoes across the globe, and new traders such as J Arun and Vitol are entering the market. Nuclear problems in Japan this summer saw spot LNG cargoes fixed at well over $15/MMBtu for some winter 2008 months; the US Energy Information Administration in early October forecast a US peak of $8.65/MMBtu in January.

Competition for Everything

Longer transport distances mean more hardware. One crunch for producers is steel, whose prices have doubled over the last three years and whose delivery lead times are growing. Competing for plate steel are other fast-growing industries such as ship-building. Major pipelines entail heavier construction equipment and more of everything else, including manpower and money. And the kinds of contractors qualified to build gas infrastructure are also tendering for work like building refineries. All this stretches facility lead time.

Last year, no final investment decisions to build liquefaction capacity were taken, as investors cited doubling of costs between project inception and earliest possible execution. Some major investment decisions still await, despite the fanfare accompanying memoranda of understanding such as those signed for Australia's North West Shelf and Gorgon projects. So there is likely to be a shortage of LNG for quite a few years yet.

Another crunch is environmental concerns. For example, ExxonMobil plans to spend $3 billion on monetizing gas which is now a by-product of oil production in Nigeria. The gas will be captured and used in applications like power generation. Other companies will have to follow suit, as flaring there is due to be banned next year. And users of gas have to consider the costs to emit carbon dioxide.

Rising demand is a major issue. In Asia, with sources of supply and centers of demand separated by thousands of kilometers of sea, all the trade has been by tankers carrying LNG from source to terminal under long-term, oil-price indexed contracts with just enough spare capacity built into the chain to allow for maintenance and limited unplanned losses of time or commodity.

Now two new gas consumers, China and India, have drawn up their chairs and sat down at the table, with gigantic appetites for energy. Oil prices are high partly because of this extra demand, taking long-term contract prices with them.

China is on the acquisition trail, joining Japan in seeking stakes upstream in liquefaction plants. Japan is active in Sakhalin Energy, the gas liquefaction and export project in Russia's Far East, for example, and China was poised to sign the largest deal in the Asia Pacific region this yearChina National Offshore Oil Corp.'s $5 billion upstream play to develop Iran's northern Pars gas field and build liquefaction plants.

North America, the world's largest traded gas market, has been self-sufficient. The US has been comfortably relying on imports from Canada to back up its own production on- and offshore, and drawing on vast amounts of storage for seasonal backup.

But its own reserves are depleting and Canada is using more gas in the energy-intensive business of extracting higher-value oil from tar sands. Canadian natural gas deliverability will fall between 7% and 15% in 2007-2009, the country's National Energy Board said this October.

Regularly high gas prices have already led to demand destruction, especially in the power and metallurgy sectors, but prices that are much lower will drive investment away from the upstream. Smaller companies seem happy to spend on drilling at $7.00/MMBtubut nobody seems very interested when the price is much below $5.00/MMBtu.

Changing the Rules

Europe, which has been supplied by a conveniently diverse mix of indigenous and foreign supplies, nearly all linked to oil prices, is also facing major challenges. It is running out of its Dutch gas, and the UK is on the way out as a major supplier.

Europe uses over 450 billion cubic meters each year, and its affluence and political stability would normally make it a highly attractive market. But its national and supranational institutions are struggling to balance so many conflicting objectives—environmental, geopolitical and market liberalizationthat investors demand stability before investing in long-term infrastructure.

Chief among the EU's objectives is a satisfactory dialogue with Russia, whose state-controlled Gazprom provides about a quarter of Europe's gas. While individual buyers within the ECchief among them Gaz de France, E.ON and ENIpursue a "business as usual approach," the European Commission has taken a different line. It wants security of gas supply, but it does not want Gazprom moving into Europe's pipelines without making concessions upstream in Russia.

LNG producers are building bigger: plant, tankers and regasification. Bigger ships mean fewer voyages and more part-loading. But the world's oceans will still see a huge increase in tanker traffic. The exemplary safety-record in LNG shipping might not be worth much if fatal accidents begin to occur.

In the last few years, cargoes have, in response to market signals, sailed from the Caribbean to the Far Eastnot their traditional marketunloaded, returned to refill in the Pacific and then waited idle for months as floating storage for ultimate delivery into Europe. This would not have been economically thinkable until recently, but a surplus of shipping helps change the dynamics.

And new technology has meant that the physical and financial burden of regasification can now be borne by the carrier, so that the onboard plant is kept in use only for short shuttle trips from tanker directly into the transmission network. This technology, marketed initially by US Excelerate, also cuts down on permitting time onshore since the infrastructure there is minimal. The UK LNG import "terminal" at Teesside was built in less than a year.

Geopolitics

There are also major new entrants into the market on the supply side. This has though not been without controversies. Europe's gas consumption comes primarily from indigenous resources or from Russia (25%). But Europe is focusing on diverse supplies and while Russia is building major pipelines to add to its already formidable array, such as the Nord Stream line with German importers, other countries such as Qatar have a beady eye on this affluent market too. Another would-be supplier is Iran. The US has been agitating to keep Iran out of the European market, but so far Iran has been its own worst enemy. But it is moving away from obstructive insistence that foreign investors sell their production to the state as soon as a field is producing.

Nevertheless, Austria's gas monopoly OMV has held lengthy dialogue with the Islamic republic on supplying gas for the Nabucco line from Turkey to Austria. And a Swiss company, EGL, is planning to bring gas from Iran across Turkey and ultimately into Italy, in competition with an Italian company, Edison.

Russia is planning another sub-Black Sea line to bring gas to Bulgaria and then into Italy and up into Austria. That avoids transit states, often a source of friction when they argue over purchase price and debts for past deliveries. That has already led to two instances of cuts in deliveries to Europe in the last few years.

To the east, central Asian republics are working out how to fill a pipeline that will supply China, while also usefully gasifying their own outposts.

Gas Cartel

With gas producers taking a broader view of their business, and many present or potential gas exporters having direct experience with the workings of OPEC, the idea has been aired of creating an analogous gas cartel.

Most recently in April in Doha, Russia set up a working group to consider how price formation could better reflect the perceived seller's market.

The almost universal system of long-term contracts with minimum annual delivery quantities militates against short-term production squeezes and opportunistic price hikesas distinct from extra spot cargoes to meet unexpected demand, such as Japan's Tokyo Electric Power Co. experienced in the aftermath of the August earthquake that shut its largest nuclear power plant. But certainly some form of displacement deals are possible, swapping pipeline for LNG deliveries to mutual advantage.

Well-established suppliers are also eyeing new markets, or old markets in new ways. Gazprom has been experimentally delivering LNG to the US and to Europe thanks to a deal with BP for a handful of LNG cargoes loaded in the Caribbean. And, by virtue of its controlling stake in the Sakhalin Energy project, taken last year at the expense of shareholders led by Shell, Gazprom will be involved in long-term sales of LNG to Asia.

Its ambitions to supply gas to China remain frozen until China feels it has no choice but to pay up for pipeline deliveries. But after China's value-destroying deal with the Australian Northwest Shelf partners, there is a risk that any price is going to seem extravagant. Nevertheless PetroChina has signed on for up to 4 million mt/year from the Gorgon and Browse Basin projects, pending a positive final decision. Those deals are for about $10/MMBtu, at today's very high oil prices, three times the price of the first deal.

Turkmenistan, which has previously confined itself to exporting gas to Russia, allowing Russia to export to higher-value markets in the West, has also struck up a dialogue with China and intermediate countries.

Fasten Your Seatbelts

What will bring further change is a combination of growing market liberalizationnot just third-party, non-discriminatory access and regulated tariffs for transport in Europe, for example, but the abandoning of monopoly practices and evolution of broader geographical links between buyers and sellers, and the continuing growth of the LNG merchantand growing gas consumption, particularly in the power sector.

Globally, these new dynamics will lead to growing confidence that there will be a liquid and increasingly transparent market where a deep pool of buyers and sellers can meet. Decisions to proceed with costly LNG projects will rely less on pre-selling a large proportion of the output. This will not be to everyone's liking, particularly those states who like to control the market. Long-term arbitrage opportunities will become slimmer while short-term volatility will increase. Increased competition for short-term gas could well make it less attractive a fuel for companies designed to operate within narrow and predictable margins.

In Europe, spot trade has had limited attraction beyond the UK, and even there, there is little liquidity on the curve. Oil indexation, which represents the bulk of gas sold at the border, gives predictable and more stable prices but is no reflection of gas supply and demand dynamics. Spot trade is likely to take a bigger share of the market but only up to a point. A key enabler of this drift will be determined by effective separation of the gas transport business from the supply business. Until now, importers have found it too easy to restrict pipeline access and so choke off competition.