Josef Auer of DB Research -
A gas glut is heralding the dawn of a new era. This new era is marked by technological progress, greater convergence between global gas markets and the declining relevance of established pricing patterns in the continental European pipeline business. The areas concerned are the typical large-scale projects, the international supply relationships and the downstream trading and usage levels.
The free-market price of gas will become the new benchmark and will be the guide for the price of pipeline gas. We expect a pronounced buyers' market to develop in the European gas sector by 2013, with North America dictating the price trend. Following the end of the low-price phase from around 2014 onwards, we do not expect to see a renaissance of the longstanding link with the oil price.
The gas glut is bringing opportunities for domestic customers to benefit from pricing changes and providing greater flexibility for industrial users. Traditional municipal utilities and regional energy suppliers are coming under pressure. By contrast, major opportunities are opening up for independent distributors, independent traders and newcomers. Power plant operators should review their procurement strategies. New challenges face gas producers and importers; they will not be in the same boat for much longer, as they will be competing against one another for tighter margins in future.
The security of supply in Europe is improving. The battle for unconventional gas deposits is in full swing. New pipelines and gas storage facilities currently appear to be less urgent. Nevertheless, there is a need to press ahead with the projects in the longer-term interest. Gas market liberalisation, the basis for the new competitive situation, must not under any circumstances be allowed to stagnate. The "Gas OPEC" is currently toothless, but its time will come. Europe should, therefore, invest in more open structures, globally diversified sources and new technologies - and also trust in the creative vigour of market participants.
Beginning of stage four of the European gas market
There are strong indications at present that, half a century on from Groningen, the fourth stage is just getting underway, bringing with it many changes and challenges for all market players. At least three observations argue in favour of this theory, pointing on balance to the dawn of a new era.
First, towards the end of the third phase, gas prices for private households, small businesses and industry surged massively up to mid-2008 in the wake of exploding oil prices. A major driver of this trend was that gas prices in important Western European buyer countries such as Germany are indexed to oil prices. This contractual arrangement, which has hitherto been regarded as sacrosanct across broad sections of the gas industry and was undeniably useful to both sides while the market in gas was starting up, has come to be regarded in recent weeks as at least partially and temporarily dispensable - even in Russia, the dominant source of supply.
Second, there are strong signs that North American and European gas markets in particular, and also some Asian gas markets, after having previously existed separately are now growing closer together. Price trends in recent months are the most powerful indicators of this. The relevance of liquefied natural gas (LNG) in this context will be discussed later.
Third, technological advances play a key part; indeed, they are probably the major driving force behind the two trends previously mentioned. New gas extraction technologies are suddenly turning gas deposits not deemed commercially viable until now (unconventional natural gas) into economically interesting options, paving the way for expansion in gas supplies on a scale not previously anticipated, chiefly in the US. What is more, instead of coming from the established gas producing regions the new volumes are widely distributed around the world.
On balance the new fourth phase on the gas market is hallmarked by technological progress, greater convergence between global gas markets and the declining relevance of established pricing patterns in continental European pipeline business (oil price formation). All this is radiating onto the big-ticket investment typical of the industry, onto international supply relationships and onto the downstream trading and consumption stages. The fourth stage just unfolding on the European gas market holds out many opportunities for market participants, but it also entails risks. Since these are closely related to current and probable medium-term price developments, it seems appropriate briefly to outline these and their causes.
From market balance to global gas glut
Price trends over the past 10 years have played out against a background of gradual transition from a world gas market broadly in equilibrium in terms of volume to a global gas glut.
In the early years of the previous decade, the virtually balanced market situation steered market participants' expectations in approximately the same direction. Up to the middle of 2008 it was thought that global growth in demand for energy necessitated a marked step-up in the supply of gas. Steep increases in the prices of fossil energies since the beginning of the decade made building up and expanding the necessary gas infrastructure profitable. Consequently, financing for these capital-intensive projects was not usually a problem. Moreover, at least up to the middle of the decade many market observers expected that the launch of trading in emission certificates in Europe would make natural gas significantly more competitive vis-Ã -vis fossil alternatives, it being widely accepted that the combustion of natural gas emits less CO2 than hard coal and lignite.
Going forward, this effect was expected to become more pronounced as heightened climate change hazards seemed inevitably to signal rising prices for tradeable pollution rights. All in all, this triggered a burst of gas-related investment, ranging from the development of new deposits through the construction of additional pipelines to additional LNG infrastructures. This investment boom - with the long time-lags typical of gas projects - is currently having the effect of pushing up the volumes of pipeline gas and LNG available around the globe. The situation is now being heightened by the development of unconventional gas, holding out the prospect of substantial additional quantities. The gas glut we are seeing at the moment looks set to persist for some time to come, with severe repercussions on pricing.
LNG spurring international gas price convergence
Since its early days, gas trading in Europe has essentially been based on physical deliveries through pipelines. The increased emergence of LNG has added another means of transmission. In terms of quantity, however, pipeline gas continues to dominate trade, above all in mainland Europe. In 2009, LNG accounted for 10% of gas supplies in the EU.
The uptrend in prices for practically all fossil energy alternatives has enhanced the competitiveness of LNG and made infrastructural investment in the value chain (such as modern vessels to carry LNG and off-loading and regasification terminals) worthwhile around the globe. LNG has injected new flexibility and fresh impetus into the international gas trade. The new transmission vehicle has provided the world regions of particular relevance to the gas trade, ie. the countries forming the triad, Europe, North America and Asia, which were previously practically unconnected on the gas market, with additional gas trading potential.
Research does indeed show that LNG has paved the way for intercontinental arbitrage, elevating gas trading to a new level at which natural gas prices are becoming more closely linked even between continents. Particularly in the Atlantic area, LNG transmissions have tended to nudge price movements in the same direction on what were previously highly segmented markets for natural gas. Up to the end of the latest energy price boom, the causal relationship was by no means unidirectional, with for example one region - North America, say - setting a price trend which another continent - in our case Europe - followed. In actual fact the impetus was more or less evenly spread.
Also important to an understanding of trading activities is that neither the US nor the European side possess the liquefaction and loading infrastructure necessary for exporting LNG. This technical shortcoming is preventing loading at low-price locations and off-loading at high-price locations that would enable brisk physical trade in gas across the Atlantic. Moreover, liquefaction is too expensive for arbitrage trading. That is why liquefaction plants are not built for arbitraging purposes. The only suitable cargoes for deliveries triggered by arbitrage are therefore those already being shipped by LNG tankers from other production areas (eg. Africa, Qatar). If the price difference offers a great enough inducement, LNG shipments floating in the Atlantic can simply be redirected and regasified at the high-price location. Arbitrage is thus ultimately limited to cargo management (as with many other durable and non-durable consumer goods). Comparatively "small volumes" therefore balance out the regional markets all round the world.
Free US prices put pressure on pipeline gas prices in Europe
In the past few months, some completely novel developments have occurred in the global gas trade. Key to this were technological breakthroughs with huge economic implications. Two particular features are apparent. First, in the present market situation many determinants are working in the same direction. Second, the convergence of gas prices is following a new pattern. It seems as if recently parameters from the US are setting the trend and European prices adjusting within a relatively narrow impact channel.
What does this process look like in detail? The real cause of the gas glut we are currently seeing is the rise in gas prices since the beginning of the last decade. This has suddenly turned the recovery of natural gas from many unconventional sources previously deemed unprofitable into an economically viable option. While it was known that the US and many other countries possessed more or less large unconventional deposits of gas in impermeable shale and coal seams (also called tight gas), the technologies required to extract this only became profitable as gas prices climbed. Essentially these enhanced gas recovery methods revolve around horizontal drilling and a hydraulic fracturing process called fracking or hydrofracking.
The innovative high-tech combination of horizontal drilling and multi-stage fracturing systems is the actual technical reason behind the creeping revolution currently taking place on the gas market. The US Department of Energy estimates that the US alone possesses sufficient recoverable unconventional gas deposits to supply the entire country for the next 90 to 120 years. Conversely, of course, this means that the US will become less dependent on imported gas than previously assumed. The large shale gas finds in North America mean that the role played by the US on the global LNG market will have to be redefined.
Genesis of a new LNG world
Until now, practically all medium- and long-range LNG scenarios have been based on the assumption that going forward the US would have to import ever larger amounts of energy as its domestic fossil energy resources were depleted. Most importantly, it was believed the US would absorb much of the additional new supply of LNG set to flood the world market over time. The US' appetite for energy thus held out the promise of keeping the global LNG market in equilibrium for the foreseeable future and ensuring that surpluses did not arise.
In reality, matters have turned out differently. Already, the rise in the production of unconventional gas is shaping pricing in the US. Whereas in 2000 just 30% of US gas production came from unconventional sources, the expansion in the volume of shale gas has since pushed this figure above the 50% mark. The new amounts enabled the spot price at the Henry Hub pipeline, which is the pricing point for the US, to disconnect early on from the other international regional markets.
The consequence of this development is that LNG volumes originally scheduled for the US are no longer required there. Redirection of these volumes and their sale on the spot markets in Europe and Asia has caused gas prices to collapse there, too, as in the US before them. In 2009, this trend was shored up by two factors that pushed prices in the same direction. First, the global economic recession subdued energy consumption, with the result that global demand for gas was lower than expected. Second, more and more LNG projects launched when prices were riding high (as already discussed) are recently becoming relevant to market activity. Both these drivers are of course ramping up the pressure on prices from the supply-side.
That this price trend has crossed the Atlantic to Europe is due chiefly to the free gas market in the UK, which is acting as something of a "release valve" for oversupply. Oversupply of LNG is ousting Norwegian gas in the UK and this is moving on to Germany instead. In north-western Europe, gas from Norway is therefore increasingly coming up against gas supplies from Russia, and the prices of both are competing with production from domestic sources. The gas glut drove down spot prices at the end of 2009 to around 1 ct/kWh (ie. below long-term averages), while the prices at German border crossings calculated by the Federal Office of Economics and Export Control (BAFA) were roughly twice as high. To put it another way, the Henry Hub spot price points the way for the spot price at the UK National Balancing Point, to which in turn the Title Transfer Facility futures market is aligned. And this price for free quantities then radiates onto all gas prices on the Continent. This also applies to prices for pipeline gas, because following liberalisation of the European natural gas market gas consumers are at liberty to choose the suppliers from whom they purchase their gas. Corporate clients and regional distributors have recently been making increasing use of this option, with the result that even long-term contracts for district gas with "take-or-pay clauses" have been affected. Ultimately, price pressures are obliging suppliers to be rather more open-minded on long-term contracts whose prices are indexed to that of oil. On balance the newfound flexibility on the part of even the major Russian gas producer signals a sea change in the gas industry.
The new international gas cosmos is thus characterised by a situation in which, unlike the previous decade, there is a unidirectional price correlation between North America and Europe (and also Asia, with certain reservations). The direction is flagged up by the Henry Hub spot price, which gas prices in Continental Europe then follow via the NBP. Whilst the price for pipeline gas previously determined events in Europe, the free gas price is now the new benchmark.
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