A low-cost formula
Share
Gas impacts on our future energy choices will depend on the persistence of demand and the sustainability of prices that could fall further if the U.S. continues to support shale and LNG


Read Oil 33

 

The past decade has been a period of remarkable change for the energy sector in the United States. The emergence of large-scale natural gas and more recently oil production from shale resources has dramatically altered estimates of U.S. domestic fossil fuel resources. In the case of natural gas in particular, these dynamics have also significantly altered long-term price expectations. The scale of these dynamics have also had a profound impact on the international natural gas and oil markets, and have resulted in a significant shift in the balance of energy geopolitics, as U.S. reliance on foreign oil wanes and the country looks to grow LNG exports.

A new inexpensive resource unlocked

The sheer scale of the impact that the development of shale resources has had on U.S. natural gas output over the past ten years is difficult to comprehend. Between its modern nadir in 2005 and the end of 2015, U.S. domestic natural gas production expanded by more 50 percent from 18 trillion cubic feet (Tcf) to just under 27 Tcf. One single play alone, the Marcellus Shale, located in the northeast near some of the country’s major gas consuming market centers, has seen its output grow more than ten-fold since 2010. It is now producing over 6 Tcf annually, or as much as Iran, the world third largest producing nation. Adding to the remarkable shale gas production growth narrative is the fact that this growth has been sustained even though U.S. natural gas prices have been very low. Since 2010, the average Henry Hub spot price has been just $3.50/MMBtu, and in fact over the more recent past that average has been even lower. Since 2014, the average has been just $3.25/MMBtu, and this low price regime looks certain to continue for several years. The medium term forward to 2021 remains at or below $3.00/MMBtu. Analysis from entities including the U.S. Energy Information Agency (EIA) and the International Energy Agency (IEA) reinforces the view that U.S. natural gas will remain low cost for the foreseeable future. Recent modeling from both agencies projects that U.S. shale gas output growth will continue to be buoyant without prices rising significantly beyond $4.00/MMBtu until the mid-2020s at the earliest. Whether these projections prove to be overly optimistic remains to be seen. Strong natural gas demand growth and low oil prices leading to a moderation in the output of very cheap co-produced gas from U.S. oil plays could push pricing into a higher range. On the other hand, the exploitation of the U.S. shale resource remains in its nascency, and in particular, very significant opportunities remain to develop better insight into how production from shale formations can be optimized.

Global gas demand increasing

Large-scale financial bets on how the world’s energy landscape will unfold over the longer-term can be a rather risky business. Just ask those who invested in LNG import terminals in the U.S. a decade or more ago. However, the future does look like it will be increasingly gas-centric. A recent IEA assessment estimates global natural gas demand will increase by 1.5 percent annually till 2040—robust growth relative to that of other fossil fuels. Importantly though, this demand growth will vary considerably across the world’s major gas consuming markets. In the U.S., demand is expected to experience only modest growth of 0.4 percent annually out to 2040. Of course, the U.S. is already a huge gas user, and so this level of growth would still amount to over 3 Tcf in absolute terms. The election of Donald Trump adds uncertainly to the U.S. gas demand growth story given his statements regarding COP21 and the Clean Power Plan. However, even if the new administration steps away from these commitments, natural gas, at least at today’s price levels, will remain reasonably competitive on cost alone with coal in the U.S. power sector. In fact, over the coming years, a bigger threat to natural gas demand growth may well come from the falling cost of renewables. An area where U.S. gas demand growth seems more assured is as a feedstock for chemicals. The structurally lower cost of U.S. gas relative to other markets is driving a strong expansion in U.S. basic chemicals manufacturing, and this growth seems unlikely to moderate over the medium term. Outside of the U.S., gas demand is expected to grow over the next several decades in each of the world’s major markets with the exception of Japan and the European Union. Unsurprisingly, the most profound growth is expected from China and India, whose gas demand is projected to triple and quadruple to 21.3 Tcf and 6.7 Tcf respectively by 2040. Middle Eastern gas demand is also expected to grow strongly during this period, with 28.3 Tcf of demand in 2040 representing a doubling of today’s usage. The future for European gas brings together a very interesting combination of issues. To begin, the region is likely to see very little demand growth over the coming twenty to thirty years. What growth does occur will come from the region’s power sector, which must deliver greenhouse-gas emissions reductions of 40 percent relative to 1990 levels by 2030. Coal to gas switching is an obvious pathway to achieving much of this goal, however, the realities of Europe’s energy evolution don't seem to be as straightforward. To start, natural gas prices in Europe have tended to be appreciably higher than in the U.S. and so there has not been the same simple economic imperative for coal to gas switching in the region as has existed of late in U.S. Additionally, the pricing of carbon from the European emissions trading scheme has not been sufficiently high to close this competitive gap.  Nevertheless, in spite of the rather anemic outlook for natural gas demand growth from Europe, the next quarter century is likely to see some important structural shifts for gas in the region. To begin, local gas supply is going to fall during this period, including supply from Norway, and so the region will become more dependent on imports. Russia has long supplied a plurality of Europe’s natural gas imports via pipeline, and this situation is likely to continue. However, what is much more interesting is how a larger and more flexible global LNG market is likely to influence pricing in Europe during these coming years, and in many respects dilute European dependency on Russian gas supply.

According to analysis from EIA and IEA U.S. shale gas output growth will continue to be buoyant without prices rising significantly beyond $4.00/MMBtu until the mid-2020s at the earliest

The fluctuations in the price and future development

Interregional trade in natural gas, either via pipeline or LNG, has traditionally been a conservative business. Given its nature, participation in this trade involves enormous upfront capital investment, and this can only be accomplished with some degree of buyer/seller bilateral risk sharing. Typically, such risk sharing has been accomplished via the use of long-term supply contracts, which have often directly linked gas prices to liquid-based benchmarks such as Japanese Crude Cocktail. Today, 37 Tcf of natural gas is traded internationally each year. This represents about 28 percent of all natural gas consumed globally. Two thirds of this gas flows via pipeline, with the balance going via LNG. That pipes dominate is not surprising owning to their relative economic advantage over LNG up to distances of approximately 2000 miles. However, going forward, the proportion of gas traded over longer distances will grow and it is now projected that the majority of interregional trade will be via LNG by 2035. The rise of U.S. shale gas over the past five years and the U.S. entry into the LNG export business has yielded a major disruption for the global gas trade, both in terms of destination flexibility and pricing. U.S. LNG export project developers are selling LNG using a “tolling” business model, which provider buyers much greater flexibility. This is a major step away from the traditional long-term bilateral contract paradigm that has dominated in the LNG space, and when coupled to a market that is now very long on LNG liquefaction capacity (as new Australian projects also come online) it represents an overall shift towards a much more flexible supply. Just as an illustration of this trend, between 2010 and 2015 the proportion of LNG traded via short-term contracts or spot market purchases jumped from 17 percent to 30 percent. In concert with greater cargo destination flexibility, LNG pricing is also transitioning away from its liquids-linked past. Perhaps even more significant than the growing destination flexibility of today’s LNG market is the emergence of more gas-on-gas LNG pricing. In 2005, more than 90 percent of European LNG was priced via a liquids linkage, today that is the case for less than 40 percent of cargos. This dynamic has been accelerated by the U.S. LNG tolling model, which offers a direct coupling between U.S. -sourced LNG cargo prices and the U.S. Henry Hub benchmark price. As a result, Asian markets can now also access gas-on-gas priced LNG, albeit via the non-local Henry Hub benchmark. Given where the world finds itself today in terms of natural gas resources and evolving gas market structures, the important questions for gas are less about whether its role will continue to grow—it most likely will till at least mid-century— and more about what gas pricing will look like going forward. The nature of the resource means it will always be relatively expensive to move over large distances, and so regions where demand and supply are co-located (assuming relatively competitive market structures are in place), the U.S. for example, will always be at a cost advantage relative to gas-dependent markets far removed from resources like Japan. However, the recent significant changes in the structure and operation of global LNG markets are likely to result in pricing across the globe that is much more reflective of the global gas supply curve adjusted for transport. This will mean the Henry Hub will become an increasingly important global benchmark, with European and Asian pricing floating above that level by an amount reflective of the contemporary LNG value chain cost. Whether any wildcards dramatically alter this view of the future remains to be seen. On the supply side, progress in the development of international shale gas might be impactful, but chances of that seem very remote. On the demand from, more aggressive carbon policies would certainly soften demand, but beyond the already agreed COP21 commitments, the prospect for agreement on further significant reduction seem remote. In fact, if I was concerned about the future for gas, the dynamic I’d be most concerned about is that further appreciable cost progress for renewables could significantly undermine demand growth in China, India and the Middle East.


See the OMC 2015 Special