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LNG IN ATLANTIC BASIN MARKETS AFTER TWO(?) WINTER PRICE SHOCKS

Morten Frisch Senior Partner Morten Frisch Consulting (MFC) 6 Holmwood Close, East Horsley, Surrey KT24 6SS, United Kingdom www.mfconsulting.co.uk Carlos Lapuerta Managing Director The Brattle Group Ltd 198 High Holborn, London WC1V 7BD, United Kingdom www.brattle.com

ABSTRACT
After providing a summary of developments in Atlantic Basin gas markets during the winters of 2005/06 and 2006/07 (until mid January 2007), the paper presents analyses of US and European gas markets, with emphasis on gas market forces that either have emerged or have manifested themselves during the two last winters. A major theme is the effect of high and very volatile prices on gas demand. Will there be a shift from gas to nuclear and coal-fired power stations? What does the future hold for energy intensive industries in North America and Europe? The paper addresses the likely future demand for LNG in the US gas market, the growing importance of gas supply diversification in European gas markets, and the resultant implications for the construction of LNG receiving terminal capacity. The paper concludes by assessing the likely demand for and future role of LNG in Atlantic Basin gas markets, and hence the likely future importance of these markets to LNG producers.

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ACKNOWLEDGMENT
When developing a most likely scenario for future LNG supply and demand it has been of invaluable help to discuss LNG project developments and the current and likely future level of operation at existing LNG plants and to compare notes on these topics with Mrs Marie-Francoise Chabrelie, Secretary General of Cedigaz in Paris. Both authors are most grateful to Marie-Francoise for this excellent help and support. All errors and omissions in the paper are however our own.

DISCLAIMER
This presentation is meant to provide an insight into current and future developments in Atlantic Basin gas markets and the likely future role of LNG in these markets. Although the authors believe that the presentation reflects a correct view of the current situation and future developments in these markets at the time of its drafting during January 2007, the authors of this paper and/or Morten Frisch Consulting, The Brattle Group Inc. and The Brattle Group Ltd. cannot be held responsible if this should prove not to be the case or if any of the conclusions drawn from this presentation should prove to be inaccurate. No representation or warranty is made as to the accuracy or completeness of the presentation and no person is entitled to rely on its contents. Any recipient of this presentation, whether in electronic, hard copy, visual or oral form, proposing to plan, build or operate projects along the gas value chain or to plan, engage in, or operate gas trading activities along the gas value chain serving markets in North America, Europe or indeed elsewhere in the world, should apply dedicated, specialist analyses to their specific legal and business challenges spanning the entire gas value chain between the gas producing and consuming countries. This presentation in no way offers to substitute for such analysis.

ABBREVIATIONS
ACQ Bcm CH DG TREN EIA EU 25 Annual Contract Quantity. Billion standard cubic meters (of pipeline quality gas, see Sm3 below). Switzerland. The European Commissions Directorate General for Transportation and Energy. The Energy Information Administration of the United States Department of Energy. The twenty-five countries that were members of the European Union in 2006 i.e. Bulgaria and Romania that joined the European Union in 2007 are not included. The European gas market area addressed in this paper. Million British thermal units. Million metric tonnes (of LNG) per year. The National Balancing Point in the United Kingdoms gas pipeline network. A standardized cubic meter of pipeline-quality gas with gross calorific value of 39 MJ. Take-or-pay, referring to purchase commitments in gas sales agreements. The Belgian gas trading hub.

EU25+CH mBtu mt/y NBP Sm3 ToP Zeebrugge

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TWO CONTRASTING WINTERS

The gas markets in both North America and Europe have been through a rollercoaster over the past two winters. The winter of 2005/06 displayed unusual characteristics in all major gas markets bordering the Atlantic Basin. The average monthly gas price at Henry Hub exceeded US$13 per mBtu during October 2005 as a result of hurricanes Katrina and Rita. Gas prices spiked again during a cold spell in December 2005, but unseasonable mild temperatures followed in North America. Gas demand fell, gas prices were soft, and large volumes of gas were delivered to storage facilities. Abundant storage stocks depressed US gas prices in 2006 until the air conditioning season in July and August. US LNG imports in 2006 have been estimated at 12.1 mt/y1 equivalent to 16.3 Bcm of pipeline-quality gas. Imports were sharply down relative to the 13.2 mt/y (equivalent to 17.8 Bcm of pipeline quality gas) that was imported in 2005. In contrast to North America, Europe experienced exceptionally cold weather with record gas demand and high prices both in the liberalised gas market in Great Britain as well as continental Europe. High crude oil prices contributed to the high gas prices in continental Europe due to the indexation of long-term gas contracts to oil products. Gas markets in the UK and Ireland suffered from a very tight combined gas supply/demand balance. These problems were exacerbated by the lack of response from the major continental European gas market players to high UK gas prices. As if this should not provide a sufficient torment for the UK authorities, the Rough Field gas storage facility, the largest gas storage in the UK that normally delivers 10 per cent of UK gas demand during peak demand periods, was damaged by fire in early 2006. At the beginning of January 2006, a gas contract dispute prompted the Russian Federations (Russias) GazProm to interrupt deliveries of gas to the Ukraine, a country that transits some 20 per cent of Europes gas supplies. This brief gas supply interruption by Europes main gas supplier was compounded by exceptionally cold winter conditions in Russia and Central European countries. Austria, Germany, France, Italy, the Czech Republic, the Slovak Republic and Hungary all witnessed partial curtailments of their Russian gas supplies during most of January and February, and part of March 2006. Drought conditions in Spain, Portugal and part of France made the energy economies of these three countries more dependent on LNG supplies than what normally would be the case. During the winter 2005/06 the average price for LNG delivered ex-ship to Mediterranean LNG receiving terminals oscillated between US$8 per mBtu and US$10 per mBtu2. Spain was in reality the price setter for LNG in Europe, although higher prices were achieved by the few LNG cargoes delivered to the new LNG terminal at the Isle of Grain in the UK that winter.

Gaul, D. and Platt, K. Short-Term Outlook Supplement: US LNG Imports - The Next Wave, Energy Information Administration, US Department of Energy, January 2007. Alvarez, A., Repsol YFP, Presentation to CWCs 7th Annual World LNG Summit in Rome, Italy, 13 October 2006.
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The winter of 2006/07 (until mid January 2007) has so far been relatively similar on both sides of the Atlantic Basin. Both market areas have seen above seasonal normal temperatures with depressed gas demand, falling gas prices and more than adequate gas in storage. Wholesale gas prices at Chicago and Boston city gates fluctuated between US$6.00 per mBtu and US$8.00 per mBtu during November and December 2006 reflecting the abundance of gas in storage. In early January 2007 gas storage facilities in the Northeast of the USA were filled to between 85 per cent and 95 per cent of capacity. The Chicago and Boston gas price levels mentioned above are low in relation to normal winter prices in these wholesale gas markets, making incremental Canadian gas exports uneconomic. This in return resulted in a dramatic reduction in the number of drilling rigs operated in Alberta and British Columbia, Canadas two main onshore gas producing provinces. The reduction in Canadian gas drilling during 2006 could result in short term gas supply problems in the US in 2007. The low level of energy imports to the US experienced in 2006 is expected to continue into 2007. Gas demand in Northwest Europe during the winter 2006/07 was until mid January 2007 well below seasonal normal levels for two reasons. Winter temperatures were well above normal levels. Gas prices in the liberalised UK market softened very considerably since the previous winter. Furthermore, the gas futures market for the winter 2006/07 peaked in April 2006 and had fallen by some 50 per cent by mid January 2007. This sharp reduction in UK gas prices appeared to have a positive impact on demand particularly from the power generation market and energy intensive industries, many of which were closed down during the winter of 2005/06 as a result of high gas prices. In January 2007 the domestic gas market in the UK had not yet had the benefit of reduced gas prices due to the pricing policies of retail gas suppliers. The UK forward price for first quarter 2007 was $7.59 on December 18 2006.3 Futures prices for gas delivery to the UK market during the early part of 2007 had by mid January 2007 fallen to below US$6.00 per mBtu. In continental Northwest Europe, border gas prices for delivery during first quarter 2007 were typically between US$7.50 per mBtu and US$10.00 per mBtu depending on delivery point and delivery flexibility. Early indications were that high gas prices based on oil product price indexation were having a negative effect on gas demand in continental Northwest Europe. As in the previous winter, drought conditions in Spain, Portugal and part of France had again prompted high gas consumption in the affected areas. Prices of LNG delivered to Spanish terminals were very high compared to other destinations in Atlantic Basin markets. The value of LNG delivered ex-ship to Spain during the first week of January 2007 was some US$10 per mBtu while this value in the UK was less than US$6 per mBtu. LNG delivered to terminals on the East Coast of the US also had a value of some US$6 per mBtu in early January 2007. Russia is in total supplying some 25 per cent of European gas demand. During the winter period approximately one third of this supply, or some 8 per cent of European demand, currently transits Belarus. A gas supply contract dispute between Russias
This price was for the forward contract on the International Petroleum Exchange (IPE) Gas Futures Market in London, for the delivery of gas during the first quarter of 2007 at the UK NBP.
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GazProm and Belarus threatened to disrupt this gas supply, but was resolved in the eleventh hour. If this dispute had not been resolved gas deliveries to Poland, Germany and the Czech Republic would again have been hit hard Based on the situation prior to mid January 2007, what lessons could Atlantic Basin gas market operators learn from the winters of 2005/06 and 2006/07? In the US the gas supply situation appeared better than anticipated only a few years ago. LNG had become a marginal gas supply source, to a large extent drawn upon during periods of weatherinduced high electricity and gas demand. European gas markets experienced very tight gas supply conditions with some fuel switching out of natural gas during the winter of 2005/06. However, energy markets were generally supplied with gas. Although not perfect, the liberalised gas market in the UK was functioning during the winter of 2005/06. The importance of providing a much higher level of gas storage capacity in the gas markets of the UK and Ireland could not be ignored. The winter of 2005/6 raised more questions about continental European gas markets. With the exception of European gas markets having a border with the Mediterranean, the high and rising gas prices experienced were having a negative impact on gas demand in Europe. Russias behaviour towards its gas transit countries and also the operation of the gas market within Russia itself gave rise to very serious concerns about the reliability of this country as Europes main gas supplier.

THE US GAS SCENE

The Effect of High Gas Prices. High gas prices are having considerably different effects on demand in North America and Europe. In the United States, high prices have led to a significant revision of demand forecasts, with serious implications for future LNG imports. The effects in Europe, although clearly present, are far more attenuated. The differences lie in a combination of demand and supply factors. High prices in the United States have prompted higher investment in domestic gas resources. High prices also make coal more attractive than gas in the United States as a fuel for thermal power stations. These two factors distinguish North American gas markets significantly from Europe: The European gas market area that is addressed in this paper, can only in a very limited way respond to high gas prices by accelerating the development of indigenous resources, and Europeans pay roughly twice as much for coal as in the United States. Gas Demand. The EIA has recently published a new base case for future gas demand in the United States4. The new base case shows gas demand increasing at a rate of 1.7% through 2015, from 615 Bcm to 717 Bcm. Two years ago we discussed the successive postponement of gas demand forecasts by the EIA5. We noted that gas demand had stagnated in the United States since the onset of high gas prices, and that it seemed unreasonable to predict such large future increases in demand. We had referred to the demand forecasts as the planned trajectory of an airplane about to take off, but each year
Annual Energy Outlook 2007/ Reference Case, Energy Information Administration, US Department of Energy (15th December 2006). Frisch, M., Carpenter, P. and Lapuerta, C., The Advent of US Gas Demand Destruction and its Likely Consequences for the Pricing of Future European Gas Supplies, paper presented at the GasTech 2005 conference, Bilbao, Spain, 16 March 2005.
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its takeoff seemed to be postponed. We produced a figure showing the successive forecasts from 2001 to 2005. We now reproduce the figure, with the last two years forecasts added.
1000 950 U.S. Gas Consumption (BCM) 900 850 800 2006 750 2007 700 650 600
0 20 10 5 5 202 20 25 200 200 201 0

2001 2002 2003

2004 2005

2006 forecast now postponed until 2018

Figure 1: EIA Gas Demand Forecasts The new 2007 base case confirms our previous concerns. The contrast with the 2000 EIA forecast is remarkable. As we suspected, demand has continued to stagnate. In early 2001, the forecast was for growth of 105 Bcm by 2006. None of that growth has materialized. Actual consumption in 2006 was even less than in 2000.6 Growth has been zero. The most recent forecast shows that the previous target for 2006 has now been pushed out to 2018. What was supposed to happen in six years will now take a total eighteen years to materialize. The forecasts for 2015 have been slashed by even more. The 2001 forecasts anticipated a total of 895 Bcm by 2015, while the new forecast is for only 717. The drop of 178 Bcm approximates the current total consumption of the United Kingdom and Italy combined, which are two of the largest national markets in Europe.

The EIA has estimated that US gas consumption in 2006 was 615 Bcm. In 2000 it was 660.

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1000 950 U.S. Gas Consumption (BCM) 900 850 800 Decrease in Forecast for 2015

2001 2002 2003

2004 2005

2006 750 2007 700 650 600

0 20 10 5 5 20 25 200 200 201 202 0

Figure 2: Reduction in EIA Gas Demand Forecasts for 2015 The US power sector is responsible for much of the change in forecast demand. In 2001, increased demand from the power sector was forecast to drive roughly three quarters of the total growth by 2015. The 2007 forecast now shows that there will be no net growth in gas demand from the power sector in the long run. In 2030, the United States power sector is anticipated to consume 209 Bcm of gas, which is virtually unchanged from the 208 Bcm consumed last year. The new forecast has reached levels that we find credible. It is difficult to foresee any long-term increase in consumption of natural gas by the power sector, when the average price of coal is so low. Although there is an international market price for coal, it applies only to a few geographic areas in the United States that must import coal from overseas due to the lack of available local resources. Many power companies in the United States are located in areas with abundant coal reserves, where local market prices lie significantly below international levels. The Department of Energy provides information concerning the average cost paid for coal in each state of the United States.7 The most recent data confirm the effect of proximity to coal reserves. Wyoming is the center of the Powder River Basin, which has the cheapest coal reserves in the United States. The basin is characterized by deep coal seams with minimal overburden, making the coal extremely economic to mine using surface methods. The coal is naturally low in sulphur. The Department of Energy shows that the average price of coal produced in Wyoming was $7.71 per ton in 2005. The price paid for coal tends to increase in the United States heading from Wyoming to the south and east, due to the costs of railroad transportation. Texas is a relatively distant state, which nevertheless has imported substantial volumes of coal from the Powder River Basin. The average price paid for coal produced in Texas was $17.39 in 2005. The
Energy Information Administration, Average Open Market Sales Price of Coal by State and Mine Type: 2005, 2004.
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differential relative to Wyoming reflects the rough magnitude of rail costs. The costs of Powder River Basin coal plus rail costs places a competitive constraint on the prices paid for coal produced in Texas. Similar factors affect the price of coal sold in states as far east as Illinois, Indiana and western Kentucky.8 The average coal price across the United States was only $24/ton. In contrast, the average price of coal purchased in Europe has exceeded $60 per ton.9 While the United States also imports some coal, and pays international market prices, international imports go to only a minority of those states that are the most distant from indigenous coal resources. Alabama is so far from the Powder River Basin and sufficiently distant from the higher-cost Illinois Basin, as to make imported coal economical. Coal produced in Alabama sold for an average of $53.63 in 2005. This is not quite as high as the average price of coal in Europe, in part because the proximity of Alabama to Colombia, a large coal exporter, enables US consumers to realize savings on international shipping costs. Almost 80% of US coal imports are from Colombia and Venezuela. To import coal from the same countries, a European power generator would have to pay substantial more in shipping costs to move the coal across the Atlantic. The Brattle Group has performed in-depth financial analyses concerning the relative economics of nuclear, coal and gas-fired power stations. One of the authors has published the results of this work at a conference for the International Association of Energy Economists (IAEE) in Wellington, New Zealand.10 Our analyses confirm that the current era of high gas prices has rendered coal-fired power stations more economic than gasfired ones. Even the prospect of future carbon trading does not make natural gas attractive for the power sector in the United States. Our analysis suggests that, at current fuel prices, emissions would have to cost $24 per tonne of carbon dioxide before gas would become more attractive than coal. This exceeds the current forward prices of $21 for carbon quoted on the German power exchange, EEX.11 Supply. Earlier we mentioned the second factor affecting prospects for LNG imports to the United States: investment in indigenous resources. Natural gas reserves have declined consistently for several years in the United States. However, drilling activity has demonstrated a significant sensitivity to natural gas prices in both the United States and Canada, the latter being a substantial exporter of gas to the US. High gas prices have prompted significant increase in the number of active rigs in the US, from 720 in the year

Illinois and Kentucky also produce coal. Their distance from the Powder River Basin is sufficient to permit a significantly higher market price, commensurate with the much higher costs of extraction. However, even in Illinois the costs of coal lie significantly below international market prices. The average price paid for coal in Western Kentucky, where the coal is produced, was $39.68 per ton in 2005. Source: Eurostat import data show an average price of $67/ton from October 2005 through October 2006 (see online data at ec.europa.eu/eurostat).
10 9

Lapuerta, C., Analysing financial risk and the relative economics of natural gas, coal-fired and nuclear power stations (presented at the IAEE Conference: Wellington, New Zealand) (February 2007)..

11

Quoted at 16 per tonne CO2 by www.eex.de on January 15, 2007 (we have converted this price in into US$ at a rate of US$ 1.29 to the ).

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2000 to 1,351.12 Figure 3 shows the extremely tight correlation between prices and drilling activity in the United States.

9 8 7

1,400

1,200

1,000

6 $/Mbtu 5 4 3
400 800

600

2 1 0 1997 Source: EIA. 1998 1999 2000 2001 2002

Rigs Prices 2003 2004 2005

200

Figure 3: Average Gas Prices and US Drilling Activity The response of the market to higher prices is promising to slow down the anticipated reduction in indigenous gas sources. Furthermore, we anticipate significant investment into unconventional gas sources, primarily coal bed methane. To this picture we should add the prospects for two large pipeline projects that would bring natural gas to the lower 48 states from the McKinsey Valley in Canada, and Prudhoe Bay in Alaska. Investment in indigenous resources and the switch to coal will together constrain significantly the scope for LNG imports to the United States. Imports should still grow relative to current levels, but at a far slower pace than previously thought. Figure 4 shows a projected supply and demand balance for the US, with LNG imports filling the gap between demand and the supplies available to serve domestic sources. We calculate the available domestic sources to serve the United States by including domestic production, Canadian gas pipeline imports, and by deducting anticipated exports from the United States to Mexico. We show the two large pipeline projects from Canada and Alaska in yellow, first appearing in 2011 and then expanding significantly in 2019 and 2020.

12

EIA, Table 5.1: Crude Oil and Natural Gas Drilling Activity Measurements The 1,351 is the average for the twelve months extending from December 2005 through November 2006, the last month for which the EIA had information available.

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Figure 4: Projected Supply and Demand for Natural Gas in the United States

EUROPE, A GROWING GAS MARKET

Gas Demand. We have analysed closely the gas demand forecasts prepared by the European Commissions DG TREN.13 More recent demand projections are available from national sources for some EU countries. However, the work by DG TREN reflects a comprehensive European effort with consistent projections for each of the first 25 member countries of the European Union, plus Switzerland (EU 25 + CH)14. We therefore base our demand forecast on the work by DG TREN after analysis and modification. Below we discuss some factors suggesting that demand will be less than forecast. We see strong grounds for a reduction in the forecast by 10 Bcm by 2015, which approximates 10% of the forecast growth. However, our principal conclusion is that high prices in Europe will not lead to a stagnation of gas demand anywhere near the scale that has occurred in the United States. Recent trends have involved a reduction in the percentage of total GDP consumed by the industrial sector in Europe. The services sector has increased in importance. This trend has a moderating effect on natural gas demand, because the services sector uses natural gas less intensively than industry. The current era of high energy prices should only accelerate Europes shift from the industrial sector to the services sector. However,
13 14

Scenarios on High Oil and Gas Prices (2006).

When analysing the European gas market and discussing its future development we define Europe as the 25 countries that were members of the European Union in 2006 (EU 25). We also include Switzerland (CH) in this definition of Europe since this country is fully integrated in the gas market of the EU 25 countries. Norway is not a full member of the European Union. We treat Norway as a gas supplier to the EU 25 +CH countries. Our analyses do not yet included Bulgaria and Romania in the definition of Europe, because they have just become members of the European Union on 1 January 2007. As neither country is an LNG supplier or importer, their inclusion would not have made any significant changes to our gas market analyses.

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the European Commission forecasts assume an unexplained sharp stagnation of this trend. Figure 5 shows the historical decline of the services sector in the EU, and the forecast assumed by the Commission when developing its projections for gas demand.

Value added by Industry (incl energy)

25% 20% 15% 10% 5% 0% 1995

Historic Trend

EU15

DG TREN Forecast Forecast

1999

2003

2007

2011

2015

2019

2023

2027

Figure 5: Historical and Projected Size of Industrial Sector in Europe The European Commission produces its forecasts only once every few years. The latest forecast was published in 2006. We can check the realism of the forecast in part by comparing to actual data. The European Central Bank publishes data concerning the size of the industrial sector. In 2005 the industrial sector represented 18.2% of gross domestic product. This percentage is already below the level that the Commission had forecast for 2030. A more reasonable scenario would entail two adjustments to the Commissions forecast: departing from the actual data witnessed for 2006, and projecting a continuation of the historical shift from the industrial to the services sector. Together these adjustments suggest that the Commission has overstated the consumption of gas by the industrial sector, and slightly underestimated the consumption of gas by the services sector. However, the net effect is an overstatement of the total demand forecast. Our proposed adjustments would reduce demand by approximately 7 Bcm in 2015. We have examined the Commissions forecasts for gas consumption by the power sector. The main weakness appears to be the assumed retirement of nuclear power stations in Sweden and Germany, which is forecast to prompt the construction of more gas-fired power stations as a substitute. High energy prices exert strong commercial pressures to extend the lives of the nuclear power stations. We would amend the forecasts to assume a continuation of these power stations through 2015. The amendment has the effect of reducing forecast gas demand by another 3 Bcm in 2015. Our proposed adjustments combine to reduce the forecast for Europe by 10 Bcm. The total extent of the revision could be higher, but we do not see major grounds to question a principal aspect of the forecast: increased demand for natural gas by the European power
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sector. Earlier we referred to The Brattle Groups work concerning the economics of nuclear, coal and gas-fired power stations.15 Our analysis shows that nuclear power is now economic in the era of high gas prices. Europe may therefore witness a shift to nuclear power. The first step would be to extend the lives of existing nuclear power stations. We include this step in our demand forecasts. The next step will be the eventual construction of new nuclear power stations. However, the political debate on nuclear power has not yet settled. The timing of new nuclear power stations will depend on the resolution of regulatory uncertainty and on the naturally long lead times for constructing new nuclear power stations. It is difficult to believe that the European market will complete substantial new nuclear capacity before the end of our forecast horizon in 2015. We have also considered whether high gas prices might lead to a resurgence of coalfired power stations in Europe. While our analysis suggests that coal is more economic than gas in the United States, coal does not have a clear advantage in Europe. Most of Europe pays more than $60/ton for coal. This high price combines with the prospective cost of carbon permits to give the power sector a relatively high tolerance threshold for natural gas prices. The era of high gas prices has renewed interest in coal, and coal could become clearly more attractive depending on technological breakthroughs in carbon sequestration. However, barring a technological breakthrough, we do not anticipate a major shift to coal in Europe prior to 2015. Coal is not equally expensive in all European countries. Greece and Germany have domestic lignite reserves, and the German tax regime is favourable to coal. Poland is a net exporter of coal. However, these countries do not account for a substantial portion of forecast new power stations prior to 2015. Three countries account for the majority of forecast new construction: England, Spain and Italy. Coal is expensive in all three countries. The most recent information suggests that 71% of all new planned power station capacity in the United Kingdom will be fired by natural gas, and the percentages for Spain and Italy exceed 90%.16 Figure 6 shows our forecast of demand and supply. This forecast has been based on the annual percentage demand growth developed by the Commissions DG TREN, which we have applied to historical gas consumption data17 with the adjustments that we have described above. The forecast entails a growth of 96 Bcm in natural gas consumption by 2015.

15 16 17

See Note 10. Platts, Power in Europe (September 16, 2006).

Cedigaz, Trends & Figures in 2005, from Natural Gas in the World (October 2006)(for all countries except the Netherlands, United Kingdom, Spain, Denmark and Ireland). The Netherlands data come from the Central Bureau for Statistics (Statistics Netherlands, Voorburg/Heerlen (2/1/2006)). For the United Kingdom we relied on National Grid, Ten Year Statement 2005 (December 2005). For Spain, Denmark and Ireland we used BP, Statistical Review of World Energy (June 2006).

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Figure 6: EU 25 + CH Gas Supply/Demand Balance Supply. The estimated supplies in Figure 6 come from our proprietary database that looks at existing import contracts, infrastructure developments, and data concerning likely domestic European production as well as the major producing countries from which Europe imports pipeline gas. The domestic production volumes (defining domestic as EU 25 + CH), again reflect projections in the European Commission DG TREN18 and from the Ministries or state oil and gas companies of particular gas-producing Member States. To estimate gas imports we considered existing contracts for Algerian, Libyan, Nigerian, Russian, Trinidadian and Ukrainian supplies. For Norwegian imports we considered the latest gas production projection issued by the Norwegian Petroleum Directorate19, modified to match available gas transportation infrastructure. LNG supplies from Egypt, Oman, Qatar and Yemen were derived from a mixture of contracted quantities and LNG infrastructure investments tied to the particular producer in European countries. Based on observations in the European gas market, we modified LNG supplies to reflect actual deliveries as outlined below. We project gas trade between EU 25 + CH countries based on information about individual gas sale and purchase agreements as well as swap arrangements. We consider both annual contract quantities (ACQs) and delivery flexibility expressed as take or pay (ToP) levels. In respect of LNG supplies we have set the ACQ for LNG receiving terminals at 90 per cent of the design capacity. Similarly we have set the ACQ under long term LNG supply agreements at 90 per cent of the annual contract quantity. As the norm we have applied 75 per cent of this adjusted ACQ as the regular annual delivery under each contract. When the buyer and the seller of the LNG are the same, we include only 50 per cent of the adjusted ACQ to reflect the merchant nature of such projects.
18 19

See Note 13. The Shelf in 2006, the Norwegian Petroleum Directorate, Stavanger, Norway (5 January 2007)

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The difference between ACQ and ToP levels indicates the supply flexibility for each country as well as EU 25 + CH as a whole. Consistent with current practice in the European gas market, we assign long distance gas pipeline supplies a high ToP level to reflect the base-load nature of these contracts. For long-term LNG contracts as well as LNG merchant or trading arrangements, we set ToP levels uniformly at 50 per cent of the adjusted ACQ, reflecting the ability of suppliers as well as buyers to divert LNG cargoes to markets outside Europe. Figure 6 above shows the gas supply and demand balance for EU 25 + CH expressed as ACQ as well as ToP, as both terms have been defined above for pipeline gas and LNG respectively. Our analysis suggests that EU 25 + CH is likely to have a balanced position between projected demand and supply until 2013, since the demand curve intersects supply between the ACQ and the ToP levels. Some 25 per cent of the gas demand within EU 25 + CH is supplied under Russian gas export contracts, most of which are of long term in nature. The reliability of these contracts has come into question after continental European countries experiences with their Russian gas supplies during the winter 2005/06. A closer analysis of the Russian gas production and transportation facilities and arrangements presents a number of serious concerns in relation to the short and medium term security of supply of Russian energy including natural gas. These concerns are independent of the Ukrainian gas supply episode in January 2006 and of the Belarusian oil transits situation, which reflected a gas supply dispute between Russia and Belarus, during January 2007. The Russian gas pipeline system faced enormous strain during the winter of 2005/06, in large part due to the demands of the domestic Russian gas market20. Domestic gas demand remains over-stimulated by price caps that make natural gas consumption artificially inexpensive. Furthermore, a cold winter in Russia such as the winter of 2005/06 creates high peaks in electricity demands, fuelling even higher gas demand by the sector on top of the demand for gas to heat residences, offices and factories. The winter of 2006/07 (until mid January 2007) was mild in the European part of Russia, and demand for both gas and electricity was below seasonal normal levels. A harsher winter might have prompted electric power blackouts and gas rationing as during the winter of 2005/06. The Russian authorities have received bad press and harsh criticism from the European Union and the heads of state of European countries that rely heavily on Russian gas imports, in response to Russias failure to deliver contractual quantities of gas during the winter of 2005/06. Public pressure has spurred the Russian Federal Government to guarantee gas supplies under export contracts with EU 25 + CH countries, at the expense of needs of the Russian population. However, elections to the Russian parliament, the Duma, and also the Russian presidential elections will take place in 2007and 2008 respectively. To please the electorate, the Russian Federal Government is using its control of GazProm to invest US$770 million to connect new domestic gas customers to the grid in 2007. By the end of 2007 an additional 13 million Russian citizens will have become gas consumers21. The Russian government appears to be trying to please the electorate by extending low priced for gas supplies to a larger part of the population. Additional strains
20

Frisch, M. The 2005/06 Winter and Russian Gas Export to Europe. (Morten Frisch Consultings Energy Newsletter, Issue 1) (28 February 2006). GazProm Connection Plans, Business in Brief, The Moscow Times (20 December 2006).

21

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will confront an already overstretched gas supply infrastructure. Furthermore, the Russian Federal Government will not likely allow the Russian electorate to freeze in the dark if the 2007/08 winter should prove to be cold. Serious consequences could arise for the European gas supplies. Looking further ahead, Russian gas consumption will continue to grow rapidly unless Russian domestic gas prices adjust to better reflect international levels. Such price adjustments are needed for two reasons: to stem domestic demand and, equally important, to provide GazProm with the necessary funds to dramatically step-up its investments in gas exploration and production in Russia, and to maintain and up-grade the vast gas transmission system on which its gas supply operations rely. Although the country has the largest gas reserves in the world and possesses a huge gas production potential, the country currently extracts 50 per cent of its gas production from fields that already are in an advance stage of production decline22. Russia had hoped to import large quantities of gas at low prices from central Asian republics, Turkmenistan and Kazakhstan in particular, at least in part to compensate for Russias difficulties shoring up declining gas production. However, Turkmenistan that possesses the largest gas reserves among the central Asian republics has started gas sales negotiations with the Chinese. Iran already imports gas from Turkmenistan, but is facing a critical gas shortage in the northern heavily populated part of the country, including the capital Tehran. This gas shortage led Iran to stop its gas exports to Turkey during a period in January 2007. Iran has formally proposed to swap gas with Kazakhstan and Turkmenistan at its border with Turkmenistan., Iran would redeliver the same amounts of gas to the two countries in the Arabian Gulf and hence give them an economic access to new export markets. Such a swap, if it takes place, could create a win win situation for all parties involved, offering large savings in infrastructure investments for Kazakhstan, Turkmenistan and Iran. Security analysts have concluded that Russia could face a gas supply gap of up to 126 Bcm/y already in 2010 even if the most optimistic gas import scenario for gas deliveries from central Asia materialises with the supply of 105 Bcm/y.23 However, increasing internal gas prices to better reflect international levels could curtail Russian domestic gas demand significantly, reducing the predicted supply gap to manageable levels. Close observers of the Russian gas industry24 agree that GazProm must allow independent oil and gas producers in Russia access to its pipeline system, and must pay such gas producers a reasonable price for their gas supplies. This is likely the only way to remove the predicted gas supply gap in 2010. Currently some 60 to 80 Bcm of gas is flared in Russia due largely to the lack of access to GazProms pipeline system. However, GazProm must provide clear price signals to independent oil and gas producers without delay, to motivate the necessary gas developments and infrastructure investments to take place. Asia Minor has in general attracted recent interest as a potential supply route to Europe. However, the recent experience in Turkey would question its ability to provide
Mrs Chabrelie, M-F, Medium-term prospects for the gas industry (preliminary) (Cedigaz: Paris, France) (15 January 2007).
23 22

Riley, A. The Coming of the Russian Gas Deficit: Consequences and Solutions, Centre for European Policy Studies (CEPS), CEPS Policy brief No. 116 (October 2006). Supra, Notes 22 and 23.

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the reliability sought by major European gas companies. With the exception of Spain and Portugal, the two countries that together constitutes the Iberian Peninsula, LNG still represents a small fraction of Europes total gas supplies. However, LNG should in the future become of greater interest to the Europeans because of the diversification it offers. With diversification comes safety. The European Commission has recently completed its sectoral inquiry into competition in the natural gas industry, and points to LNG as a hope for both enhanced security and increased competition.25

LNG IN ATLANTIC BASIN GAS MARKETS

Multiple price drivers are developing in Atlantic Basin gas markets as the growth in LNG promotes interconnection. The strongest drivers over the past two years have been the unusual circumstances in Spain: drought reduced the generation of hydroelectric power, requiring significantly more despatch of gas-fired power stations, raising the demand for natural gas. Spains influence has also stemmed from its position of prominence as the largest importer of natural gas in the Atlantic Basin. Spain also had a severe winter in 2005/6. In the future, weather conditions and the Russian situation will determine whether Europe or North America will drive winter LNG prices. Europe will be more important for LNG exporters in terms of its annual demand. However, the air-conditioning peak in the United States summer markets will exert a strong influence. The capacity of US regasification terminals will likely exceed the demand for LNG. We have compared the EIAs forecast of LNG imports to the maximum realistic ACQs for the existing regasification terminals and projects that are likely to proceed. We estimate the ACQs as roughly 67% of the nameplate capacity of the terminals. Our analysis reveals a prospective utilization of the terminals of around 30% to 40% during the period to 2015. The resulting excess capacity and prospective low utilization of terminals is consistent with our view of the US exerting a strong seasonal influence on the Atlantic basin. We have performed the same analysis for Europe. We compare the sustainable capacity of European re-gasification terminals to the Cedigaz forecast of demand for LNG.26 In Europe terminal utilization will be closer to base-load operations, particularly if Russia should have difficulty meeting its contractual obligations. Our analysis suggests utilization ratios ranging from 78% to 93% over the forecast period. The Pacific basin is another price driver exerting a strong influence on the Atlantic basin.27 We foresee a growing influence of the Pacific basin. To date the available liquefaction capacity in the Atlantic basin has approximated a base-load demand level for the Atlantic basin re-gasification capacity. It was technically feasible for Atlantic basin consumers to rely exclusively on Atlantic basin producers, although there has been active trade with LNG producers located in the Arabian Gulf.

Communication from the Commission, Inquiry pursuant to Article 17 of Regulation (EC) No 1/2003 into the European gas and electricity sectors (Final Report)(10 January 2007).
26

25

World LNG Outlook-2006 Edition (preliminary LNG supply and demand data), Cedigaz, Paris France (15th January 2007). See Frisch, M. and Lapuerta, C., the Value of Middle East LNG in the Atlantic Basin After the 2005/6 Winter Price Shock, (presented at the GasTech 2006 Conference, Abu Dhabi, UAE)(4 December 2006).

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Demand growth in the Atlantic basin will soon increase its reliance on Arabian Gulf supplies. Figure 7 shows our forecasts. Demand in both the Atlantic basin and Pacific basin will exceed the liquefaction capacity in either area. Each basin will therefore seek Middle East supplies to balance the respective markets. Although it has been assumed that no Iranian LNG project will come on stream prior to 2015 and that Qatari LNG production capacity will be caped at 77.2 mt/y, we foresee the availability of a near double LNG liquefaction capacity by 2015 to accommodate the forecast demand.
450 400 350 300 Pacific Basin Supply bcm 250 200 Middle East Supply 150 100 50 0 2006 Atlantic Basin Supply Atlantic Basin Demand Pacific Basin Demand

2007

2008

2009

2010

2011

2012

2013

2014

2015

Figure 7: The Atlantic Basin in the Context of World LNG Supply and Demand Our demand estimates for the US derive from the EIA. For Europe we have developed our own forecasts based on the proprietary database described earlier. For the Pacific basin we have relied on a demand forecast by Cedigaz.28 To measure supply we have identified existing and planned additions to liquefaction capacity. We have included liquefaction capacity at only 90% of its nameplate capacity. However, if past experience is a guide, actual capacity may be even less as operational problems arise with both liquefaction plants and feed-gas supplies. Indonesia, Nigeria, Trinidad & Tobago, Egypt, Oman, Malaysia, Qatar and Australia have all experienced recent operational problems or feed-gas problems. Some excess liquefaction capacity is necessary to cushion the market against these types of problems, which will likely recur. Although the total supply exceeds demand on the figure, the margin is modest and consistent with a balanced market, given the likelihood of technical problems at any point of time. In this paper we have focused on the period up to 2015. We see competition between Atlantic and Pacific Basin LNG markets for available supply in a global LNG market that will fluctuate between being balanced and being marginally short of product supply. If Russia should experience problems meeting its long-term gas supply obligations with the EU 25 + CH countries, it will likely resolve any surpluses facing particular countries in
28

Supra, Note 26.

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Europe today. To overcome Russian problems, European gas markets would resort to their positions as dominant LNG buyers within the Atlantic basin, potentially becoming the LNG price setters on a world-wide basis.

ABOUT THE AUTHORS

Morten Frisch, Senior Partner, Morten Frisch Consulting (MFC) Mr Frischs has more than 30 years of hands-on experience addressing strategic, commercial and operational issues along the entire value chain for LNG and pipeline gas. This experience stems from work for the Norwegian Government, multinational oil companies and from work as a consultant since 1990. The first time Mr. Frisch led a gas sale negotiation was in 1976, the year his first dealings with LNG receiving terminals (Everett and Cove Point terminals, USA) also took place. His first LNG marketing work was conducted in 1980 (the then Phillips Petroleums Bonny LNG project in Nigeria). Since 1990 Mr. Frisch has conducted extensive work related to natural gas in the Middle East, Iran, Russia, and Central and Western Europe. He has also provided consulting services to clients or projects in North and West Africa, Japan, Australia and New Zealand, and he has acted as an expert witness in major arbitrations and court cases concerning commercial and operational gas issues. Mr. Frisch is a chartered engineer in his home country of Norway and an economist (degrees from University of Newcastle upon Tyne, UK and Massachusetts Institute of Technology (MIT), USA). He is a member of the Society of Petroleum Engineers (SPE) (since 1975), the International Association of Energy Economics (IAEE) and the British Institute of Energy Economics (BIEE). He has published a number of major articles addressing strategic and commercial gas issues. Carlos Lapuerta, Principal, The Brattle Group Inc and Managing Director, The Brattle Group Limited Mr Lapuerta directs the London office of The Brattle Group, an international consultancy specialising in the economic and financial analysis of the energy industry. His practice focuses on the valuation of natural gas businesses, the analysis of competition in natural gas markets, and on the appropriate design of regulations for the liberalisation of the gas industry. Much of the work involves business economics, performing rigorous numerical analyses of business questions. His regulatory expertise focuses on the liberalisation of the gas industry, particularly its rules for third-party access to pipelines, and its effects on commercial gas operations. He has considerable experience with the electricity industry, which natural gas companies find useful to tap when assessing future developments in the European power market and their likely impact on natural gas markets. Mr. Lapuerta has presented expert witness testimony in major commercial arbitrations concerning economic and financial issues in the electricity and gas industries. Mr. Lapuerta has degrees in law and economics from Harvard University.

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