Natural gas oversupply creating buyers' market

Aug. 3, 2009
Natural gas buyers everywhere stand to from the current global gas oversupply.

Natural gas buyers everywhere stand to from the current global gas oversupply. The timing, duration, and extent of the oversupply, however, will vary between regions, with different implications for different sellers and buyers. The current market favors buyers that can access spot gas, while others are likely to be overcontracted, with associated competitive and contractual problems.

Background

While many factors have shaped the global gas market in recent years, some stand out:

  • Expectations of robust economic growth triggered huge growth in gas demand expectations globally.
  • Declines in North American production led to a massive anticipated increase in LNG import requirements.
  • A lack of project sanctions for major new developments globally curtailed long-term gas supply availability.
  • Direct competition between gas and oil in the Asia market, particularly China, led to high-value pricing.
  • Oil prices reached record levels, profoundly influencing gas price expectations.

In aggregate these factors created a market strongly favoring sellers over buyers.

More recent events, however, have shifted market balance away from sellers. The combination of the global slide into economic recession, the dramatic growth in gas availability from unconventional sources in North America, and the largest wave of new LNG supply ever to hit the global market has contributed to a global gas glut, driving spot prices for gas down everywhere. Unfortunately for sellers, this situation looks to get worse and the market is increasingly favoring buyers.

This article considers the extent of the oversupply of gas, the measures suppliers may take to alleviate the oversupply, and the implications for the dynamics between sellers and buyers of gas in the Pacific and Atlantic basins.

Pacific supply-demand

Up to 2008 the Pacific basin had to call on short-term LNG from the Middle East and the Atlantic to meet demand (Fig. 1). This situation has changed. Economic contraction has lowered near-term LNG demand in the primary Asia Pacific LNG markets of Japan, Korea, and Taiwan. A number of major Asian LNG buyers have nominated reduced LNG offtake under some of their long-term supply contracts in line with downward quantity tolerances, affecting supply projects in the Pacific and Middle East. At the same time some 34 billion cu m/year of new Pacific LNG projects (excluding Middle East) are coming on line 2009-10, including Sakhalin-2, Tangguh, and Pluto, resulting in an oversupplied Pacific LNG market.

A number of factors will address near-term Pacific market oversupply.

• China and India’s demand elasticity will enable further short-term sales of LNG, but this will be limited. India has shown the greatest spot appetite to date, but demand has been restricted by the recent start-up of deliveries of domestic gas from the Krishna Godaveri basin and the force majeure outage at the recently completed Dahej regasification terminal, now lifted. The recent industrial slowdown has restricted China’s appetite, which in the near-term will also be affected by regasification capacity constraints.

• Some LNG suppliers, both in the Pacific and the Middle East, will choose not to sell LNG at low prices, particularly national oil companies or governments with a diminished remaining gas resource base such as Brunei. Some gas will be kept in the ground, therefore.

• Some gas previously earmarked for LNG export will be redirected to higher-value uses such as the domestic market or LPG extraction, as is occurring in Indonesia.

• Atlantic Basin LNG underpins some existing LNG contracts with Asian customers; for example, BG supply deals with Asian customers. These cargoes could be swapped with available Pacific LNG, providing customers with product of a specification with which they may be more familiar and reducing transport costs in the process.

• It also seems likely some spot cargoes of Pacific LNG will be routed into the US West Coast and Atlantic markets over the next couple of years.

But prices of spot sales of gas are likely to remain subdued to 2011. From 2012 Wood Mackenzie estimates the Pacific will once again require incremental LNG from the Middle East or the Atlantic to balance the market. Strong medium-term growth in China’s LNG import requirements predicate this estimate.

Chinese buyers are in advanced stages of negotiations for contracting more than 10 million tonnes/year of LNG from several potential new projects. Other Asian buyers are seeking LNG in the same time period due to the expiry of contracts in Indonesia, Brunei, and Malaysia. This supplier competition, combined with uncertainty about which new projects under consideration will actually progress to final investment decision (FID), is contributing some uncertainty in the market, particularly for 2013-14 supply.

This medium-term supply-demand picture still favors sellers, providing price support in the negotiation of long-term contracts. Analysis, however, suggests the Pacific market east of India requires only a further 36 billion cu m/year of new LNG in 2015, while the combined potential output capacity of PNG LNG, Queensland Curtis, GLNG, Ichthys, and Donggi—all ostensibly chasing FID within the next 18 months—is 57 billion cu m/year when fully operational. Qatar could also decide to re-market flexible Atlantic LNG into the Pacific and lock in the market ahead of these new LNG projects.1

A raft of FIDs on new LNG projects in the Pacific could show an oversupply developing in 2015 and beyond and would change the pricing dynamic to one favoring buyers. As the likelihood of FID on new volumes becomes more concrete, the strength of sellers in subsequent negotiations deteriorates.

Prospective sellers are already offering concessions to buyers in anticipation, concessions thought unthinkable a year ago, such as project equity and volume flexibility. While indexation at more than 14% Japanese crude cocktail (JCC) in recent agreements, however, is lower than the oil-parity prices sellers were used to demanding, current pricing arrangements still reflect residual seller strength, for now.

Atlantic supply-demand

Economic contraction has reduced near-term demand for gas in both Europe and North America. But the results in the Atlantic Basin, both in terms of supply-demand balance and pricing, depend on how major gas producers interact with Europe.

Europe

Over the next 2-3 years continued infrastructure development, such as Algeria’s Medgaz pipeline to Spain and Russia’s proposed Nord Stream pipeline to Germany has the potential to increase the availability of piped gas from major suppliers to Europe, while reduced domestic demand for gas in many supplier countries, most notably Russia, has increased export availability.

LNG available to Europe is also increasing. In 2008 some 18 billion cu m of LNG moved from the Atlantic to markets in the Pacific, but reduced Pacific demand means Atlantic LNG will now seek markets closer to home. Close to half of the new Qatargas-2 and Ras Laffan-3 LNG projects, with combined nameplate capacity of more than 40 billion cu m/year, is coming on line in 2009-10, earmarked for markets in Northwest Europe.

Wood Mackenzie estimates 140 billion cu m/year of discretionary pipe gas and flexible LNG will compete for an average contestable European market of about 70 billion cu m/year between 2010 and 2012. The contestable pipe-LNG market in Europe is that part of gas demand for which discretionary pipe gas and flexible LNG compete. This excludes most European demand, including that covered by firm take-or-pay contracts. It also excludes markets in which physical constraints prevent competition and a minimum volume will continue to be supplied.

A number of factors can address European oversupply.

• Major suppliers may delay development of new projects for which large amounts of capital expenditure remain outstanding. For example, Algeria’s decision to delay the Skikda LNG replacement completion—for which 80% of the capital still needed to be spent—to 2013 from 2011.

• Major piped-gas suppliers to Europe, including Russia, Norway, Algeria, and the Netherlands, may elect to back out discretionary gas to accommodate new LNG and sustain reasonable spot price levels in Europe. But major piped-gas suppliers may elect to remain in the market, maximizing market share while driving down prices to shut out new LNG.

• Qatar may attempt to defend European price levels to support LNG prices in Asia. Instead of maximizing LNG supply to Europe, which on its surface would provide a higher netback than the US when prices in the two centers are connected (as is likely over the next few years), Qatar may elect to send more LNG to North America

• Other LNG suppliers will simply prefer to send gas to North America because of better netbacks; e.g. Trinidad and some African suppliers, depending on pricing dynamics.

This oversupply puts European spot prices at risk of being established by the alternative available market, which for many LNG suppliers will be North America, allowing prices in North America to set the price in Europe over the next few years (Fig. 2).

Wood Mackenzie forecasts spot prices for gas in Europe will be lower than the oil-indexed levels typical in the long-term contracts making up more than 80% of Europe’s traded gas, giving great benefit to gas buyers able to access spot gas. Buyers with long-term contracts will also nominate down to take-or-pay levels to maximize their ability to purchase spot gas.

A prolonged disconnect between spot prices and contract prices could lead some buyers to seek to renegotiate the pricing levels in their long-term contracts via price re-opener clauses. Potential buyers negotiating new long-term contracts will also consider themselves in a favorable position. Some buyers, including those in both western and eastern Europe, may find a more willing response from LNG sellers keen to identify new markets for product.2 Others may seek greater volume flexibility on pipe contracts to enable them to deepen their procurement portfolio.

Not all buyers, however, will benefit. The reduced demand outlook will leave some over-contracted; their take-or-pay offtake commitments under long-term contracts requiring them to take more gas than needed. Such buyers will seek to carry-forward some of their offtake commitments.

Wood Mackenzie also sees major current pipeline suppliers of gas as holding a strong position when negotiating terms of long-term supply contracts. The sanctioning of new LNG projects in the Atlantic will inevitably fall victim to subdued price levels, and the failure to develop LNG projects combined with a lack of other gas supply alternatives to Europe will help sow a return to pricing power for the major piped-gas exporters. These events will likely cause spot prices to trend back to levels consistent with long-term contracts by 2013.

North America

The North American market is also over-supplied. North America was expected to be short of indigenous gas to meet demand and would have to compete for LNG in the global gas market. But dramatic increases in availability of indigenous gas from unconventional sources, particularly shale gas, have given North America the potential to be essentially self-sufficient in gas for some time, removing the need for large volumes of LNG to meet demand.

Infrastructure and contracts, however, remain in place to route a lot of new LNG to North America, and as long as Europe and the Pacific are long gas the large liquid market of North America will be the market of last resort for LNG. These factors have led to a marked decrease in the number of active rigs in the US, from a peak of more than 1,600 in 2008 to levels closer to 700 today, as suppliers seek to remove sub-economic gas from market.

LNG is likely to displace indigenous gas in North America, requiring further reductions in drilling rigs in the near-term as the market seeks a new clearing price encouraging development of sufficient indigenous supplies to balance the market. Effectively higher LNG imports will lead to lower North American prices and buyers in North America will continue to benefit from the oversupply. The attractiveness of the price, however, will depend on the tactics of such major supplying countries as Russia, Norway, and Qatar.

References

  1. Wood Mackenzie Global Gas Insight, “Pacific LNG—Oil Parity Pricing Forever?” September 2008.
  2. Wood Mackenzie Global Gas Insight “Ukraine/Russia ‘09—The Implications For EU Security of Supply,” February 2009.

The authors

Noel Tomnay ([email protected]) heads up Wood Mackenzie’s global gas group, based in the UK, developing the company’s view on global gas issues. He previously established Wood Mackenzie’s Asia-Pacific consultancy practice in Singapore where he advised national oil companies, majors, independents, and utilities on Pacific basin gas. Tomnay also has developed and led a number of Wood Mackenzie multiclient studies and research products addressing gas issues. He joined Wood Mackenzie in 1998, having started his career as a facilities engineer with BP International and has worked in the UK, Indonesia, and Eastern Africa. He earned a bachelors of engineering (1989) from the University of Glasgow, is a chartered engineer, and holds an MBA from the University of Edinburgh.
Stephen O’Rourke (stephen.o’[email protected]) is the research manager for the global gas service. As part of the global gas research team, O’Rourke plays a key role in providing supply, production, and cost profiles for the global gas model and in delivering the Wood Mackenzie base case to global gas model clients. He previously led the Australasia upstream research team at Wood Mackenzie. O’Rourke holds a masters in business studies from University College, Dublin.