Fear grips EU gas trade
‘War premium’ makes LNG obscenely profitable – and too expensive to burn
Natural gas used to be known as the ‘champagne’ fuel, a luxury energy source that only wealthy nations could afford. Coal, by contrast, was ‘beer’ – the cheap and ubiquitous fuel of the masses. As the world plunges into a full-blown energy crisis that carries a tangible risk of physical supply shortages, liquefied natural gas cargoes are becoming as valuable as original Rembrandt, Cézanne or Munch masterpieces.
It is hard to overstate the insanity going on in energy markets right now. The risk premium that Russia’s invasion added to already-overheated global commodities has created an exceptional money-making opportunity for those participants placed to capture the enormous differentials between energy-producing basins and import-dependent regions.
Nowhere is this more apparent than in natural gas. Sanctions risk is growing by the day, with the UK on Tuesday banning Russian oil imports but excluding gas – for now, at least – and the US moving to ban all Russian energy imports. Extreme uncertainty of an imminent cut-off in Russian gas flows is driving market sentiment in giddying and erratic ways. Prices are moved by fear, not fundamentals.
Let’s take a look at the recent rollercoaster action on EU gas hubs, before analysing what this means for US LNG profit margins and the profitability of burning such expensive gas in EU power markets. Then we will wrap up with the EU Commission’s latest attempt to bring some semblance of sanity to this madness and, ultimately, wean the bloc off Russian gas.
Europe’s liberalised gas market trading hubs are now essentially broken. April-dated gas futures traded on Dutch TTF, the European gas benchmark trading hub, became untethered from reality on Monday. Mind-bending swings pushed the contract to a peak of almost €350/MWh before plunging by more than €100/MWh amid thin trading volumes.
Moves like this render pointless any attempt at analysing supply-demand fundamentals. For what it’s worth, Russian flows into Europe have risen in recent days and demand is pretty typical for this time of year. But that’s where the normality ends.
Sanctions are not the only concern. Russia’s bombardment of Ukrainian towns could result in accidental or deliberate damage to gas pipelines, or Moscow itself could turn off the taps in retaliation. Today’s gas flows are all but irrelevant. It’s all about what could happen tomorrow.
Extreme volatility is what happens when a major gas exporter invades the country that transits its gas to end-consumers. The ‘war premium’ is strongest in April reflecting intense near-term uncertainty, but the same effects are ratcheting up prices all along the forward curve. Hedging exposure is all but impossible without huge collateral risk. Ultimately, consumers and taxpayers will be gutted by the costs being accrued today.
Obscene LNG profits
The opportunity for LNG producers is exquisite. The differentials between producing regions such as the US, and gas-shocked Europe, are unlike anything the natural gas world has ever seen. Prices on Henry Hub, the US Gulf Coast benchmark, might have doubled to more than $5/MMBtu. But with TTF above $60/MMBtu, the margins on selling Henry Hub-costed LNG into European markets are eye-watering.
A single cargo of US LNG could, in theory, generate a profit of more than $200 million in April if costed at 115% of Henry Hub and sold into the European gas spot market. Due to the opacity of the LNG market, there is no way of knowing whether any actual spot trades are being completed at these prices. There is reason to doubt that they are.
For a start, most LNG cargoes are bought and sold under long-term contracts indexed to the price of oil. Contracts typically range from 10% to 13% of Brent, which on Wednesday shot above £130/barrel. This gives an oil indexed LNG price of $13-17/MMBtu, valuing a typical LNG cargo of 165,000 cubic metres at $50-65 million. Freight and regasification costs would bring that figure lower still.
But that’s not the most interesting part. Gas priced at TTF is simply unburnable in any EU power market with alternatives, such as coal. The clean spark spread – the profit from gas-fired power generation after deducting the cost of purchasing carbon credits – is barely positive for a 50% efficient combined cycle gas turbine (CCGT) all along the forward curve out to June 2023.
For a 60% efficient CCGT, the story is a little better with a positive spread until April 2023. But the margin on coal-fired generation is significantly better than gas, even though the price of API2 coal has shot up from $119 per tonne at the start of 2021 to $430/t today. That’s because the energy-equivalent value of coal is just $17/MMBtu, which is extremely high by historic standards but still a long way from setting fire to a Rembrandt.
Of course, this does not mean gas is not being used to keep the lights on in Europe. It absolutely is, but mostly to meet marginal demand that can’t be satisfied by burning coal. Needless to say, burning priceless gas under Europe’s marginal pricing system is keeping wholesale electricity markets firmly in record-setting territory.
Also, European utilities are still buying Russian gas under their cheaper oil-indexed long-term contracts with Gazprom. And then there is the question of domestic heating, where there is no alternative to consumers than simply going cold.
EU grapples with gas insanity
All of this raises impossible-to-answer questions about how much of these costs will be passed through to consumers, or how Europe can possibly hope to refill depleted gas stocks in time for next winter. Filling storage is an acute problem when the prompt price is so much higher than the forward curve. There is no incentive to inject gas that is essentially priceless today but which the market expects to become much cheaper by withdrawal season.
The EU Commission yesterday proposed an obligation to fill EU gas stocks to “at least 90%” by 1 October 2022. Doing so could cost an estimated €160 billion with TTF priced at €200/MWh, or €64 billion at €80/MWh. Energy commissioner Kadri Simson said Brussels has “outlined price regulation, state aid and tax measures to protect European households and businesses against the impact of the exceptionally high prices”.
The Commission will consult on “a new State aid Temporary Crisis Framework to grant aid to companies affected by the crisis, in particular those facing high energy costs”. It will also consider “emergency measures to limit the contagion effect of gas prices in electricity prices, such as temporary price limits”; and assess options to optimise the electricity market design. Might this herald the end of marginal pricing? We shall see.
On Europe’s dependence on Russian gas, the Commission had this to say (emphasis added):
“Phasing out our dependence on fossil fuels from Russia can be done well before 2030. To do so, the Commission proposes to develop a REPowerEU plan that will increase the resilience of the EU-wide energy system based on two pillars: Diversifying gas supplies, via higher Liquefied Natural Gas (LNG) and pipeline imports from non-Russian suppliers, and larger volumes of biomethane and renewable hydrogen production and imports; and, reducing faster the use of fossil fuels in our homes, buildings, industry, and power system, by boosting energy efficiency, increasing renewables and electrification, and addressing infrastructure bottlenecks.
“Full implementation of the Commission's ‘Fit for 55' proposals would already reduce our annual fossil gas consumption by 30%, equivalent to 100 billion cubic metres (bcm), by 2030. With the measures in the REPowerEU plan, we could gradually remove at least 155 bcm of fossil gas use, which is equivalent to the volume imported from Russia in 2021. Nearly two thirds of that reduction can be achieved within a year, ending the EU's overdependence on a single supplier.” – EU Commission