Natural gas is its own worst enemy

Big Oil’s heralded ‘bridge fuel’ is pricing itself out of the energy transition

Natural gas prices are soaring across Europe and Asia, propelled by resilient demand and patchy supplies. This demonstrates how deeply gas has become entrenched in the global economy – and how poorly equipped the gas industry is to provide the affordable ‘bridge fuel’ it says the energy transition needs. The partially commoditised nature of gas trade complicates pricing, exacerbates volatility, fuels supercycles and deters investment – heaping uncertainty onto long-term gas demand. And then there is the small question of emissions.

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Endless arguments over the emissions footprint of natural gas are providing the warm-up entertainment ahead of the COP26 climate talks in Glasgow. Assuming the event is not postponed, as several prominent NGOs are now demanding, the role of gas in the energy transition will be a focal point of talks among global leaders, policymakers and their entourage.

COP26 will take place against a dramatic backdrop of rampant energy and commodities inflation. Aluminium, coking coal, uranium, copper and hot-rolled steel are all trading at or near multi-year highs.

Wholesale gas prices in the UK and continental Europe broke successive all-time highs in recent days, climbing above $19 per million British thermal units (MMBtu). The spot market for liquefied natural gas in Asia is red hot, with cargoes changing hands for more than $20/MMBtu. This is highly unusual in September, before the winter buying rally kicks in.

These gas prices roughly equate to $110 per barrel oil-equivalent. With Brent trading flat at ~$72/barrel, gas is commanding a huge premium. Does its attribute as a cleaner-burning fossil fuel merit this?

The turnaround over the last 12 months has been spectacular. This time last year, in the midst of the pandemic, European gas hubs fell as low as $2/MMBtu and Asian spot LNG cargoes were struggling to fetch $3.50/MMBtu. EU gas stores were brimming and LNG freight rates soared as vessels were used as floating storage.

US liquefaction export plants were shut in for months as buyers paid hefty penalties to turn down cargoes they were contractually obliged to lift. There was simply nowhere to put the gas. There was even idle speculation that futures contracts in over-supplied markets might briefly follow WTI crude into negative territory (this didn’t happen).

There are clear winners in this giddying recovery: gas and LNG exporters able to access inflated hub and spot market prices. US LNG exporter Cheniere this week announced its first-ever dividend after reaching a “cash flow inflection point”, fuelled in part by firm demand.

It matters not that Cheniere buys its gas from US suppliers priced at Henry Hub (HH), which is trading above $5/MMBtu for the first time since 2014. The margin from buying LNG priced at HH plus the liquefaction cost and selling it at Dutch Title Transfer Facility (TTF) or Japan-Korea Marker (JKM) prices is enormous, regardless of the shipping cost (which has fallen from its winter peak but remains high).

Gas and LNG buyers on long-term oil-indexed contracts are also sitting pretty, as Brent-linked prices are now significantly below the going rate in the spot market. Oil indexation is still the dominant price formulation for LNG in Asia, but less prevalent in Europe, where gas is traded on liquid hubs that enable genuine price discovery.

At 13% Brent slope, an LNG cargo would change hands for $9.36/MMBtu — around half the price for futures contracts on Platts’ Japan-Korea Marker over the coming northern hemisphere winter.

Some LNG buyers are now asking their long-term suppliers for more oil-indexed volumes, which would presumably attract a handsome margin if re-sold into the spot market. Expect the middlemen – commodity traders – to make a killing.

An expensive luxury

But with incumbency comes responsibility, and the losers are ordinary people all over the world. Expensive gas is hurting the global economic recovery and having all sorts of perverse and unwelcome outcomes. Power prices are surging across the UK and Europe, pushing small unhedged energy suppliers into insolvency.

As if to ram home the message that climate change is one massive market failure, cheap and dirty fuels are all benefitting from the switch away from more expensive cleaner-burning gas.

The UK has fired up dormant coal units and paid a record £4,950/MWh to a gas-fired peaker to balance the market. Coal remains profitable in EU power markets, despite the carbon price rally.

In Asia and the Middle East, utilities are burning more high-sulphur fuel oil (HSFO) and coal for power. Power demand in China, the world’s biggest gas importer, is driving Chinese coal futures to record highs.

Even LNG carriers are using less of their precious cargo for propulsion and turning to heavy fuel oil (HFO).

At today’s gas and crude prices, it now makes sense for natural gas exporting countries to start burning more oil for power generation, to free up gas/LNG for export and capitalise on this heady market opportunity.

With European gas storage levels below their five-year average and Russia facing its own domestic gas supply crunch, it is conceivable that UK/EU hub prices won’t come down much this winter. And since Europe must compete with other regions for LNG cargoes, the world might have to endure expensive natural gas for many more months.

A quick look at the gas/LNG forward curves supports this view: Asian LNG JKM futures contracts peak at $22.50/MMBtu in February and are trading at ~$20/MMBtu until March 2022. Asian LNG can’t be bought in the futures market for less than $10/MMBtu until April 2023.

In Europe, the Dutch TTF gas hub is trading well above €50 per MWh (~$18/MMBtu) even in March 2022:

Futures contracts reflect today’s sentiment and are a bet on future market outturn. Often things turn out differently. But energy retailers procure volumes and hedge their positions using futures contracts. If these prices persist and are passed through, end users will either pay through the nose or dial down consumption.

Energy-intensive industries could face curtailment in peak hours. A rise in the cost of fertiliser — which is derived from natural gas — could impact agricultural productivity and push food prices higher.

If this translates into pay stagnation, job losses and a higher cost of living, politicians will face uncomfortable questions from workers and consumers (i.e. voters) and trade bodies (i.e. campaign donors). Keep one eye on Germany: day-ahead and year-ahead electricity prices are testing all-time highs, barely two weeks before an historic federal election.


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Vicious investment cycle

The gas industry knows high prices are bad for business. LNG advocates are perennially warning that under-investment in new supply will leave a structural deficit, driving prices higher and amplifying volatility. That argument has fallen on deaf ears, and understandably so. How can investment flow when prices are prone to whipsawing?

Gas is stuck in a damaging feedback loop of volatility and uncertainty: explosive global price movements undermine new liquefaction projects seeking investment, delaying new supply volumes and clouding the demand outlook.

This exacerbates price spikes and fuels supercycles, as investment and construction lead times lag market signals by years. When market sentiment turns definitively in favour of cutting big cheques for capital projects, a flurry of investment flows into newbuild projects.

Amid the euphoria, often too much money is thrown at too many projects with marginal economics. These all come online within a two/three-year window, resulting in a supply glut that crashes the market. Those that placed the worst bets get badly burned, ushering in a multi-year investment bear market. Then the cycle begins again.

The International Gas Union said in its World LNG Report 2021 in June:

“There were more than a dozen liquefaction plants scheduled for final investment decision (FID) in 2020, but only one project took a positive FID. All others were deferred. So far in 2021, Qatar has taken FID on its North Field East mega-expansion project, which likely has a further deterrent effect on developers as key buyers remain hesitant to sign long term agreements as they face continued demand uncertainty.”

Developers are struggling to apportion LNG project risks between buyers, sellers and investors. Could a more liquid gas market help break that deadlock?

The case for free trade

Natural gas used to be a bit like electricity: a local or regional play, with international trade limited to the few countries linked by interconnectors/pipelines.

Molecules flowed from producing basins into demand centres such as city gas distribution networks or large industrial facilities. The biggest price driver was the local weather forecast.

Over the years, growth in LNG trade has disrupted that sleepy dynamic and partially commoditised natural gas, linking regional markets and establishing complex intercontinental pricing relationships.

Global trade evens out pricing: LNG exports tend to bring over-supplied local gas market prices more in line with international benchmarks, while the arrival of competitive global supplies tempered prices in gas importing countries.

Ever-greater commoditisation would narrow the spreads between producing regions/basins (e.g. US Gulf of Mexico) and import-dependent regions (e.g. north-west Europe, Asia-Pacific).

But how far can this trend go? Will the gas/LNG market ever become akin to crude, with shipments optimised via free trade in deeply liquid and transparent exchanges under standardised terms?

The curse of the ‘semi-fungible molecule’

The physical attributes of gas are a hindrance to commoditisation. Oil and coal are easy to unload and store for long periods at room temperature. Gas must be super-chilled into a liquid state for seaborne transportation, meaning it boils off during oceanic voyages or when stored in liquid form.

And then there is the enduring problem of associated gas at remote oil wells – molecules that bubble up with crude and must be captured and disposed of responsibly. Way too much upstream gas is still being vented or flared off, even at today’s crazy prices, because infrastructure can’t be built overnight to get stranded molecules to market.

What would it take to stimulate investment in infrastructure to gather all those pesky unwanted molecules and pipe them to the nearest gas grid node or LNG export facility?

Unless gas-fired bitcoin mining goes mainstream or regulators impose punitive penalties on flaring, wellhead gas prices would probably need to float far above historical averages in every producing basin for an extended period to tip the investment calculus. This would act as a rising floor, pushing global prices higher across the board and eroding demand in price-sensitive markets.

Market illiquidity is a Catch-22. Since gas is not fully commoditised, LNG export projects require customers to commit to long-term bilateral offtake contracts in order to underpin project finance. But these contracts often lack transparency and contain terms that impede diverting or re-selling of cargoes, which undermines commoditisation.

There has been some progress in recent years towards shorter-duration LNG contracts with less onerous provisions. But most LNG cargoes are still bought and sold under opaque long-term deals.

Moreover, even if gas/LNG trade was fully liberalised, standardised and commoditised, supply would still need to be balanced with demand. Severe demand spikes or supply shocks would drive prices higher all over the world. Perhaps the peaks and troughs wouldn’t be so extreme.

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Market signals vs. virtue signals

The long-term outlook for gas demand is already uncertain because many countries have embraced ‘net zero’ emissions targets that leave little space for gas consumption to grow post-2030. The fact that these highly ambitious goals are unlikely to be met is another source of uncertainty. Bets are being hedged accordingly.

Meanwhile, rhetorical support for a gas-free energy transition is gathering steam as campaigners turn up the heat on policymakers to cut support for fossil-based methane. Investing in gas infrastructure is becoming unfashionable, even as the market is screaming for more supply.

This disconnect means the fungibility of natural gas cannot be improved quickly or easily. But as the boom in cheaper and dirtier fuels so painfully illustrates, today there is no clean alternative to expensive gas that is ready at scale to keep the global economy ticking over. Renewables, batteries and efficiency measures will take time to rise to the challenge.

As a result, we face a situation where jobs, growth, crop yields, inflation and thus even monetary policy are to some extent beholden to a semi-fungible molecule: one that is still being wasted in vast quantities on one side of the world, while other regions face the prospect of prolonged price spikes or actual shortages.

Unless the industry can figure out how to correct this dysfunctional dynamic, we are faced with two possible outcomes. Either gas will enjoy only a stunted role as the world’s ‘bridge fuel’, or the world will have to endure wild price swings for decades to come.

Seb Kennedy | Energy Flux | 8th September 2021

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