The price of freedom (gas)
DEEP DIVE: The need to reduce gas demand - and political squabbling - has never been more urgent
Europe is on track to import more than 600 cargoes of US LNG this year
Each cargo could earn traders up to $125 million in the spot market
EU gas buyers are signing up for long-term LNG deals to mitigate spot price volatility
EU leaders are squabbling over a pointless price cap instead of fast-tracking vital demand reduction policies
Disclaimer: all opinions expressed here are mine, not those of my employer
If you were in any doubt about where the real money is being made during this prolonged energy crisis, look no further than commodities trading house Trafigura. The Swiss-based global trader made an eye-popping $7 billion profit in its 2022 annual results. That’s more than the company’s previous four years’ profits combined. Shareholders and top traders are divvying up a cool $1.7 billion in payouts.
Trafigura trades the full gamut of oil and petroleum products, with crude accounting for nearly half of its physically traded volumes. Liquefied natural gas (LNG) is only a small part of its portfolio (4% by volume) but Trafigura is an important player in transatlantic gas trade. The company holds LNG offtake agreements with Cheniere Marketing and Freeport LNG in the US, and with other LNG producers in the Middle East and Asia.
Trafigura also holds positions across the gas value chain and leveraged those to help get gas to Europe.
“Using our network of leased pipelines, we were able to carry gas from the Permian Basin, which straddles West Texas and southeastern New Mexico, to liquefaction plants on the coast, then across the Atlantic to deliver it to our regasification slots in Europe.
“From here, our LNG and Natural gas team was able to trade and deliver the molecules to where they were needed. In many instances, the gas went into leased storage ahead of the winter.” – Trafigura
So when we talk about the gas trade becoming obscenely profitable from war in Ukraine, Trafigura is the type of company to hold in mind. It makes money at every stage of the process: when the molecules are piped from the wellhead into the Texas gas grid; when they are liquefied and loaded onto a cryogenic vessel for transport; while they are en route to Europe; when they are unloaded at a receiving terminal and warmed up back into a gaseous state; when those molecules are pumped into the transmission network; and when they are injected into an underground storage facility (and when withdrawn later).
There is a moral debate to be had about whether lining the (already deep) pockets of Trafigura’s traders and shareholders is preferable to sending (considerably less) money to the Kremlin for the same amount of gas. In the context of war in Ukraine, Trafigura could be painted as part of a heroic corporate effort to bring ‘freedom molecules’ to Europe. Even if we accept this premise, the financial cost of those ‘molecules of freedom’ bears scrutiny.
Wait, gas traders are making how much?
Transatlantic LNG trade has rarely been more profitable. Let’s break it down for a theoretical spot cargo loading at a US Gulf Coast liquefaction plant and sailing to a north-west European regasification terminal over the New Year period.
The main profit driver is the differential between the cost of upstream gas and the marketable price in the end-user market. For US LNG, the cost base is Henry Hub (currently $6.50 per million British thermal units) and the end price is TTF, the European benchmark ($38/MMBtu).
From this, we deduct the cost of liquefaction (15% of Henry Hub) and transportation (30-day round trip at a cost of $220,000 per day). This gives us a netback of $30.63/MMBtu. For a standard 165,000 cubic metre vessel sold on the spot market for delivery in January 2023, the profit margin is $117 million.
How does that compare to shipping the same cargo to north Asia? Pretty favourably. Accounting for a 70-day roundtrip and passage through the Panama Canal, the netback is $96 million. This is why spot cargoes are heading to Belgium rather than Beijing.
Looking at the forward curve, the economic calculus remains heavily in favour of shipping American spot cargoes to Europe until at least August 2023. US-EU cargo profitability peaks at $125 million in June 2023 and does not drop significantly below that figure until January 2024:
The ‘European premium’ is the market pricing in the herculean task of refilling severely depleted EU gas stocks with little or no recourse to Russian pipeline gas flows. For the EU to achieve its storage target of 90% full by the start of winter 2023/24, it will (again) have to deprive emerging Asian economies of access to affordable gas. If Chinese buying appetite returns with a vengeance, and/or the current cold snap foretells a very long and harsh winter, $125 million for a boatload of LNG could start to look like a bargain.
Golden age of… LNG?
These are illustrative figures only and come with several caveats. Forward curves offer a snapshot of market sentiment, and are a poor tool for forecasting outturn. Most LNG is traded under long-term bilateral contracts indexed to Brent, not sold on the spot market. And the actual netbacks captured by spot trades are subject to variables such as sunk costs and each trader’s hedging strategy.
Yet the numbers are instructive for one simple reason: LNG will account for an ever-increasing share of global natural gas trade for the foreseeable future, and Europe is supercharging that shift by swapping cheaper Russian pipeline gas for incremental LNG volumes procured in the spot market.
As profits spiralled, US LNG shipments into European countries spiked from 322 cargoes in the whole of last year to 588 cargoes from January-September 2022. At this rate, Europe (excluding Turkey) will import somewhere between 600-700 cargoes this year:
In volumetric terms, the EU will import 50 billion cubic metres (+60%) more LNG in 2022 compared with 2021, with US cargoes accounting for two-thirds of the increase. A significant (but unknown) proportion of these will have been procured at spot prices similar to those highlighted above.
The International Energy Agency (IEA) caused a stir by calling an end to the ‘golden age of gas’ in its latest World Energy Outlook, which forecasts global gas demand plateauing from the late 2020s. But LNG overtook pipelines as the principal conduit for gas trade in 2021 and the gulf is expected to widen over the coming decades, regardless of how fast the world decarbonises:
Overcoming commitment issues
The corporate response to this structural shift to higher cost gas is clear: buy more LNG under long-term contracts and avoid exposure to spiky spot markets that periodically price cargoes at $125 million. European buyers are coming around to the Chinese way of thinking: if buying spot is going to be a wild ride, why not lock in lower/less volatile prices for longer?
War and parabolic prices have eviscerated any lingering reticence among European buyers towards long-term contracting. Engie recently signed up for 0.875 million tons per year of LNG over 15 years from Sempra’s proposed Port Arthur plant in Texas. The French utility committed to lift double that volume from NextDecade’s Rio Grande LNG project in May 2022. Separately, the government of Germany is underwriting a $3 billion loan agreement with (you guessed it) Trafigura to deliver “substantial volumes” of LNG into European gas grids.
There remains a very real risk that European gas demand collapses at some point in the next 15 years, possibly as these new LNG sales and purchase agreements (SPAs) are coming into effect. A deep recession could coincide with an anticipated wave of new supply entering the market in 2025, potentially yielding a new LNG glut. Buyers signing new SPAs today will seek comfort from their ability to divert US cargoes to any destination without penalty, and hope that ‘premium’ Asian markets pick up any slack.
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Squabbling while Rome burns
There is some logic to the corporate response. Sadly, the political response in Europe has been anything but. The prospect of TTF periodically ‘going vertical’ prompted European policymakers to threaten to bludgeon gas trade with a blunt instrument: a ‘market correction mechanism’, AKA a wholesale price cap.
EU leaders agreed on the principle of capping the price of gas traded on the benchmark TTF contract. Yet they remain divided over crucial details, such as the cap level and conditions that must be met to trigger it. The EU Commission proposed a cap of €275 per MWh that would never come into effect, but seems to be leaning towards a lower cap and fewer safeguards.
The fundamental problem is that the cap will either be ineffective (if it is too high) or counter-productive (if it is too low). It is not clear that there is a happy middle ground to be found here.
The European Central Bank and Intercontinental Exchange (ICE) were quick to warn of the sky falling in if this is implemented. While a cap might influence bidding behaviour, the reality is that even a lower threshold is unlikely to be triggered often, if ever. A low cap of €220/MWh equates to $62/MMBtu, a price that front-month TTF has not breached at any point during the last 18 months of war premiums and scarcity pricing.
Price caps subsidise those that least require financial support, and drive demand by insulating heavy consumers from price signals. This is clearly unhelpful when Europe faces a supply crunch. If the cap is set low enough to be triggered frequently, it could undermine Europe’s ability to pay those insane sums outlined above that are necessary to lure spot cargoes away from Asia. Refilling gas stocks next spring would become that much harder with a stringent cap hamstringing Europe’s ability to compete in global gas markets.
Oblivious to the obvious
The cap debacle is also a huge distraction from the more urgent (and obvious) task of removing obstacles to achieving the EU’s renewable and energy efficiency goals, as set out in the Fit for 55 and REPowerEU packages. Chief among these is the need to reduce the permitting burden and lag on renewable energy projects and transmission lines. Measures to address regulatory barriers are now being held hostage by infighting.
Doubling down on low-cost renewables and no-regrets efficiency measures are the only real hedge available to Europe. Thankfully, they are an excellent hedge. Data from climate analytics firm TransitionZeroshow that, despite a small post-Covid inflationary blip, building new wind and solar plus storage capacity is still absurdly cheap compared to operating existing coal-fired power stations.
But economics alone are not enough. The long payback on capital-intensive renewables projects exposes them to “policy and politics over successive election cycles”, says TransitionZero. Recent moves by some European capitals to impose windfall taxes on inframarginal generators are a prime example of what not to do to unleash investment in this space.
This is kneejerk policymaking at its worst. Insulating buildings and displacing gas in power generation have the huge advantage of actually lowering gas demand (and emissions!). If EU leaders focussed on these twin objectives rather than the desire to be seen ‘doing something’ about the energy crisis, Europe would not need to bankrupt itself and deprive poorer countries of LNG just to stay warm every winter. It really is that simple.
Seb Kennedy | Energy Flux | 14 December 2022
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Full disclosure: TransitionZero is my employer. Disclaimer: all opinions expressed here are mine, not theirs.
I'd note that long term contracts were originally aimed by GDF (the ancestor of Engie) so this is not new in Europe. The difficulty for LNG imports is to sign long term contracts indexed to oil or Henry Hub ands have to deal with TTF on the other side.
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