Moving away from dependence on Russian gas will carry a high cost for Europe and some of the positives around LNG need to be grounded in realism, according to a senior oil and gas expert with McKinsey & Company. Peter Lambert was speaking at this year’s Energy Ireland conference.
Back in 2001, the world had a “pretty disconnected set of markets” which mainly covered Europe, North America and North Asia. The nine main export routes each connected one producing region with one consuming region.
By 2011, the number of main export routes had increased to 20 and five new import markets had opened up: India, China, South East Asia, the Middle East and Latin America.
“We also had much more connectivity,” he noted, pointing to the Middle East’s links with Asia and North America. Russia has recently announced a pipeline contract with China and North America is moving towards being a large scale exporter of LNG, almost certainly to Europe and Asia.
However, in a paradox, prices have diverged rather than converged in recent years. Recent prices per mmbtu have ranged from just under $4 in the US to around $12 in Europe and $16 in Japan.
Three major discontinuities explain this trend: the shale gas revolution in North America; a significant and enduring demand drop in Europe; and strong Asian demand growth.
Back in 2007 or 2008, he recalled that “very few people would point to the possibility of any of these three things happening.” At that time, for example, a massive amount of spending was going into LNG import terminals in North America but this thinking had reversed within the next two years. Likewise in Europe, it’s unlikely that anyone would have anticipated the scale of the drop in gas demand over the recession which has put “huge pressures” on the traditional price linkage with oil.
Asian demand for gas has grown more strongly than anticipated and all nuclear power has been switched off in Japan after the Fukushima disaster.
“Alongside that extra demand from Japan, for LNG to substitute for its nuclear power, we’ve also seen relatively strong demand from China and we can anticipate demand growth from South East Asia and India over the next few years.”
Within Europe, German import prices have become more closely aligned to hub price levels rather than the traditional oil linked formula. While there has been a rise in gas prices since 2009, this would have reached $14 per mmbtu if gas prices had continued to follow the oil-linked formula.
The lower than anticipated rise is explained by the sale of gas into traded markets by over-contracted suppliers in Europe, a shift towards selling gas at prices directly linked to traded markets, and the resetting of prices by Russian suppliers.
In the longer term, it is possible that prices could fall to a cash cost ($4-7 for most North Sea fields) but McKinsey expects this to be unsustainable: “Most gas fields decline over time if you don’t invest in them.”
The cost of new investments to keep those fields “alive” is another possible price driver, resulting in a price of $7-11. If that is not enough to meet demand, Europe may need to get its supply through additional pipelines. This could bring prices up to a $9-11 bracket. If all pipeline options are exhausted, the next option is LNG ($12-15).
Until recently, McKinsey’s overall assessment was that long-term prices were likely to be around $7-10 as new fields have to be made to work and the market was relatively well supplied.
The Ukraine dispute has now become “the elephant in the room.” Lambert recalled: “When we signed the contracts to bring supply from Russia in the 1980s, it was very clear. It was actually pointed out by the Reagan Administration and others that if Europe commits to taking so much supply from Russia, it effectively means that Europe cannot impose significant economic sanctions on Russia because we are so dependent on the supply of their gas.”
US and European politicians are now looking at how to reduce that dependency but some of the difficulties associated with the alternatives have been underestimated. At present, there is just one shale gas rig in the UK and three in Poland. Russia supplied 130bcm to Europe in 2012 but the consultancy’s most optimistic estimate for shale gas is only 5-10bcm by 2020.
Iraq could theoretically export 20-30bcm but developing that resource could cost $50 billion – not to mention the country’s political instability. LNG is therefore “probably the only option” for diversifying the supply from Russia.
McKinsey’s view is that Asian growth will be very strong and Asians are willing to pay higher prices than Europeans. China has ambitious targets for shale gas development but, as in Europe, these do not match the activity in the field.
North American LNG exports are expected to remain below 200bcm per annum and are more likely to be closer to 100bcm due to limited permitting, the economics of individual projects and the capacity of the industry to build export terminals. Similarly, there are uncertainties about LNG sources from Australia, Russia and East Africa. The vast majority of LNG is also currently sold at an oil-linked price, which is likely to remain high.
Only one LNG project is currently under construction in North America and some suppliers in other regions have not yet signed contracts for export.
If no LNG was produced in North America, the price from other sources would be $13 per mmbtu. If the most optimistic predictions for US LNG were achieved, the cost would fall to $10-11.
McKinsey projects that prices will stay higher than $12 in order to keep ahead of projected demand. Producers are struggling to sign contracts and developers are building more LNG than before, which is likely to result in delays.
“You just about manage to replace the declining facilities and to meet the demand growth with the capacity that’s currently under construction,” he commented. “We don’t suddenly see lots of excess supply coming onstream.”
All of this raises questions for Europe, including whether it wants to pay the cost of energy independence from Russia and how to become more flexible and resilient. On the last point, he concluded: “There’s clearly going to be uncertainty about how Russia behaves; we’ve seen that in Ukraine recently. And if we do decide to switch to a greater dependence on LNG, there’s uncertainty in the LNG market anyway.”