Rethinking strategies

Iván Martén asks: How will low oil prices affect natural= gas markets?

Global natural gas markets have already felt some impact from the slide in oil prices. But they will be affected to a much greater degree if oil prices remain in the $50-to- $60 range for an extended period. Below we examine the US, Asian, and European markets to gauge their potential responses.

The US
In early 2014, the U.S. Energy Information Administration projected that US demand for natural gas would reach 770 bcm in 2020. Given the extent to which oil prices have fallen subsequently, however, that projection, especially its assumptions regarding exports and demand from the transportation sector, is likely far too ambitious. For US LNG exports to appeal to Asian and European buyers, spreads between US Henry Hub prices and prices in Asia (which are indexed to the price of oil) and Europe (which are indexed mainly to hub prices) must be sufficiently wide. But spreads have narrowed considerably as oil prices have fallen. Demand from transportation, meanwhile, stands to be dampened significantly by narrowing price differentials between natural gas and oil products, which will likely reduce substitution of the former for the latter. All told, we expect US demand in 2020 to be well below the EIA’s projection.

The fall in oil prices will also weigh on US production of natural gas, since oil and gas companies are likely to scale back development. A major reason for this is that, with cash flows from their currently operating oil fields shrinking, these companies have less cash to invest. This will force them to be increasingly selective in the investments they make, and projects with relatively high break-even prices, which would include some gas-development projects in the current environment, could be delayed or canceled. Coupled with this, the economics of many ‘wet’ gas fields – those with a high liquids content – have been eroded by the oil price fall, which could further reduce investment. Given the above, we believe that a prolonged period of low oil prices would lead to a smaller US natural gas market. It would also limit the US’ role as an LNG exporter, Rethinking Strategies Fig1retard the development of natural gas’ role in the transportation sector, and reduce the price competitiveness of US-produced natural gas on the global market.

By region, Asia has had the world’s fastest growth in demand for natural gas in recent years, with demand rising by more than six per cent annually for the past five years. Historically, Asia has relied heavily on imports to satisfy its demand, given relatively limited local production. To ensure security of supply, Asian buyers have relied principally on long-term contracts, largely indexed to oil prices.

Given the linkage of Asian gas contracts to oil prices, the recent fall in oil prices will directly impact Asian gas prices, pushing them significantly lower. Indeed, northeast Asian LNG spot prices have already fallen significantly. Another factor that will put downward pressure on prices in Asia is planned LNG development projects in Australia and Papua New Guinea. These could introduce a large volume (roughly 90 bcm per year) of new supply to the market.

A key near-term effect of lower oil prices – and one that could remain in place over the longer term if oil prices stay low – is a reduction in the perceived need among Asian LNG buyers for index diversification. Over the past few years, Asian buyers have looked to broaden the basket of indices they use when securing LNG supply, with a particular push to move away from oil in favor of Henry Hub–indexed volumes, whose prices became increasingly attractive compared with prices for oil-indexed volumes when oil was about $100 per barrel. With oil prices now well below that, and with more uncertainty over the competitiveness of US LNG, Asian buyers have to review their diversification strategies.

Over the medium to longer term, it seems likely that, if the current oil-price environment persists, it will enhance the sustainable development of Asia’s natural gas market.

Europe’s natural gas market has evolved into one with significant liquidity. In 2013, for example, the volume of gas traded in all of the region’s hubs combined exceeded natural gas demand in those countries by a factor of ten. Today, most volumes in Europe are indexed to hub prices, which are decoupled from oil prices. This decoupling was quite evident in 2014, when oil prices and European natural gas prices moved in largely opposite directions for much of the year. (See the graph above.)

The relationship between oil prices and natural gas prices has changed significantly in Europe in the past decade, reflecting an evolution of the indexation structure of gas contracts in the region. In 2005, about 70 per cent of European natural gas volumes were indexed to prices of oil and oil products; by 2013, almost 80 per cent of volumes were indexed to hub prices.

This change in European market structure is a direct consequence of several rounds of renegotiations between European midstream players (including E.ON, RWE, and GDF Suez) and their main natural gas suppliers (such as Gazprom, Statoil, and GasTerra). This effort was undertaken several years ago by midstream players with the goal of adapting their supply portfolios to the prevailing gas-market environment. The effort remains in progress, thus we expect hub-based indexation in Europe to continue to increase.

For European natural gas contracts that remain indexed to oil prices, the decline in the price of oil has had a direct impact on contract prices. Hence holders of these contracts have less pressure to renegotiate them. We believe, however, that oil indexation will remain a risky strategy for midstream players over the longer term, given the enormous potential for margin volatility.

The risk of an oil indexation strategy to relevant European midstream companies could prove even greater in the near to medium term, given the indirect effect of falling oil prices on the European market. Europe acts as a sink for surplus international LNG volumes. In a scenario of low LNG prices in Asia, some LNG-supplying countries, such as Qatar, and LNG portfolio players could redirect part of their volumes to the European market, thus fostering competition in Europe between traditional pipeline suppliers (namely, Norway, Russia, and Algeria) and core LNG sellers. This could push gas prices in European hubs to levels below the prices of natural gas contracts that are indexed to oil and oil products at current prices.

The fall in oil prices has material implications for the major natural gas markets. In Asia’s market, the effects will be direct; in the US and Europe, they will be largely indirect. Players in all markets will need to think through their strategies carefully if they hope to capitalise fully on the opportunities that emerge.

The Boston Consulting Group
Iván Martén is a senior partner and managing director of The Boston Consulting Group and the global leader of the firm’s Energy practice. The Boston Consulting Group (BCG) is a global management consulting firm and the world’s leading advisor on business strategy. It partners with clients from the private, public, and not-for-profit sectors in all regions to identify their highestvalue opportunities, address their most critical challenges, and transform their enterprises. Founded in 1963, BCG is a private company with 81 offices in 45 countries.

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Issue 122 July 2015