The impact of North American LNG exports on European gas pricing
Project economics, and not regulatory red tape, will ultimately be the key determinant of how many North American LNG export projects proceed. These economics are far from certain in the longer term as question marks surround the ability of the US to maintain the current momentum of shale gas production at a competitive cost. However the possibility of gas exports from North America promises to add an interesting new driver of European gas pricing dynamics.
February 27, 2012
In a recent article we outlined the projects aiming to export North American produced gas in the form of LNG. These projects face a challenging task of navigating their way through the complex regulatory approval processes. But project economics, in large part driven by regional gas price differentials between the US and destination markets, will ultimately be the key determinant of how many of these projects proceed and what volume of gas they export. These economics are far from certain in the longer term as question marks surround the ability of the US to maintain the current momentum of shale gas production at a competitive cost. However the possibility of gas exports from North America promises to add an interesting new driver of European gas pricing dynamics.
But doubts remain about the sustainability and economics of the revolution …
The underlying pillar of the North American LNG export investment case is the continued supply of cheap shale gas production. While there is significant momentum and optimism behind the evolution of shale gas production, the industry faces some substantial challenges. There is little dispute over the scale of shale gas reserves, but there is significant uncertainty as to whether production can be grown or even maintained at current levels. Shale gas well production rates decline much quicker than those of conventional gas fields. As such new wells must be brought to market with greater regularity just to maintain production levels. This may prove difficult for a number of reasons. Firstly, a high proportion of yield from shale gas plays typically come from wells in concentrated “sweet spots”, many of which have been extensively drilled. Secondly, a recent report from the US Environment Protection Agency formally linked shale gas extraction with pollution of groundwater aquifers. If this results in further scrutiny it may slow the rate at which new drilling is approved.
But perhaps one of the biggest challenges to replacing declining production from existing shale gas wells is one of simple economics. Some observers have claimed that new production costs are significantly underestimated and could be as high as 6.5 $/mmBTu (including land leases, direct costs, taxes and return on capital). Many of the current shale gas production wells have been committed assuming a much lower unit cost of production as costs on existing land leases are typically treated as a sunk cost because the resource rights are forfeited if drilling does not commence before a specified date. These economics appear very challenging against current Henry Hub prices (with spots prices at less than 3 $/mmBTu) even assuming a very bullish view of forward prices. So what about the economics of LNG exports? The table below gives a rough breakdown of the costs of exporting LNG to Europe.
Table 1: North American LNG Export Economics
Source: The impact of a globalising market on future European gas supply and pricing, Howard Rogers, OIES, Jan 2012.
Note, at times the short run transportation and processing costs may be less due to some components having a lower opportunity cost (for example, if it is not possible to sell back unused liquification capacity, companies could treat the cost as sunk and be willing to utilise the capacity below this cost).
The impact on European prices and price dynamics
Based on current US and European prices the economics look attractive. But if the Long Run Marginal Cost (LRMC) of gas is over 6.0 $/mmBTu then the economics start to look marginal given current European prices. This is demonstrated graphically in the chart below.
Chart 1: Current Atlantic basin gas prices and NA export economics
Source: as table above. Forward gas prices from CME and ICE as at 23rd Feb.
It has been suggested that that the expectation of North American exports to Europe, and the resulting impact on prices, has already been reflected in the European forward curve. European forward prices for summer delivery in 2015/16 are around the estimated LRMC of US LNG into Europe. However the fact that Henry Hub prices are still well below $6.0-6.5mmBTu, the implied equilibrium level in the LNG export scenario, brings this interpretation into question. This doubt is consistent with the current uncertainty surrounding the timing and volumes of LNG exports from North America.
Regardless of whether or not European gas forward markets have priced in North American LNG exports, these exports will add another arbitrage or substitution play to the European market. Under conditions where North American LNG exports flow across the Atlantic to supply Europe, European hub prices are likely to be supported at the delivered cost of the LNG. If European hub prices fall below this level it will act to choke off US supply as exporters are unwilling to deliver cargoes. However this relationship may break down in conditions of global LNG supply surplus, for example if European gas hubs are used as a ‘sink’ for surplus Middle Eastern cargoes.
There are two key existing dynamics that also act to constrain the movement of European gas prices. If gas hub prices are below oil indexed contract prices, contract deliveries are minimised to ‘take or pay’ levels putting upward pressure on prices. The opposite conditions exist if hub prices are below contract prices. Although it is important to note that this dynamic depends on significant unutilised ‘take or pay’ volumes in the market.
A similar dynamic can be observed in the level of gas demand for power generation. If gas fired power generation is cheaper than coal on a marginal cost basis, gas demand from power generation increases supporting gas prices. The opposite effect occurs if gas prices increase to the point where gas plant is displaced by coal at the margin, with falling gas demand putting downward pressure on gas prices.
The export of substantial volumes of LNG from North America and its ability to impact European price movements adds another interesting dynamic to interact with the two described above.