Dawning of a New Era: The LNG Story

Summary

Spurred on by higher natural gas prices and a growing demand for cleaner fuels, interest in new liquefied natural gas (LNG) facilities has mushroomed. At the end of 2004, over forty new receiving and regasification stations were being proposed in the United States, and another ten were seeking siting approvals in Mexico and Canada. Even if less than ten percent of these projects are approved and built, more than twenty percent of United States gas demand may be supplied by LNG facilities by 2012. On the production side, the number of countries contemplating the construction of liquefaction facilities has doubled, and existing producers are scurrying to build more and larger facilities.

A glance at the economics shows why. Since the mid 1990s the costs of every stage of the LNG chain – gas production, liquefaction, shipping, and regasification – have dropped substantially. Today LNG costs have fallen below those of domestic pipeline gas in both the United States and Europe. Actual LNG costs depend on many variables, but range from as low as $2.50 per Mcf to approximately $3.50 per Mcf (as compared with the price of pipeline gas in the United States of $7.00 per Mcf). Industry experts believe that improvements in technology, especially for tankers, could lower these costs still further.

While costs have dropped, the price paid by consumers is likely to track the price of pipeline gas. Hence, the profits from LNG trade may be considerable, given the gap between the domestic price of natural gas and the cost of importing LNG. The competition to capture these profits will be fierce, but if history is any judge, most will be retained upstream – in the hands of the producers and their host governments.

This paper addresses two important questions:

1)Will competitive pressures change the structure of today’s LNG markets?

2)As more LNG is traded, will the national security concerns that have characterized oil markets over the past thirty years also begin to characterize gas markets?

Competition

In the last ten years, wholesale markets for electricity in the United States, Europe, and Japan have become highly competitive. Firms with lower fuel prices have a distinct advantage. United States domestic gas markets have deregulated, and Europe is moving in the same direction. Driven by competitive forces, both the direct and indirect purchasers of LNG are exerting strong pressure on sellers to reduce prices and increase volume flexibility. Some experts speculate that as the demand for LNG grows, buyers will transform the market from one characterized by rigid long-term contracts to one characterized by merchant sellers who rely on spot markets and arbitrage opportunities. However, the evidence suggests that while the market will become more flexible, the basic framework under which LNG has been traded will remain, at least for the near and mid-term.

The financial risks inherent in investing in each subsidiary in the chain of companies that comprises the LNG industry are too large to be left to the vicissitudes of the marketplace. Despite the current rhetoric, most liquefaction plants, shipping fleets and regasification faculties will be anchored by long-term contracts. Fluctuations in volume are considered more risky than price volatility, and thus upstream LNG producers will attempt to lock in long-term commitments to purchase supply, while allowing prices to shadow those in the importing country’s gas market.

Security

With international natural gas trade poised to increase four-fold, consuming country governments have expressed concerns about the possibility of future politically motivated disruptions in LNG supplies. Will the problems inherent in oil dependence be replicated by a new set of security problems? This paper argues that such fears are overstated for several reasons:

1) Between 2005-2030, imported LNG volumes as a percent of the total amount of gas consumed will under almost every growth scenario remain much lower than that for oil. The only exceptions will be countries such as Japan or India that have limited domestic supplies. In these countries, LNG will continue to supply large boilers and electric generating stations and thus compete with substitute fuels, such as low-sulfur diesel oil or coal.

2) The number of new liquefaction and regasification facilities and the number of LNG tankers will be significantly greater in 2012 than in 2004. While this growth by itself does not insure against disruptions, it does indicate that buyers and sellers will have more options to purchase and deliver substitute supplies. This will be especially true if the size of spot markets grows in proportion to the total amount of gas.

3) Investments in redundant facilities and more storage, the use of sharing agreements among regasification and liquefaction facilities, and the design and development of more flexible contracts will give importing countries greater flexibility to weather supply disruptions. Japan has aggressively pursued every one of these options, and its success in managing the recent curtailment of LNG deliveries from the Arun facility in Indonesia is an example of how such actions can reduce a country’s vulnerability.

4) In the case of natural gas, both the country being disrupted and the country doing the disrupting face significant costs. The former may lose gas supplies, but the latter endangers its flow of hard currency, trade in other commodities, and its standing in the international community. This interdependence can be increased through the development of creative trade and investment arrangements that would be linked, either formally or informally, to LNG contracts.

LNG markets differ from oil markets in many ways, including size, the character of the participants, the nature of the investments, and patterns of trade. While specific accidents will happen, their impact will be localized and the global market will adjust more efficiently as the number of players and the size of the market increases.