Dr. Vitaliy Yermakov Head of Center for Energy Policy Research National Research University – Higher School of Economics
Published on 16 August 2018 by Julia Sadieva
LNG MARKETS: THE BATTLE FOR MARKET SHARE NOT CANCELLED, JUST POSTPONED
For the past five years the prevailing view among analysts watching the global LNG market was the imminent supply glut. New LNG plants in Australia, US and Russia would create on overhang of supply that would struggle to find demand. The regional gas prices in Europe and Asia that had already declined in line with oil prices would converge around the lower band of short-run variable costs for key suppliers. This would lead to “lower for longer” price environment for global gas that would replicate oil market developments during 2015-2016. The expected glut of LNG during 2017-20 and the emergence of Europe as a residual market for flexible volumes would set the stage for a battle for the market share in the European gas market between LNG suppliers and the incumbent pipeline suppliers, most importantly Russia.
The reality in 2017 and 2018 has turned out to be different. There is no excess supply. Regional gas prices have diverged, with price differentials between Asia and Europe, and Asia and the US indicating that markets are short gas. Gas demand in Europe started to recover, but imports of LNG to Europe declined. Russia’s pipeline gas imports to Europe have gone up, and Russia’s share of European gas consumption is 35%, up from 27% just few years ago.
What have the analysts missed? The short answer is: they underestimated China’s appetite for gas. The country has beaten the most optimistic expectations, turning into the world’s fastest-growing natural gas market in 2017. Consumption grew by 15%, more than twice the rate of economic growth. China’s LNG imports in 2017 increased by a stunning 46%, essentially taking all new global LNG supply off the market. China’s government set out new targets for clean air and energy balance that imply strong natural gas demand growth for at least the next decade that would also mean progressively rising LNG imports.
So, has the pendulum swung and the gas market tightness is here for long? There is sufficient body of evidence to support this view, but there are strong reasons to use cautious approach as well. The rebalancing of the global oil market has led to oil prices approaching $80 per barrel. In many markets gas prices are based not on gas-on-gas competition, but are derived from the formulae linked to prices of substitutes, most commonly a basket of refined oil products (this is what is known in the industry as oil-indexation). A usual feature of the oil-indexed formulae for gas prices is a time lag, from 3 to 9 months. High oil price now means high formula gas prices next year. Rising prices for pipeline gas and LNG may rein in demand, especially in countries with price sensitive consumption. It is worth noting that when prices of LNG in Asia in 2015-2016 declined to $6-7 per MMBtu they became lower than the regulated city gate gas prices in China. The record growth of China’s gas demand for cheap LNG may give way to mere moderate growth in 2019-2020 if LNG prices exceed the price levels comfortable for the consumers in Asia and start creating inflationary pressures for the economies in large. (See Figure 1)
Traded gas prices in key global regional markets
Source: Center for Energy Policy Research, National Research University – Higher School of Economics, the data from the World Bank
At the same time, new LNG projects that add supply in 2019-2020 still have the potential to make the market long and lead to fierce competition for the market share among suppliers. In this situation the price levels at which the possible price war between LNG and pipeline gas in Europe takes place will influence the perceptions of the seriousness and duration of the challenge for the incumbent low cost suppliers and thus matter a great deal for understanding the logic behind their strategic responses.
In a low oil price environment to 2020 Russian gas with its sunk upstream and transportation costs looks very attractive compared with US Gulf Coast LNG on the basis of cost of supply, so the Russian strategists may decide that the competitive threat from the US LNG suppliers that would struggle to recover their variable costs is not serious.
But price recovery (oil prices at $70-80 per barrel, gas prices at $8-10 per MMBtu) in 2018-2019 gives US LNG projects a chance to recover their full costs. They, therefore, would become serious competitors to Russia’s pipeline gas in Europe. (See Figure 2)
Price sensitivity of gas-on-gas versus oil-indexed gas competition
Source: Center for Energy Policy Research, National Research University – Higher School of Economics
Russia’s gas export strategy in Europe so far has been based on value maximization proposition rather than on protecting its market share. Russia has accepted the role of a balancer for the European gas market as part of its legacy long-term contracts that contain significant seasonal and structural flexibility. But if the new challenge from the growing number of LNG projects that would target Europe becomes an extended threat to Russia’s market share, it may change its position and attempt to defend its market share.
Russia’s response to the challenge to its market share in Europe, in our view, is going to be retroactive rather than proactive and matched to the perceived threat. Depending on the future path of the oil price, this strategy may play out well for Gazprom, but may also result in an extended period of lower exports and lost revenues.
Two key elements of Russia defensive strategy in the European gas markets could become, first, restricting flexibility in its contracts with Europe, and second, putting more of its gas to European hubs to initiate a “price war” with alternative suppliers.