Facing headwinds

Both the oil and the gas industry are navigating a sea of change that will affect the future outlook of both industries. European refiners have been experiencing a sharp decline in domestic oil demand and tougher competition abroad. While the gas industry is under pressure to change its business model and adapt to more flexible business practices. Gas markets are likely to be affected by price volatility as conflicting interests from LNG, renewables and carbon markets interplay. In contrast with the US, natural gas consumption in Europe has been declining in the last three years and market share has been lost to both coal and renewable energy.

The IEA revised down its forecast for European gas consumption for the period between 2013 and 2018. According to the IEA, gas consumption will increase by only 12 billion m³ from 513 billion m³ in 2012 to 525 billion m³ in 2018. The new forecast places future European gas consumption below pre recession levels. According to the IEA, the high price of gas relative to coal and the low price of carbon will negatively affect gas consumption in the period between 2013 and 2018.

Many European electric power producers with the flexibility to use coal fired generators have switched to coal to take advantage of lower coal prices relative to gas. The US has become the main supplier of coal to Europe as low US gas prices turned coal less competitive in the US market and made exports of coal to Europe more attractive.

However, the preference for coal could be short lived as many European countries will be decommissioning older, less efficient coal plants in the next five years and the European environmental agenda takes precedent over profitability considerations. In 2013 coal consumption dropped 6% mainly because of the decommissioning of several coal fired power plants in Europe.

Russia's expanding gas market share

Russian physical gas deliveries into Europe increased by 10% in the first six months of 2013. This increase in Russian gas imports was driven by lower supplies from Norway and North Africa and lower LNG imports. The decline in demand for LNG in Europe was motivated by weak gas consumption and high LNG prices. LNG producers and traders have been focusing on the growing Asia LNG markets and some LNG cargoes designated for Europe have been reloaded and redirected to Asia. This trade is emerging as an important additional supply source for Asia and has the unintended consequence of benefiting Russian gas exports.

Oil indexation versus hub price indexation

A great proportion of natural gas price in Europe is still based on oil prices. It is not possible to get an accurate view on oil indexation versus hub indexation levels. The majority of the supply contracts are structural long term contracts with confidentiality clauses. The European Commission estimates that approximately 50% of European natural gas supply is indexed to oil. Moreover, approximately 80% of Russian natural gas supplies to OECD Europe are linked to oil.

The increasing level of hub indexation in European gas supply contracts has been one of the main trends marking the evolution of the gas market over the past few years. Hub indexation has been gathering momentum as North West European hub prices have traded below oil indexed contract levels for the last five years. This has been a key factor in the development of hub liquidity and transparency and opened a gap between high cost long term contracts and short term contract prices.

Gazprom and North Africa producers have been keen defenders of oil price indexation. However, there are signs that even Gazprom is beginning to make concessions. The marketing and trading arm of Gazprom in Germany has signed a 3 year deal with Centrica for the supply of 2.4 billion m³ gas to the UK priced at the NBP hub. Statoil has been more willing to accept increasing levels of hub indexation and has recognised that the majority of the company’s gas supply contracts will be hub indexed in the future. Recently, the company has signed a 10 year 45 billion ft³ supply deal with BASF linked to the German hubs.

European oil demand in 2014

European oil markets are slowly coming out of the doldrums and in 2014 some European countries are expected to experience increases in oil demand triggered by more dynamic economic growth. The IMF European GDP forecast of 1% for 2014 cannot be considered impressive but it is still an improvement from the 0.6% GDP decline expected for 2013. The signs of recovery in oil demand during 2013 were mixed with Germany and UK showing encouraging increases in diesel demand but Spain and Italy still exhibiting sharp declines in motor fuel demand by 4% and 8% respectively in the first six months of 2013. France recorded a combined decline of diesel and gasoline demand of 1.8% in the first half of 2013 according to the industry group Union Francaise of the Industries Petrolieres (UFIP). The outlook for European oil demand is expected to be weak in the next two years with the UK Petroleum Industry Association (UKPIA) forecasting oil demand growth of 0.1%/y until 2015. Oil demand growth is expected to increase slightly after 2015, according to the UKPIA, particularly in the southern European countries that enjoy greater prospects of economic growth.

Increased dependency on oil imports

The structural imbalance between gasoline churning European refineries and market requirements for increasing volumes of diesel places the European industry at a great disadvantage. The economic downturn, high crude oil prices and vehicles efficiencies reduced oil demand and forced refiners to cut runs imposing additional downward pressure on refinery margins. As a result, 16 European refineries had to shut down since 2008. Data from BP shows France suffered the steepest refining capacity loss, 25%, while Germany, UK and Italy lost 11%, 11% and 8% respectively between 2008 and 2012.

The switch from gasoline to diesel has been driven by a combination of taxation favouring diesel and efficiencies in diesel engine. In contrast to diesel robust growth, gasoline’s demand in Europe has been declining at a rate of 3%/y for more than a decade. In Central and East Europe, gasoline has been growing but in countries such as Poland, Turkey and Ukraine the switch from gasoline to diesel has been taking place for the last few years. The overall net effect is an increasing gasoline surplus that will continue to be exported to the US and West Africa.

The imbalance between refinery production and market requirements resulted in a growing deficit of diesel/gasoil and a surplus of gasoline. Total gasoil/diesel imports grew from 49 million tpy in 2008 to over 53 million t in 2012 (Figure 1), with the impact of the recession on demand being generally offset by temporary or permanent refinery closures. Gasoline exports exceeded 48 million t from 2008, although there was a small decline over the period as a result of refinery closures and reduction in refinery utilisation rates.

Reduced gasoline exports to the US

The weakness of the European refining sector is being exacerbated by the drastic reduction of gasoline exports to the US markets. A combination of lower US consumption and domestic production replacing imports has significantly reduced gasoline import requirements by the US. Refiners in Europe are struggling to find new markets to replace the volumes of gasoline previously sent to the US and face tough competition from other refining centres for markets in West Africa and in the Mediterranean region.

No rosy prospects for the oil industry in 2014

The continuing switch from gasoline to diesel in Europe has boosted diesel growth rates in the past ten years. However, diesel growth rates in Europe are forecast to be much reduced in the future compared to past performance due to improved engine efficiencies and market saturation. Spain and France, for example, are approaching diesel market share of 80% of total cars on the road. Therefore, in the future the European diesel market needs to rely on real economic growth rather than fuel substitution to sustain a good level of diesel demand growth. The prospects for European fuel demand in 2014 are going to be mixed, Germany and the UK are already showing good recovery in diesel demand and both countries are expected to achieve diesel demand growth of around 2% in 2014 relative to 2013. On the other hand, Italy, Spain, Portugal and Greece have been the worst affected by the economic downturn and oil demand in those countries are still expected to decline in 2014.

Conclusion

European oil and gas industries are undergoing many changes and facing many challenges. The nature of these challenges can potentially change the outlook for both the oil and the gas sectors in Europe. Energy dependency and security of supply are underlying ‘themes’ linking the two industries. European authorities and European consumers are increasingly concerned with oil and gas supply reliability and affordable prices. Despite of all these fears, the dependency to oil and gas imports is estimated to increase in 2014 and beyond. The expansion of European gas hubs is regarded as a positive development by European consumers and will help to keep gas prices under control. Under intense pressure from consumer countries and facing competitive challenges from other sources of energy, the gas industry is being forced to renegotiate long term contracts and accept more flexible price mechanisms. 

The full article can be found in the January issue of Hydrocarbon Engineering.

Read the article online at: https://www.hydrocarbonengineering.com/gas-processing/10012014/facing_headwinds37/