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The downside of demand: part one

Hydrocarbon Engineering,

Since the price of crude oil began to sink at the end of 2014, the effect of cheaper oil on natural gas has largely been ignored. This article looks at some of the reasons behind this rather abrupt change in fortune for the European gas industry, before going on to explore some of the trends occurring in the energy industry as a result.

A crash in oil

There is a surprising amount of support for the theory that OPEC, in particular Saudi Arabia, was the sole force behind the oil price crash of 2014. While OPEC does indeed play a profoundly important role in the global oil market, there are a myriad of factors that have, and are still contributing to both the oil price and its effect on the gas industry.

First, the importance of the shale fields cannot be underestimated. Oil recovered via hydraulic fracturing from the shale fields in the US increased from 111 000 bpd in 2004 to 553 000 bpd in 2011. With staggering speed, the US had been transformed from a net importer of oil to a net exporter, when export permits are approved by Washington, that is.

Which was all very well until China announced a slowdown in growth in mid 2014, compounded in the following December by the news that its economic expansion had been the slowest since 1990. When China became the world’s largest importer of oil in 2013 it had long formed the lynchpin of most analysts’ forecasts for oil price development and was often viewed as the single fulcrum around which the world economy could turn. Instead, China’s slackening growth meant it must act quickly; according to Platt’s, crude oil imports had already decreased by 9% y/y by July 2014, reflecting weaker domestic demand and having a profound effect on the availability of oil worldwide.

The resulting supply glut and corresponding drop in price was perhaps to be expected, regardless of OPEC’s policy on production. If we add to that the effect of long term economic stagnation in Europe, combined with much higher energy efficiency and an increase in the renewable share of the energy market, an oil price of over US$100/bbl was perhaps unsustainable under those conditions.

Equals a crash in gas

As the price of gas is linked to the price of oil through indexation mechanisms, a drop in oil value would eventually be replicated in the price of natural gas. Historically joined because a gas market simply did not exist in the 1960s when it was first uncovered, it seemed logical to link gas to oil as they were in competition for the then key markets of heating and power generation.

As both the sources and uses of gas have evolved, however, arguments for delinking the two commodities are increasing in volume. The main effect of the current indexation system is that gas contracts are sold at the same price as oil. But as demand for gas has decreased, major importers of gas argue that long term supply contracts should be separated from oil. Forced to buy expensive gas from exporters but with a slowly eroding end user, European importers in particular were hit hard by US$100 oil.

While the two commodities remain linked, however, the sudden drop in oil has caused a corresponding decrease in the price of gas. Between November 2014 and March 2015, the price of gas fell from US$4.5/million Btu to only US$2.5/million Btu. This may give some respite to the aforementioned European importers who suffered from high oil prices, but it still does not change the fundamental demand problems the European gas market is suffering from.

EU energy policy

European gas has largely been a victim of the same forces that oil has, namely, economic stagnation in Europe, a decrease in Chinese growth and oversupply following the shale boom in the US and Canada. However, there are a number of additional factors that have contributed to a significant decrease in demand for natural gas in Europe.

EU energy policy has, for a start, actively supported higher energy efficiency as laid out in the 2012 Energy Efficiency Directive. This requires energy distributors or sales companies to achieve energy savings of 1.5%/y via a number of different measures in order to reach its 20% efficiency target by 2020.This so called 20-20-20 target is but one of the EU’s key climate change policies. The Kyoto Protocol and the ‘Roadmap for moving to a competitive low carbon economy in 2050’, whose chief aim is to reduce emissions from power generation, industry, transport, buildings and construction, are also affecting key gas markets. Consequently, most member countries have responded to these directives by focusing their energy policies on technologies or objectives that do not actively consider the gas industry.

Renewables have been the main beneficiaries, having increased their share of the power generation mix and become the focus of numerous national energy policies.

Part two of this article will be available soon.

Written by Amy Faulconbridge, T.A. Cook. This is an abridged version of an article taken from the June 2015 issue of Hydrocarbon Engineering.

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