The downside of demand: part two

Read part one of this article here.

Competing with coal

Ideal as that is for the environment, the unpredictability of European weather means that at times of low wind and cloudy conditions, extra capacity needs to be provided as reliable back up. As a much cleaner alternative to coal, gas fired power plants would be the obvious choice and has to some extent been supported by EU policy.

Once portrayed as the key driver of gas demand growth in Europe only a few years ago, gas fired power generation is now facing a significant challenge in the form of coal. As the US began to produce its own sources of fuel for power generation and feedstock, the need for foreign and domestic coal declined. Once again, the increased availability of coal made it particularly cheap for European importers.

This dynamic is now changing as a lower European gas price and the relative unpopularity of coal begin to have an effect. Using gas to shore up renewable production makes sense environmentally, but volatility from more spot contracts and fluctuating gas prices may act as a break on development while coal still retains financial viability. How gas will be used in power generation also depends fundamentally on its availability, that is, the security of supply.

Russian roulette

European energy security as a concept is, for most Europeans, directly tied to Russia. However, the issue of gas security, that is, the question of whether President Putin will at some point decide to ‘turn the gas off’ and what Europe will do if he does, is not quite as dramatic as some headlines would have readers believe.

The fall in natural gas prices mentioned above has done quite some damage to Moscow, which apparently gains one fifth of its budget revenue from Gazprom alone. As European sanctions and a mild winter have weakened demand, so the pricing power and market share Gazprom enjoys in Europe are weakening too, reflected in a 60% drop in the company’s third quarter net profits announced in January.

Blaming the impact of Ukrainian debt and the insecurity it risks by sending gas through Ukraine to Europe, Gazprom cancelled its South Stream project that would have taken gas through the Black Sea to Bulgaria. This does not mean to say that the gas will simply stop flowing West though, the EU represents 29% of the gas imported from Russia, translating into huge revenues that Moscow dearly needs.

At the same time, the EU has been pondering its own changes to gas supply. Norway’s Foreign Minister Borge Brande offered to increase the supply of gas from Norway to Europe at a discussion on energy security in March, building upon the 20% that it already provides. Meanwhile Iran, also suffering from sanctions over its nuclear programme and a most unlikely white knight, offered to supply gas to Europe via the Caspian Basin in early 2014.

Liquid alternative

Whichever deals are finally struck between the EU and the different suppliers on offer, the way in which gas is supplied to Europe is also changing. The pipeline network is not only ageing but costly and time consuming to upgrade, let alone poorly connected between some European member states. By freezing gas into LNG, it can be far more easily transported by boat or rail around the world. However, the same influences that affected pipeline gas and oil have affected LNG prices, which themselves are widely variable.

As LNG, too, is linked to the oil price, the 2014 crash will only now begin to have a dramatic effect on LNG prices as the 6 - 9 month contracts begin to expire. Again, the same factors come into play, European economic stagnation, Chinese growth contraction and renewable advancement, making LNG replicate the fate of oil and natural pipeline gas. This has already resulted in the delay or cancellation of a number of LNG projects.

The future for Europe

As these closures begin to take effect and Asian LNG prices decrease (down to less than US$7/million Btu in March) on the back of gradually contracting demand, the price differential between Asian and European LNG could likely decrease, having a balancing effect on world LNG flows. That would be a major advantage for LNG importers and the European processing companies they deliver to, who have struggled to compete against international peers and their access to cheaper feedstock from shale.

Even if only short term, margin increases for European processors will not only allow the reinvestment of revenue into current and future terminals but also enable increased energy diversification against a currently high reliance on Russian pipeline gas. Considering that BP anticipates that LNG will account for 30% of EU consumption by 2035, its role as part of European energy policy and political negotiation will no doubt increase.

Nevertheless, long term strategic decisions must be taken by importers and processors alike as to the nature of future investment and operations. Even if LNG growth is likely, natural pipeline gas is still under significant price pressure and the economic and political tensions affecting the European gas market will not disappear overnight.

In this environment, ensuring that every possible aspect of operations and production has been optimised for profitability is crucial and could make the difference between those that survive those that do not. In a market where the balance of power can shift with alarming speed, survival may indeed be the only viable strategy.

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

Read the article online at: https://www.hydrocarbonengineering.com/special-reports/05062015/the-downside-of-demand-part-two-886/