2012-02-15

China - the catalyst for gas exports

By Mark Robinson, Investors Chronicle (FT)

This month's cold snap may have provided a fillip for the UK's energy utilities, but it came too late for the gas producers themselves – at least those operating across the Atlantic. The northern winter, which hitherto had been positively balmy, gave way to a more familiar Artic blast, although it proved insufficient to alleviate a slump in US wholesale gas prices.

This constricted fourth-quarter earnings for operators with US interests, such as Royal Dutch Shell, and it may have prompted some to question whether the huge sums that have been pumped into gas infrastructure assets actually constitutes money well spent, particularly if the current glut in US supply becomes a recurrent feature of the market.

The first thing to remember is that the US gas market operates effectively in isolation – at least for the time being, anyway. For now, export prices for Liquefied Natural Gas (LNG) are decoupled from the US market. The principal seaborne export hubs are located in Qatar and Australia, where prices are increasingly determined by Asian demand, whereas prices for much of Europe are linked (somewhat spuriously) to crude oil prices, reflecting Moscow's influence.

Admittedly, it has recently been suggested that because the US is now producing so much natural gas (from unconventional sources) that Washington may eventually be required to approve the development of a dedicated export terminal on the eastern seaboard to exploit foreign demand. By midway through the decade, it's conceivable that the US could be making inroads into those European energy markets now in thrall to Russia's Gazprom.

Gas expands

Although Shell's fourth-quarter earnings were eroded by gas price volatility, the group still made great store of the fact that it has ploughed billions into cutting-edge, gas-conversion technologies through projects such as Pearl GTL and Qatargas 4 LNG. Shell, in common with other industry players such as Exxon, Santos and Woodside Petroleum, has made large-scale capital outlays in expectation that natural gas usage is set to increase significantly, both in absolute terms, and as a proportion of the global energy mix. This also helps to explain why UK utility Centrica recently forked out £142m to up its stake in the Statfjord gas field. Centrica is obviously committed to expanding its reserve base, but it would be rather reluctant to add any assets to its balance sheet if it anticipated that they were likely to depreciate significantly in value over the long term.

The last 'World Energy Outlook' report published by the International Energy Agency (IEA) supports the view that natural gas is the world's fastest-growing energy source; only the rapidity and scale of the increase remains open to conjecture. The IEA estimates that primary demand could increase by 55 per cent through to 2035. Most of this new demand will be concentrated in non-OECD countries, where demand is expected to rise at a much faster rate than OECD countries. An increase in global production equivalent to treble that of Russia's (the world's biggest producer) will be required to meet the increase.

Chinese gas guzzler

Unsurprisingly, the People's Republic of China provides the principal catalyst; its government has made the expansion of gas-fired power plants a strategic priority. Less than 2 per cent of China's electricity is now generated in this manner, but Beijing intends to raise this to 10 per cent by the end of the decade. Some UK operators, such as Green Dragon Gas, moved quickly to exploit China's growing appetite for gas by utilising their experience of the unconventional drilling industry in North America. Nevertheless, China's increasing proportional reliance on gas, allied to the exponential growth in its generating capacity, means that the country will invariably place greater demands on global export markets, and thereby bolster prices.

Given its proximity to both India and China, the former Soviet region comprising the Commonwealth of Independent States (CIS) is set to become one of the world's principal gas export hubs. Much will depend on how rapidly existing infrastructure in the region can be utilised to exploit the growth in Asian demand, while the conduit into Europe's markets is still dominated by Gazprom, although its effective monopoly is no longer quite so secure.

A free-hand in distribution would present tremendous opportunities for UK oil and gas companies with a foothold in the region. The business model of one such operator, Tethys Petroleum, could be transformed overnight if, and when, new pipeline routes to Asia and Europe come onstream. The latter could be more problematic. The chief executive of Tethys, Dr David Robson, is confident that "the enormous gas potential of Tethys' acreage in Tajikistan could be exploited either by export to China, or via the trans-Afghan pipeline system to the Indian sub-continent", but he warns that Europe needs to "get together and work with the Central Asian nations" if it wants to secure an independent route for gas supply.

IC VIEW:

While growth rates and impending energy deficits ensure that the big manufacturing economies of Asia will increasingly turn to natural gas to fuel GDP, environmental issues are also providing an impetus for demand, as evidenced by Beijing's new focus on clean air policies, and the upsurge in Japanese gas demand post Fukushima. Australian and Qatari exports will ramp up rapidly, but Central Asian production will be required to meet burgeoning demand in China. The unconventional gas segment of the US economy has developed so rapidly, that the structural implications for the US economy are currently difficult to assess, although they're likely to be profound.

FAVOURITES: We've been singing the praises ofGreen Dragon Gasfor some time. Flexibility and specialisation are both key to Green Dragon's business, but its chairman Randeep Grewal clearly appreciates the value of applying a stakeholder model to its operations in China. This means that, unusually for a relatively small player, it is now firmly established at a regional level. The company is currently building its distribution and sales capability, which should enhance an already promising growth profile.

OUTSIDERS: It's probably a tad premature to ring the death knell for one of the world's biggest energy companies, butGazpromis now faced with a growing number of alternatives to Russian supply, including the increased size and number of LNG super tankers, together with the rapid expansion of North American shale gas production. Unfortunately, the corporate health of Gazprom is inextricably linked to Russia's political stability, which only adds to the uncertainty.

THE BROKER'S VIEW:

North American gas prices have reached 10-year lows as the growth in shale gas production and a warm winter have led to oversupply that could take up to two years to alleviate. Although a price recovery is expected in the next two years, it should be a return to price levels much lower than seen in previous peaks. Natural gas consumers are taking full advantage of the low prices by increasing industrial output and electric power production and have begun locking in long-term forward prices. With supply growth expected to remain robust, major North American producers such as Shell and ExxonMobil are looking to export surplus gas volumes from the US Gulf Coast and the West Coast of Canada in the form of LNG by late 2015.

On the other side of the world, the picture for gas prices is much more encouraging. Domestic demand growth in Russia, China and Kazakhstan is galloping. However social agenda from governments of the region has often maintained a cap on domestic gas prices. We believe this could change soon. Post 2012 elections, it is likely that domestic gas prices will resume their increase in Russia. Numerous large international companies such as TNK-BP are already playing that theme with increasing investment in domestic gas. Additionally, the imminent expansion of regional gas infrastructure such as the Central Asia-China gas pipeline over the next few years is expected to unlock gas resources to gas hungry markets like the Southern Kazakhstan provinces or China. Exploration and production Juniors like Dragon Oil in Turkmenistan, Tethys Petroleum and Condor Petroleum in Kazakhstan could be the big winners in that new environment.

Stephane Foucaud & Martin King are respectively managing director and vice president of Institutional Research at FirstEnergy Capital.