Gas Goes Global

This article appears in the May issue of Oilweek; image from here.

By Peter McKenzie-Brown

Last year was awful for Canadian natural gas producers. Development and production costs were at record levels, yet the average Canadian price at AECO was $7.66 per thousand cubic feet – seventy-four cents lower than American producers received at Henry Hub. But then, as suddenly as they had ebbed, prices began to flow. At time of writing, spot prices for natural gas are much higher than their 2007 average, and climbing.

To a surprising degree, these changes reflect global changes in the natural gas business. Historically, natural gas has been a regional business, and North America continues to be somewhat isolated from gas developments elsewhere in the world. According to CEO Robin Mann of AJM Petroleum Consultants, North American markets are presently somewhat isolated from the situation. However, he has no doubt that “gas is becoming a global commodity. Whether we like it or not, we are going to be caught up in it” – and, probably, sooner than you think.

The globalization of the world’s natural gas industry is being driven by a combination of economic and geopolitical forces. For example, consider the world’s second-largest gas-consuming region, Europe.

Geopolitics of change: Democracies around the world celebrated this decade’s revolutions in Eastern Europe. Serbia’s overthrow of its strongman in 2000 was quickly followed by the Orange Revolution in Ukraine and the Rose Revolution in Georgia. In each case the western world applauded.

Their biggest neighbour didn’t, though. Not known for its democratic credentials, the Russian bear responded to each revolution by clawing at the gas taps. It also apparently equipped saboteurs with explosives and sent them inside the country to destroy Georgia’s distribution link from the giant Russian gas monopoly, Gazprom. On instructions from Moscow, Gazprom even stopped deliveries to tiny Belarus for hesitating to “reunify” with Mother Russia. Belarusians had to quickly get used to being Russia’s 90th region.

These countries aren’t members of the European Union. However, expansion to 27 members has increased Europe’s dependence on Russian natural gas, so this pattern of behaviour has become a matter of deep concern. Now reliant on Gazprom for more than 60% of its gas supply, Europe is scrambling to find new sources.

Europe’s mad scramble is one driver behind the globalization of gas. Another is rapidly growing gas demand in the developing world – another trend with geopolitical overtones. The author of a best-selling book (A Thousand Barrels per Second) recently issued in Japanese and Chinese translations, ARC Financial’s Peter Tertzakian used China to illustrate the shift.

Coal and oil have played themselves out as easily harnessed and accessible fuels in that country, he says, and the country has to diversify into other fuels. “China’s pattern of energy usage is following the pattern of all other already industrialized countries. First you dam up all your rivers, then you move on to coal, then you start using oil as a booster rocket for the economy. Once you’ve done that, increasing your use of those fuels becomes unsustainable and you have to make a rapid shift to alternative energies – and the alternatives for China and other industrializing countries are natural gas and nuclear energy.”

Here, more geopolitical overtones enter the scene: The growing markets of East Asia and the nervous markets of Europe do not have a great deal of domestic gas supply. The planet’s greatest reserves are in the Middle East and the former Soviet Union – both of them diplomatically touchy regions. And most of the world’s other stranded supplies are in remote countries with access to the sea. These factors are helping drive a surprisingly rapid transformation of the global gas business.

A geophysicist by training, AJM’s Mann is bullish about the global gas market for the long-term. To a large extent this is because so much of the world’s gas potential is either undeveloped or stranded. This means a great deal is there to be developed for sale as LNG or, as in much of Southeast Asia, by subsea pipeline.

In terms of untapped potential, top of his list is West Africa. “We’re doing some work in Congo, where a few years ago you would be crazy to go, and that’s making me optimistic. There’s a chance that some West African governments will get their act together and stay true to their word, and if that happens that stretch of the continent could become a real hotbed of activity. There’s a lot of potential there.” However, he cautions, “we’ve been to this movie before. They could go back to their old ways, and this thing could blow up in their face.”

The biggest arbitrage: In Peter Tertzakian’s office is a meeting table with a single ornament in the centre: about the size of two fists, a wooden model of the globe. When you talk to him about the world gas business, he caresses this artefact, frequently turning it on its silent axis to demonstrate his points.

There are, of course, only two commercial ways to transport natural gas: by pipeline, and as LNG. Pipelines are being built with abandon, including vast networks of undersea lines that are, for example, connecting the vast Southeast Asian archipelago. For the most part, though, pipelines connect regions; they cannot connect the world.

For that, you need liquefied natural gas (LNG) – methane under such high pressures and deep cold that it forms into a liquid that can be shipped by tanker. To create a global market you also need a motive. Try this one on for size: “Natural gas,” says Tertzakian, “represents the biggest arbitrage opportunity in the world.”

Arbitrage is the practice of taking advantage of a price differential between two or more markets. A combination of matching deals that capitalize upon the imbalance, the difference between the market prices generates the profit. There isn’t much arbitrage opportunity in oil, because the global oil market is very efficient market, from hub to hub. There are lots of tankers on the seas, so arbitrage can easily be worked out. But for natural gas, which can sell in Chile and North Africa for as little as $1-2 per thousand cubic feet, arbitrage isn’t yet easy.

How do you get it from those sources to the high-priced markets of Europe and Japan and, increasingly, North America? The answer is LNG – although, says Robin Mann, “The major issue for LNG development seems to be in the development of liquefaction plants. They are expensive to build and two of them were recently cancelled. Increasingly right now we have regasification terminals that can receive (LNG) but we don’t have enough overseas exporters” to deliver production to overseas markets. That is changing. “The globalization of the gas business is happening much faster than I thought,” says Tertzakian, but he believes it’s a phenomenon Canada needs to embrace.

He lists a number of key reasons. For one, “every energy commodity today is under stress and tension, and the world is jockeying to figure out what energy mix they are going to use.” The competition for available energy is intense, and this is driving up prices worldwide. Contrary to the notion that “cheap LNG is going to come in and clobber us,” Tertzakian argues that LNG is the “friend” of North America’s gas producers. “It’s the most expensive molecule that sets the price,” he says, “not the cheapest molecule. That’s Economics 101.”

Another reason global gas markets have become so much more efficient is that LNG contracts have shifted from the old “port to port” model. A buyer can now redirect a shipment anywhere, and anywhere usually means to the customer willing to pay the highest price. Since the world’s LNG receiving terminals are underutilized, there is stiff competition for offshore supply. As a result – out comes the small wooden globe – “cargos have been shipped right around the world, from Trinidad all the way over here, to China. If (customers) are paying $15 in China or Japan but only $5 or $6 in the United States, East Asia is where the gas is going to go.” Only a few years ago, he says, no one could have predicted that.

LNG technology is changing quickly. New tankers are twice as big as they were in the past, so per unit transportation costs are coming down. Also, some tankers now have their own liquefaction facilities. Instead of receiving liquefied gas from an onshore plant, these tankers essentially just need a natural gas connection. Once connected to a pipe, they can liquefy the gas as they pump it into their holds.

The environmental advantages of gas are yet another compelling reason for countries to increase their use of the commodity. As things stand now, in developing Asia people are choking from diesel fumes and coal emissions. According to a World Bank study of Chinese pollution only 1% of China’s 560 million city dwellers breathe air the European Union considers safe. The resulting lung disease helps make natural gas a compelling fuel alternative.

Until recently, the world’s oil markets were efficient while the world’s gas markets were not. This is changing. “At the beginning of last year lots of gas tankers were coming to North America, (delivering up to four billion cubic feet (BCF) per day of LNG imports into the US), but by fall they were not,” says Tertzakian. Recently, LNG imports in the US were down to half a BCF per day.

The reason for this dramatic swing is that last summer LNG prices were more than twice as high in the US as in Europe, “so the tankers were all rushing over here. This is representative of the new era, which is one of the semi-globalization of the gas business. The big transatlantic price differences are being ironed out. It is also rather new. Companies like the UK’s BG Group have effectively globalized the industry. Gas is becoming much like oil.”

Although the Atlantic basin is the most advanced illustration of where the gas business is going, Tertzakian says, the Pacific basin is “getting there.” He twirls the globe: “These regions (China, India, the Middle East) have a trump card to play – natural gas – and they are playing it right now.”

Moving parts: For both geographic and political reasons – think NAFTA – North America is to a large extent a self-contained unit in the natural gas scene. But that is changing rapidly, and for many reasons. Among the gas bulls interviewed for this article there is a fascinating debate about whether Canada should consider joining the world’s small number of LNG exporters. This would only make sense, of course, if North America actually developed a surplus of natural gas, and Canada needed to build overseas markets.

“The Americans are trying to decouple from Canadian gas, but I don’t think they necessarily will,” says AJM’s Robin Mann. “The US is in better shape than they were five years ago. East Texas has had some big plays” and the States have been leaders in developing non-conventional resources like coal-bed methane (CBM) and shale gas. “Will this offset all the declines in the US? We don’t think so.”

Part of Mann’s thinking is that Canadian exports are bound to decline. “We need to add roughly 3.5 BCF (of daily productivity) each year just to maintain production. Based on our best guess about this year’s drilling in Western Canada, at the end of 2008 we are going to end up one BCF short. As we move forward to 2015, if all the oil sands projects go ahead, we will need an additional 2.5 BCF per day for oilsands use. Where is that going to come from? Exports to America. When you start adding all these things in, they are going to affect Canada’s exports.”

AJM’s geoscience vice president, Dave Russum, agrees. “CBM and shale gas development is sufficient to prop up American production rates to some degree, but it certainly doesn’t look as though it will grow the rates above current levels and we will in all likelihood see a decline in production in the United States.” The technology for this kind of development has greatly improved, but “the question is price. There is no shortage of gas in the US – the numbers are staggering. However, it is not cheap gas. The Barnett shale is an anomaly because of its location (near Dallas), for example, and despite all its advantages the margins there are pretty skimpy.”

Peter Tertzakian is the contrarian. “There are some yellow flags looming,” he says. “Production from the south-central United States (Texas, Oklahoma, Louisiana and Arkansas) is growing. If this production keeps growing, and it has already squeezed out LNG imports, what are the implications for Canada? A production surge in the US could potentially be a threat. The producers in Texas have much lower costs and much better netbacks; they are closer to the main (pipeline) arteries and they have bigger and more immediate markets.”

A constant theme of the interview with Tertzakian was his perception of the rapidly changing dynamics of the gas business. “There are a lot of moving parts. Everything is shifting. Compare today to only 18 months ago. Now we have the globalization of gas; a resurgence of gas production in the Lower 48; changing technology; changes in Canadian royalties and taxes; increases in demand in Western Canada, especially Alberta. Canadian production is falling off. LNG is being squeezed out. And we have to understand the productive potential of unconventional resources like CBM and shale gas. The gas industry has to be very mindful of all these things. We can’t just sit around and read the weather forecast to get an idea of how much we will be paid for our gas. We have to look around and figure out how we can be competitive.”

Mann acknowledges the competitive advantages of the American industry. “Pricing is higher there and costs are lower. You don’t have winter access problems, moving rigs and equipment around is simple, and the infrastructure is well developed. Also they don’t have the human capital problem that we have here – the Fort McMurray effect, which is driving up labour costs for everyone in the industry. In Canada operating costs for gas producers are going up (despite lower drilling day rates), and they aren’t going to come down.”

Tertzakian stresses that he sees a gas surplus in America as anything but a slam dunk. He sees it as a risk complicated by the fact that “right now we have all these pipes into one market. We only have one customer. That’s a dangerous thing, to only have one customer.” To protect Canadian interests, he suggests building an LNG export terminal in BC “so we are not hostage to a single customer.” He picks up the globe. “Look how close our west coast is to Korea.

As the interview ends, Tertzakian offers a final word of caution. “Generally I’m bullish (about the gas industry). But I think we in western Canada have to be very proactive in thinking about what all the changes mean. We need to be nimble, and we can’t afford just to be a price-taker. The Canadian sector has to work better with government to optimize the value of this resource. What sense would it make to produce this increasingly valuable resource and have it sold at lower prices in the United States if there were higher prices being paid around the world?”