Just a decade ago, the oil and gas industry was preparing for a structurally transformative change in which the United States would become a major importer of liquefied natural gas (LNG) supplies from the Middle East, Africa, Russia, and other distant locations. This hailed a dramatic shift in how disparate regional markets would become increasingly linked through trade, with the US becoming a major consumer of global natural gas. However, recent upstream developments in North America have shaken the Magic 8-Ball that is the global energy market, and everyone is scrambling for a view of what will come next. The US is now considered a possible exporter of LNG, and perhaps even crude oil, which was an unthinkable notion just a decade ago.
At a recent conference at Rice University’s Baker Institute, the initial findings from “The Geopolitics of Natural Gas” – a joint study by the Geopolitics of Energy Project at Harvard University's Kennedy School and the Baker Institute’s Center for Energy Studies – were discussed. A headline from that conference was the finding that regional price differentials across natural gas markets would compress over the next few years. This finding carries massive implications for LNG export projects currently being developed in the US and Canada. But here is the punch line: Market deepening and, by corollary, growth in gas market liquidity will be transformative, and almost ironically, will be prompted by the international price differentials that exist today due to a lack of physical liquidity. This lends credence to the saying: “the best cure for high prices is high prices.” The current prices around the world present large arbitrage opportunities, which, given the capital intensity of long distance natural gas trade, generally requires multiple years of planning and execution. The development of LNG export capability from the US is only one such margin of response. Other margins where we are seeing hints of development include (i) shale gas resources in China; (ii) pipeline infrastructure from Russia, Central Asia and South Asia to Northeast Asia; and (iii) LNG supplies from East Africa, the Middle East, and Australia.
While these other responsive margins are important, they may not carry the same impact on international trade relationships that the emergence of the US as a global supplier will carry. Asian and European consumers generally view adding US exports to their portfolios as desirable because it ties them to a very liquid gas market with low risk of disruption. A physical connection to the most liquid market in the world will ultimately have spillover effects, and catalyze a shift in how natural gas is traded.
The importance of a deep, liquid market is witnessed regularly in North America. For instance, the disaster at Fukushima in Japan triggered an unexpected rise in demand for LNG. However, constraints on the ability to provide sufficient supplies in the short run to meet the unexpected demand shock resulted in the spot price of Asian LNG rising to record levels relative to other global spot price markers. This phenomenon is not unprecedented, as we see similar circumstances in the continental North American market when extreme cold hits certain market areas and drives up local demand in excess of what existing pipeline capacity can deliver, as recently witnessed by extreme cold weather triggering the daily price in Boston (at Algonquin City Gate and TGP Zone 6) to jump to over $100 per mcf above the price at Henry Hub. Fortunately, consumers in the affected regions do not have to deal with these types of “basis blowouts” for extended periods because the demand surge subsides when the cold passes.
Perhaps the most salient point here is that the depth of the US market provides sufficient liquidity for price differences to be quickly arbitraged as deliverability constraints relax. By contrast, the Asian market price will persist at high levels until some physical change is implemented to alleviate the near term deliverability constraints. For one, the market is currently thin, meaning liquidity is low. As a result, market adjustments could take a while to materialize because the construction of new LNG and pipeline capacity to move supply into the market is plagued with long lead times. As the US begins to export LNG, the global market will deepen and become physically linked to the North American market. This should facilitate even greater trade, thereby altering the liquidity paradigm of the global gas market. The end result could be a swift convergence to regional price differentials that are reflective of transport costs.
This market altering effect will extend to project finance and investment decisions as well. A direct link between the US and abroad will serve to accelerate international market liquidity. All else equal, this will alter the financing risk of new infrastructure projects, driving market evolution that can dramatically reduce the importance of bilateral trade relationships. Such an outcome carries with it tremendous implications for geopolitical relationships, discouraging strategic suppliers from wielding the natural gas as a tool in foreign policy. This follows because as the global gas market deepens, new trade relationships will emerge according to the impacts that market players perceive a variety of factors will have on global markets, rather than explicitly on bilateral arrangements. Producers will be challenged to maintain their grip on regional market share. Instead producers will be vying for market share, and consumers will be vying for flexibility in purchasing agreements. In the end, the international gas market will emerge as something dramatically different from what it is today, so says the Magic 8-Ball.
Post by Kenneth B Medlock III, Senior Director, Center for Energy Studies, Rice University’s Baker Institute, and Keily Miller, Research Associate, Center for Energy Studies, Rice University’s Baker Institute
