As the first shipments of LNG from the United State to Europe, South America, or Asia loom, the salient question is not the “volume question” (i.e., how many Btus or Bcf will be outward bound to an overseas destination) but rather the “basis question:” Will first shipments be profitable? Will any future shipments be profitable? If not, can we bid adieu to United States LNG exports? Will there be minuscule or zero volumes if intercontinental basis cannot support them?
Is it possible that all the links in the supply chain garner positive margin (i.e., make money) on these first shipments? Any shipment? In particular, will participating suppliers, gatherers and processors, pipes to liquefaction, liquefaction, shippers, regasification, pipes to market, and consumers that comprise the supply chain all make money? Will there be one or more links in the chain obliged to lose money? Will the ultimate end user be contractually forced to take gas at an “out-of-the-money” price, above fair market value? Taking gas at an “out-of-the-money” price above fair market value is an economic loss, whether or not a “take” price may be prescribed in a contract. (“Out-of-the-money” contracts are losses, and they can often find themselves quickly renegotiated or vitiated.)
If one or more of the parties along the way fails to make money or loses money, what would we expect that party to do in future transactions? Continue to move gas in spite of the loss? Continue to pay for gas at “out-of-the-money” prices governed by “out-of-the-money” contracts? Continue to honor a purchase contract notwithstanding losses? In recent years, we have seen LNG customers vitiating or renegotiating out-of-the-money contracts in favor of mark-to-market, gas-on-gas prices. Is that just an anomaly, never to rear its head again, or are current and future contracts imperiled? Are gas and LNG the only commodity in the world that require contracts in order to be viable? Are contracts intrinsic to that business?
Profitability is the criterion driving LNG flows and decision making. LNG doesn’t flow from a low-demand region to a high-demand region; it flows from a low-price region to a high-price region. Price, not demand, dictates flows. And profitability cannot possibly occur unless the basis differential from the source to the destination is more than enough to pay for all the pipe-to-liquefaction, all the liquefaction, all the shipping, all the regasification, and all the pipe-to-market cost. Hopefully there is also a bit of return, because if not, no new capacity will be built.
Using NBP as an example, the price at NBP is totally independent of the transportation cost (including losses) from Sabine Pass to NBP. Market prices and basis differentials do not magically line up so that the Sabine-to-NBP route is intrinsically profitable. Quite the contrary, the price at Sabine is set by gas-on-gas competition in the United States, and the price at NBP is set by gas-on-gas competition in England and Europe. The hope of any LNG vendor is that his cost to deliver is lower than the gas-on-gas price in England minus the gas-on-gas price at Sabine. If so, he sells. If not, he doesn’t.
We answer the salient questions using the ArrowHead Global Gas Model, an extensively detailed, multi-regional, world-scope supply-transportation-demand model summarized in Figure 1. There are myriad sources of natural gas emerging around the world, and they are likely to have an effect on myriad regional markets around the world interconnected by myriad pipes and ships. The answer from this model for a robust supply case appears in Figure 2. If we observe March 2016 prices in those two markets, they differ by approximately $2.19/MMBtu (reported by cmegroup.com on March 22, 2016). If we look at the longer term, those basis differentials promise to head toward $3/Mcf but no higher. The reality is that $3/Mcf is not enough to pay the total of the costs for pipe to the liquefaction point plus liquefaction plus shipping plus regasification plus pipe to the liquid market, much less any return on any of those assets. In our robust supply case, basis differentials are not going to be sufficient to support LNG export at full cost. Exacerbating the chronically narrow basis differential is the plethora of LNG routes to each destination that emanate from lower cost supply coupled with lower transportation cost (closer proximity), routes that compete favorably with United States routes.
The basis differentials in Figure 2 are not likely to pay the full supply chain costs from the United States. There must be other considerations in world gas markets that render such volumes economic. Those considerations must reduce the cost of:
- Pipe from the liquidity point (Henry Hub) to the liquefaction point at Sabine Pass
- Liquefaction
- Shipping to the receiving regasification terminal in England
- Regasification in England
- Pipe from the regasification point to the NBP liquidity point in England
Alternatively, they must portend paucity of upstream supply, paucity of competing supply, or acceleration of downstream demand. Our model identifies and quantifies such forces.
As it appears today, flows outward bound from the United States appear to be at some risk. (Our models can calculate a probability distribution over future price.) We have seen recent articles that question growth of LNG exports from the United States. Some have generally reached the right answer, but they incorrectly attribute the reason to shrinking demand in key target markets. It is not demand but rather price and price differentials that drive LNG. It is not shrinking demand that is driving down gas price and basis to target markets. In a forthcoming article, I will carefully address what is driving price and basis in world natural gas markets, how we have accurately analyzed it, and why it is important.
About the Author:
Dr. Dale Nesbitt is a noted national and international energy, resource, microeconomics, modeling, and risk analysis expert. He is president of Arrowhead Economics and the inventor and manager of the ArrowHead Global Oil Model and ArrowHead Global Gas Model and prior to 2011 oil, gas, and power models by Altos, MarketPoint, and Decision Focus. Dr. Nesbitt has been in energy market decision support, analysis, and modeling continuously since 1974. He holds a PhD in Engineering-Economic Systems from Stanford University and teaches there.