Paper PS1-3

LNG AS A NEW FORCE IN GLOBAL ENERGY SECURITY

James Ball President & Chief Mentor Patricia Roberts Managing Consultant Gas Strategies 35 New Bridge Street London EC4V 6BW

ABSTRACT LNG has always played a part in contributing to the security of supply of gas importing nations. However, in the past few years this role has widened as several countries otherwise well endowed with pipeline gas supply have turned their attention to facilitating LNG import capabilities even where it is not immediately obvious that LNG is the best commercial option. This trend has been highlighted by new geopolitical shifts which have resulted in national resource holders seeking to exert international influence through their gas links with importing countries. But there are other security drivers for LNG. It can feature as an integral part of purely commercially-driven market security of supply, replacing dwindling domestic production in newly import dependent countries. LNG exporting countries may also contribute to investment in infrastructure in order to secure demand outlets in liberalised markets. This paper addresses the issues regarding LNGs ability to enhance global gas supply security. It will review the importance of physical supply security and the positive effect of the continuity of long term partnerships; it will also consider the geopolitics of LNG supply compared to pipeline gas. Where there are concerns regarding the efficacy of LNG, these will be addressed.

PS1-3.1

Paper PS1-3

A simple definition of supply security in a gas market is the ability to balance daily supply and demand. In order to be able to do this there must be adequate investment in infrastructure all along the supply chain that can be mobilised when required. Unlike oil, where market security measures have been focused largely on storage, gas requires an emphasis on infrastructure investment and diversity of supply. Over many years, global gas markets have been investing heavily in gas importation, transmission and storage infrastructure and supply security has improved as a consequence impressively so, given that markets have also been growing significantly. The gas sector is highly capital intensive as a consequence of the need to invest in long term infrastructure and also of the relatively high proportion of high pressure transportation services in the overall supply cost. This in turn has promoted long term partnerships along the chain and a stable platform on which investors can support gas supply and demand growth. For import-dependent nations and companies, market supply security is made more challenging both by a need to avert undue dependence on one supplier and by another force the political security of gas supply and gas demand. This is often present in both positive and negative guises. It has become much more important for industry participants to manage these additional features alongside the physical supply logistics and long term partnerships. Political security is driven by the shifting relationships and motivations of governments of both producer and consumer countries, especially where their actions result in, or are perceived to pose a risk of, both short and long term supply (and demand) disruption. Whilst gas markets have been developing globally and adjusting to manage these issues, LNG has been growing from a niche business connecting a handful of countries some forty years ago to a global presence of about 156 mtpa of sales in 2006 (estimated at time of writing). Although LNG is only still a small proportion of current global gas supply (7% of total gas produced in 2005 and around 25% of total gas traded cross border), LNG is predicted to take a higher share of the internationally traded gas market through to 2020. Indeed, the requirement for new forms of gas supply diversity is a consequence of changing trade patterns, such as the major US and UK markets becoming more import dependent. Long term partnerships in LNG Stable long term partnerships are very important in the development of LNG supply chains globally and contribute significantly to an individual countrys supply security. Throughout its history, the LNG business has depended on the formation of long term partnerships between buyers and sellers, often aided by explicitly linked diplomatic initiatives between the two countries (for example Algeria and France or Indonesia and Japan) an approach that is expected to continue. Appropriate investments in liquefaction, shipping, regasification and transmission capacity by producers and consumers have ensured that there is good alignment in building, operating and protecting the LNG supply chain. The high degree of stability has ensured that rateable supplies reach customers according to an agreed annual schedule and consequently that rateable annual incomes can be provided to suppliers to underpin the financing of their supply projects and, separately, that regular income accrues to the customers through their sales in order to underpin their infrastructure investments. Gas Strategies
PS1-3.2

Paper PS1-3

Consulting sees evidence of the continuation of direct government-to-government relationships developed to progress LNG supply projects, but we now also see many governments of importing countries embracing LNG as a viable long term energy source and intentionally providing the necessary stable and attractive investment climate for new LNG infrastructure. Likewise, some LNG exporting countries are encouraging supply projects to target specific markets which meet their own pre-existing geopolitical imperatives. Business models In recent years, we have seen LNG partnerships built around an integrated supply chain model. This business model has resulted in an even closer alignment of the commercial partners who share investments along the supply chain, which clearly enhances overall supply chain security as there is a very strong alignment of business objectives. Interestingly, this has not always required overt diplomatic efforts by the relevant governments, although governmental input is still required where the overlapping investment opens up a new trade route, particularly where producers are investing in receiving facilities. Still, even where the integrated investments are mainly driven by the agenda of commercial entities, implicit government endorsement can come in the form of ECA financing or the involvement of multilateral lending agencies. The physical supply logistics of LNG The physical supply logistics of LNG can also enhance an importing countrys supply security in a number of ways. Firstly, the abundance of LNG supply locations around the world has been steadily increasing as a result of unit cost optimisation throughout the supply chain. LNG supply projects can compete against pipeline gas in an increasing number of distant and varied gas markets, and this trend is expected to continue between 2007 and 2020. There are currently plans to construct in excess of 200 mtpa of new LNG supply capacity, which could result in the number of exporting countries rising from 13 to 19. The confidence of project sponsors in LNG supply is directly linked to the growth of LNG demand in both established and new gas markets. So during this period, LNG is expected to grow significantly in North America, Europe, the Indian subcontinent and throughout Asia, and up to 12 new countries are planning to import LNG on a long term basis by 2020. Secondly, the increasing number of economic supply options for any particular importing market naturally increases the diversity of supply, which is directly linked to the enhancement of security of supply in respect to the physical operability of the LNG supply chains, not to mention the commercial advantage of widening optionality. Upstream and midstream Force Majeure risks are spread over more countries and more ships, so although the probability of Force Majeure events occurring may be higher if consumers have more sources of supply their net impact may yet be lower if supply sources are diversified. Thirdly, LNG import terminals may also bypass traditional pipeline supply routes that can be constrained by complex transiting rights sometimes involving several countries and slow negotiations. The careful siting of new regasification terminals can also provide LNG producers with relatively fast, direct, cost effective access to high demand centres

PS1-3.3

Paper PS1-3

and niche markets. A pronounced example of this is the growing number of power companies beginning to depend on LNG imports, a positive endorsement for LNGs supply integrity (though not always the most flattering endorsement of their confidence in the openness of their own countrys gas infrastructure). Growing seasonality of demand is another feature of several gas markets, and LNG can be relatively responsive to seasonal peaks in consumers off take patterns. This can be explicit in long term contracts to less liquid markets, such as sales and purchase contracts with a heavy bias towards the delivery of a consumers annual volumes during a 5-6 month window. The growing flexibility of LNG exports also enables the use of a variety of ships and ship sizes, which can also help meet short term seasonal requirements. Pricing Lastly, it is important to recognise that LNG is priced to compete in markets either on relevant gas priced indices or, where these are not available, on pricing formulae based on alternative fuels, particularly crude oil and/or oil products. This enables easy comparison of the gas price to those of alternative fuels and can enhance a countrys security by pricing gas on a fungible and comparable alternative. Indeed, it is a feature of a more enlightened import energy policy that governments ensure that LNG is not only allowed but encouraged to respond to price signals and that investors in import infrastructure are not penalised for responding to market forces. The force of geopolitics Having discussed the physical supply chain attributes of LNG, it is important now to address the impact of governments political and economic use of gas supply (and demand) in affecting the efficiency of the supply chain. As mentioned above, LNG has long been the most geopolitical arena of international gas trade. For most of the time this has involved bilateral relations between buying and selling countries which has either facilitated commercial dealings or even explicitly driven and underpinned them, particularly in the early stages of a nations entry into LNG. This was clearly evident in the launch of each of the LNG export efforts in the Middle East that involved Asian buyers, crucial in the launch of Indonesias sales to Japan, Korea and Taiwan and also in Algerias sales to Spain and Belgium. It was also for a very long time a dominant part of LNG trade between France and Algeria. Supply diversity is a key driver for several import countries that embrace LNG even though they are surrounded by gas rich nations that can supply by pipeline. For example, Poland and Singapore have commissioned LNG import terminal feasibility studies primarily as a result of a wish to diversify their long term supply options. Furthermore, in countries where governments pride themselves on letting market forces rule the supply and price of gas, there have been explicit moves particularly at the national level to create a friendly investment climate of LNG import infrastructure this is done precisely to capture the extra supply security LNG is perceived to bring. Regulators in both Europe and the US have specially exempted LNG terminals from open access rules which apply to local pipelines so that competing import projects can vie commercially with each other

PS1-3.4

Paper PS1-3

to add to supply. The UK government has been particularly successful in creating an explicitly open environment, which has resulted in one operating terminal, two under construction as well as the construction of the first GasPort facility to take regasified LNG directly into the UK grid. Finally, we should emphasise that certain LNG exporters have grasped the geopolitical opportunities which the widening consumer security agenda affords and so are taking up the challenge to fight for market share in markets long dominated by piped exports from a handful of suppliers. How long this will last is by no means certain, but while the phenomenon exists it is worth noting. CONCERNS REGARDING LNGS SUPPLY RISKS There is no doubt then that LNG has a firm and growing reputation on the security of supply agenda. But it is not a panacea for the gas industry and indeed there are concerns which need to be addressed on both a relative and an absolute basis regarding LNG as compared to pipeline gas and other fuels. LNG country and location supply risk LNG is increasingly being developed in more remote and more challenging environments where pipeline gas is either not a viable option or where LNG is far more feasible. Supply projects may involve gas supply sourced onshore or offshore, from deep water, from marine protected areas with very strict operating requirements or from areas with a combination of several hostile features that drive up both risk and cost. Looking to the future, it seems that this will continue to be the case. These challenging parameters result in requirements for ever more skilful process engineering and project management capabilities and usually for the scaling up of production trains. Even the least worrying challenges, such as suppliers with a proven track record suffering single-train teething problems, may cause buyers to doubt the operational reliability of their supplier and consequently to be concerned about the risk of Force Majeure events occurring, their frequency and their magnitude. These are legitimate concerns, although the track record of the industry is extremely impressive. There have been very few outages caused by the failure of process engineering in any of the 13 LNGexporting countries. Force Majeure events, to the extent they do happen, are generally mitigated extremely quickly and professionally, and other exporting countries and pipeline suppliers have tended to provide short term assistance. The apportionment approach in LNG contracting from LNG producers has ensured off-takers are treated equitably. As LNG production in more remote or geographically hostile locations comes onto the agenda, however, it may become more difficult for the wider community to rally round. Indeed, sometimes, such as in todays tight market, action by suppliers alone will be insufficient and this has caused buyers, particularly in Asia Pacific, to take on this role themselves. Still, even with the record spot prices recorded last winter, LNG sellers remained remarkably loyal to their long term Asian buyers.

PS1-3.5

Paper PS1-3

But let us now add country risk: what of the new LNG exporters who have not been part of this big happy family in the past? And what about the countries who are more concerned with national control than with attracting investors? So far there has been remarkably little actual and perceived country risk in LNG. This may be changing. But it is mitigated on a global level simply by the growing diversity of suppliers, the volume of trade and the growing role of open markets in directing supply. LNG cargo scheduling and delivery performance Marine delivery of gas and subsequent regasification involves more process steps than gas supply by pipeline and may present some concerns to consumers, particularly if they are in areas prone to bad weather and where there are an increased number of shared access regasification terminals. There are legitimate concerns relating to cargo scheduling and throughput efficiency, but the track record of the LNG industry to date in managing the marine supply risk is very good indeed. The issue of whether large capacity receiving terminals with multi access users can be operated efficiently still needs to be tested. There are some examples of open access and third party access working well, and it is certainly in the interests of all parties to cooperate and find solutions. Failing that, there are usually provisions for a third party system operator to impose a practical solution in order to ensure smooth operations. Price arbitrage and diversion of LNG away from its intended markets Another feature which gas consumers must consider when they are purchasing LNG as opposed to pipeline gas is the fact that LNG can in many cases be diverted away from the intended import location. This could happen if attractive arbitrages open, offering considerable value creation opportunities in other markets either on a spot or term basis. The usual mechanism to effect diversions is for the LNG to be replaced with other gas (either an alternative LNG cargo or pipeline gas), and for the cargo to be diverted to the higher valued market. Concerns over supply security can be mitigated for consumers, however, by ensuring that the sales agreements for the gas ensure that diversions are performed by mutual agreement and that suppliers pay full replacement costs for the gas. Looking at this issue from an alternative view point, one can say that if a particular gas market is short of gas and is prepared to pay a premium to attract LNG to it from other markets, LNG may offer the only means of meeting these short term demands. Limited storage LNG supply chains do not usually involve much redundancy in storage. In some countries, such as Japan and Korea where there is no pipeline supply, a surfeit of regasification capacity is used judiciously to manage short term supply and demand requirements. More recently, we have also seen some evidence of LNG ships acting as short term floating storage. It is not expected however that the LNG supply chain will provide any structural supply storage due to its costs, and any impact of this will be minimal. But we do see storage being used at higher capacity and this not only adds to security of supply but also dampens price volatility for buyers.

PS1-3.6

Paper PS1-3

Global convergence of LNG prices The global convergence of LNG prices is a concern to some consumers, particularly when market demand exceeds supply, so that the diversion of cargoes from liquid markets supported by pipeline supply alternatives will help towards a global gas price convergence. There has been speculation that this may happen around the US Henry Hub pricing index, although this not happened yet. Even if it did, Henry Hub may not be the only show in town. LNG producers have generally sought diversity in sales pricing to different markets in order to hedge revenues from their sales portfolios. As a consequence regional price convergence looks more likely than global pricing convergence. CONCLUSION This paper has touched on just a few of the many ways in which LNG has risen up the security of supply agenda and how it can address some of the concerns of importing countries. (An entire paper could be devoted to examining consumers safety fears, the power of Nimbyism and the danger that LNG supply cost escalation might end its growing competitiveness with pipeline gas). But we have seen that LNG is no longer a minor relative of the international gas trade and also that companies and policy makers alike are recognising that its superior flexibility features makes it not just another way to deliver gas but a fundamentally different way of delivering energy security. The sooner the LNG industry grasps this reality and seeks to play an active part in this agenda the better.

James Ball and Patricia Roberts, Gas Strategies Consulting, January 2007

PS1-3.7