Natural Gas and International Relations (Part I)

Why will natural gas play an increasingly important part in the world’s energy future?

August 11, 2010

Why will natural gas play an increasingly important part in the world's energy future?

Until a year and a half ago, the gas market used to be very predictable, almost boring. On the demand side, annual growth used to be around 3% — give or take a percentage point.

On the supply side, Europe was almost exclusively served by domestic production and a small number of gas producing countries — Russia, Norway, Algeria and Libya — which were linked to us via pipelines and long-term oil-linked take-or-pay contracts.

Fast forward 18 months and the situation looks very different.

On the one hand, global demand has collapsed owing to the recession: In Europe, gas consumption decreased by around 6% in 2009.

On the other, the shale gas revolution in the United States has extinguished the need to import gas into North America, freeing up a lot of supply for the rest of the world. Liquefied natural gas (LNG) cargoes which used to make straight for the United States have now changed route and are sailing into Europe and Asia.

The collapse in demand and the increase in supply has had a huge effect on prices.

LNG spot prices in Europe have fallen to roughly a third of their peak in 2008, a trend that is mirrored in the United States and Asia.

But while spot prices have collapsed, the price of gas under long-term contracts has not. That is because the price of gas in long-term take-or-pay contracts isn't linked to demand and supply, but to the price of oil. And oil prices have recovered significantly since the economic crisis first hit.

This puts Europe's traditional gas suppliers and the midstream players — such as Eni — in a tricky spot. We still pay companies such as Sonatrach and Gazprom some $9 per thousand BTUs (MBtu) of gas. On the other hand, those who buy their gas at the Zeebrugge Hub in Belgium or at the NBP in the UK can get it for something like $5 per MBtu, which gives them a head start when it comes to winning new customers.

In this upheaval, suppliers and midstreamers have two obvious priorities. The first is that no one wants to lose money. And the second is that no one wants to lose market share.

As a result, we are now seeing some degree of flexibility in long-term contracts with price re-negotiations and changes in the terms of take-or-pay contracts.

Unsurprisingly, the fact that the European market is flooded with gas from LNG imports has downgraded the importance of supply security on the global agenda.

Two years ago, supply security — the EU's relationship with Russia, the threat posed by Ukraine, diversification of supply sources, gas storage capacity — would have been at the top of the agenda for any multilateral meeting, from the G8 to the EU summits.

Today, it barely gets a mention.

But there are several good reasons to believe that supply security will climb back on the global agenda before too long:

  • The first is that the economic recovery will stimulate a bounce-back in gas demand. In 2009, gas consumption in Europe was 480 billion cubic meters (bcm), down from 515 bcm the year before. These 35 bcm are coming back, potentially as early as 2012.
  • But gas demand growth is also a secular trend. Gas is by far the cleanest fossil fuel, emitting 50% less CO2 than coal and 30% less than oil when used to generate one kilowatt hour of electricity. That means that gas is currently the best way we have of combining economic development and environmental preservation — including tackling climate change.
  • As well as being the cleanest fossil fuel, gas is now even cheaper relative to oil and coal. Historically, a barrel of oil equivalent (i.e., a quantity of gas which contains the same amount of energy as a barrel of oil) used to cost 70% of a barrel of oil. This year, spot gas has traded as low as 30% of the price of oil.

    Clean and cheap is a good combination, providing an incentive to switch to gas wherever possible. That's especially true for electricity generation, but also for residential heating and even in the oil-dominated transport sector. It is not inconceivable that a structural change on the supply side could have structural impacts on consumption.

    The impact on consumption is potentially huge. Just think that 60% of European electricity is generated by coal or nuclear plants. Many of the coal-fired plants are ancient and obsolete. And some of the nuclear plants are so old that they should already be phased out. If you assume that half of European coal and nuclear capacity will be replaced by gas by 2020, you would get up to 200 bcm of extra demand.

    If gas continues to be so cheap, it could even take a significant share of the transport market. There is certainly room for growth. Today, natural gas vehicles account for only around 1% of the vehicles in the world.

    To sum up, gas has always been versatile, efficient and clean. And now it is also very cheap. That is why it will play an increasingly important part in our energy future. We believe that at Eni, and it is central to our strategy.

    But while cheap gas is good news for the economy and for the environment, we must be aware that it is also having an impact on supply, causing investment in production and infrastructure to more or less dry up. Gas projects are being postponed all along the value chain.

    Add together increased demand — 35 bcm from the economic recovery, plus another 200 bcm from gas-displacing coal and nuclear power — and the European gas market could grow from 480 bcm today to over 700 bcm in 2020.

    All this growth and more would need to come from imports. That's because European domestic gas production is expected to decline by about 100 bcm by 2020. Imports would therefore need to double from 300 bcm today to as much as 600 bcm. This is a huge amount — equivalent to the present annual consumption of the entire United States.

    If at the same time you pull the handbrake on investments in gas production and transport, in the not-too-distant future, supply security will be back on the agenda.

    Editor's Note: This piece has been adapted from a speech made by Eni CEO Paolo Scaroni during the 2010 workshop of the Council for the United States and Italy in Venice on June 11, 2010.

    Read Part II here.

  • Takeaways

    Gas has always been versatile, efficient and clean. And now it is also very cheap. That is why it will play an increasingly important part in our energy future.

    Gas is by far the cleanest fossil fuel, emitting 50% less CO2 than coal and 30% less than oil when used to generate one kilowatt hour of electricity.

    While cheap gas is good news for the economy and for the environment, it is also having an impact on supply, causing investment in production and infrastructure to more or less dry up.

    LNG spot prices in Europe have fallen to roughly a third of their peak in 2008, a trend that is mirrored in the United States and Asia.