The duopoly still efficiently manages European gas prices...but for how long?

Based on the interaction between energy commodities in Europe, we note that the rebound in gas prices in mid-2014 can be explained by the fact that Norway and Russia (with more than a 50% share of the European gas market) can swing supply to make sure that prices do not drop below a floor. This is why today the NBP price shows a large price spread vs other commodities.

Source: SG Cross Asset Research/Commodities, Bloomberg.

We believe that the massive reduction in Groningen production allowed Russia to pursue its long-term rent-maximisation process unchanged even when facing adverse conditions (EU and US sanctions and resumption of demand destruction). This has allowed the $6/MBtu (38p/th) floor to nearly hold so far in 2015e.

Source: SG Cross Asset Research/Commodities, Datastream.

With NBP and spot LNG in Asia on par, we are seeing an increase in net LNG berthing in Europe. Europe is and will continue to be the “dumping” ground for excess LNG as Asia has contracted enough gas.

Source: SG Cross Asset Research/Commodities, IHS

With re-commissioned Angola and new Australia, US and Russian LNG set to hit the market in the coming years, two questions remain: 1) how will this extra supply be spread in the 2016e-2020e timeframe? and; 2) can another Final Investment Decision (FID) be expected, which could bring even more supply during this time frame?

Source: SG Cross Asset Research/Commodities

LNG supply will start to grow by more than 6%pa from 2016e to 2020e but the growth should be back loaded and not front loaded as the consensus thinks.

LNG supply growth (Y-o-Y)

Source: SG Cross Asset Research/Commodities, GIIGNL

US LNG will materialise at a time when the biggest LNG market (Japan) witnesses demand reduction and when supply grows massively again thanks to Australia. This is the worst possible timing for this new LNG as it has no dedicated market. Therefore, Europe will likely be the “dumping” ground for this US LNG.

We believe Russia will not engage in a price war as long as it can export more than 100bcm/y to Europe OECD excluding Turkey. But, as Gazprom has both market power and a lower supply cost (the ruble devaluation resulting from US sanctions on Russia has had the effect of making Russian gas even more cost competitive), it could engage in a price war that will push US LNG out of Europe and mean US trains will have to stop production. But, to stop US LNG cargoes from berthing in Europe, the European price will have to be below HH + $2/MBtu as liquefaction, regas and part of the shipping costs are sunk costs. With low US gas prices, this would be a vicious circle for producers and a virtuous circle for the European Commission and European gas consumers.

So far, five liquefaction plants (a total of 63mtpa) are under construction in the US. US coal has displaced Russian gas in Europe since 2012, and, from 2017e, US LNG will reduce the need for Russian gas in Europe. The 63mtpa under construction in the US will be above the total European LNG needs. Hence, if the US continues to invest in new LNG trains, Europe will not be in a position to soak up the extra volumes, unless there is a price war to boost demand. With companies more cautious about capex, it seems unlikely any liquefaction FID will be taken any time soon to allow more supply to be produced this side of 2020e.

The Norway-Russia duopoly has three options for managing gas prices in Europe:

1.  To achieve a high price (above the cost of US LNG or of new pipe gas, i.e. today above 8$/Mbtu) as in 2012-2013 by tightening supply. This option has not been pursued since early 2014 as it prompted FIDs to bring additional “new” gas into Europe.
2. To stay in a tunnel between the EU floor and the incentive for new gas (i.e. today between $6 and $8/Mbtu) by swinging supply to adjust to demand. So far, this option is the best for long-term rent maximisation.
3. To engage in a price war to stop future US LNG production (at below HH+$2/Mbtu, i.e. today below $4/Mbtu) by using some of its spare production capacity (Gazprom alone has more than 100bcm/y of unused production capacity). We believe such a strategy does not make sense as long as US volumes do not materially impact Russian export volumes in Europe.

Author

Senior Analyst and author European Gas and LNG – Société Générale, and Author of the book “After the US shale gas revolution”, Dr Thierry Bros deliberates on European gas prices in the future. He asks how the extra supply of gas will be spread in 2016e-2020e and whether another Final Investment Decision (FID) should be expected, which could bring even more supply during this time frame.