The ill-fated gas strategy of the oil majors

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LNG ship leaves Darwin harbour in Australia (photo Eyeweed)

LNG ship leaves Darwin harbour in Australia (photo Eyeweed)

The recent focus of major oil companies on gas (and LNG in particular) may be ill-fated, writes geophysicist Jilles van den Beukel. Gas is systematically less profitable than oil. And the oversupply of LNG (and resulting low prices) is likely to last much longer than the oversupply of oil.

The major international oil companies have gradually increased their focus on gas, to the extent that they are now sometimes jokingly referred to as Big Gas rather than Big Oil. For companies like Shell and BP gas now comprises more than 50% of their total production.

Around 2010 this shift to gas still appeared to be very attractive. An expectation of continued high prices and demand growth (in particular in South-East Asia) resulted in project approval for a number of large LNG projects, mostly in Australia. The 2011 report from the International Energy Agency (IEA), “Are we entering a golden age of gas?” reflected the industry thinking at the time. The question mark in the title of the report was not taken too seriously; the rest of the report was. The recent IEA 2016 medium-term gas market report (released on June 8) paints a picture that is a far cry from the golden age of gas as envisaged in 2011.

To some extent this change of strategy was made out of necessity rather than out of choice. Replacing oil reserves had become increasingly difficult. Gas reserves are more accessible and have a wider global distribution. Cleaner gas was expected to take away market share from coal due to environmental concerns. As a transition fuel it should allow the majors to continue to grow without having to dramatically change their business model.

The strategy to move away from oil has now run into problems. Gas demand forecasts have been reduced. The onset of gas oversupply resulted in a dramatic drop in Asian gas spot prices in 2014. The subsequent, unrelated, drop in oil prices (resulting in lower gas prices for gas sold on oil-indexed contracts) exacerbated the situation for gas producers. At the same time a number of LNG projects, which have experienced large cost overruns, are about to come on the market. For the coming years the supply demand balance for gas and LNG looks worse than it does for oil.

Jilles gas 1

In addition to this typical boom and bust cycle (be it one with what now looks like a prolonged bust) there are a number of more fundamental reasons why I believe that gas (and in particular high cost LNG) is systematically less profitable than oil and why the strategy of the majors to increasingly focus on gas may turn out to be ill-fated:

  • Gas is a global free market; oil is not (hence oil trades at a premium)
  • Gas is expensive to transport. Gas transport cost is often higher than the cost of feed-in gas
  • Gas faces stronger competition than oil
  • Shale gas is a stronger competitor to gas than shale oil to oil

Gas is a global free market, oil is not

Oil prices are higher than what they would be in a global free market. OPEC may be an organization whose members are often not able to reach agreement but even a poorly functioning cartel is better for prices than no cartel.

Low-cost Middle East producers are not producing to their full geological potential, whether due to political instability or due to a policy to maximize revenue rather than volume in the long term. As a result their reserves to production ratios are relatively high. Additional oil can still be developed in a country like Saudi Arabia at a cost way below that of deepwater oil or shale oil. They choose not to do so as gaining a substantial amount of market share will result in a much longer period of low oil prices than merely defending market share.

The painful last two years in oil markets are the long-term normal for gas markets

For gas, there is no such thing as an OPEC. Russia may not produce gas to its full potential but its role in gas markets is a far cry from the role that Saudi Arabia has played in oil markets for decades. The painful last two years in oil markets are the long-term normal for gas markets.

Gas transport is expensive (especially when it requires liquefaction), oil transport is cheap

Due to its low energy density, gas is much more expensive to transport than other fossil fuels. Transport of gas requires pipelines (for shorter distances) or liquefaction (for longer distances). It is especially LNG that incurs high costs. Only 30 % of LNG cost is related to feed-in gas; the bulk of the cost is related to liquefaction, transport and regasification. The total cost of transporting gas in the LNG chain is at least twice the cost of transporting via pipeline.

In any country where sufficient other sources of gas are available (whether conventional or unconventional) that can be transported by pipeline, LNG faces an uphill battle. In Europe, US-sourced LNG will have difficulty competing with lower-cost Russian gas. In China, Australian-sourced LNG will have to compete with Russian-sourced gas and (in future) with locally sourced shale gas. LNG is the high-cost gas that faces the most pain in periods of oversupply and low gas prices (equivalent to oil sands or Arctic oil in the world of oil). It used to be profitable – at a time when it functioned as a niche supply to countries (e.g. Japan) that had no alternative options.

Gas faces stronger competition than oil

The most important use for oil is transport. Alternatives for oil are less readily available in the short term. Even for light vehicles a transition to electric vehicles will take considerable time. It remains to be seen if (and when) the use of electric vehicles can compensate for increased road transport on a global basis. Decades of increased fuel efficiency, for any form of transport, have as yet not resulted in peak oil demand. For heavy vehicles, airplanes and shipping a transition is even more difficult.

The most important use for gas is power generation, where coal and renewables are strong competitors. The low cost of coal remains a strong advantage, limiting the rate at which especially non-OECD countries will move away from coal. Reduced costs and climate concerns result in renewables now making significant inroads – which is more of a concern for gas than for oil.

European LNG is going to need strong political support in order to be successful

The only place where gas has a high and increasing share in power generation is the US. This is solely due to low-cost shale gas – which does not help the majors in any way. In Europe gas is being squeezed between coal (which still enjoys significant political support in Eastern Europe) and renewables. European gas demand is 20% lower than what it was a decade ago.

Countries like China and India have so far chosen cheap coal for the bulk of its power generation. By now, should  they want to start reducing the share of coal, they may move straight to renewables, bypassing gas. The IEA now expects gas to be responsible for only 8% of Chinese power generation in 2040, up from the current 4% but still way below a global average of about 23%. Gas (and especially high-cost imported LNG) is simply not the best compromise between cost, emissions and energy security for a country like China.

The majors are not making much progress in selling gas as a transition fuel. It is cleaner than coal and yet it remains a fossil fuel and methane emissions are subject to increasing public scrutiny.

Shale gas is a stronger competitor to gas than shale oil to oil

The BP long-term scenarios have shale gas providing for about 25% of the total gas supply on a global basis in 2035. Shale oil is only expected to provide for about 10% of the total oil supply by that time. Other scenarios, such as those provided by the IEA, paint a similar picture.

The situation in the US, the only place where shale oil and gas are mature industries, provides the background for this. US shale gas is firmly established at the lower end of a gas cost curve. Since 2009, when shale gas took off in earnest, it has completely outcompeted conventional gas in the US. Shale oil, on the other hand, faces more of a struggle. Shale oil projects have a significant cost range but on average US shale oil is situated in the middle of the global oil cost curve.

Given the knowledge and efficiency of the US oil (service) industry any non-US shale oil will be at a higher cost (and will struggle to reach the level of activity needed to bring down costs and establish sweet spots). Long-term scenarios like those created by BP or the IEA expect non-US shale gas to have a higher chance to take off than non-US shale oil. For any place in the world where shale gas can overcome the technical issues in the early phase as well as public acceptance issues it may outcompete conventional gas (and in particular high-cost LNG) as it has done in the US. This may be unlikely to happen in Europe but has a real chance of happening in China or Argentina. 

The current LNG oversupply is more severe than the current oil oversupply 

For oil, the difference between supply and demand over the last two years has not exceeded 2 million barrels / day (close to 2% of total production). By now (June 2016) supply and demand are starting to approach a balanced situation. In anticipation of a further reduction of supply (related to the investment cuts over the last two years), oil prices have started to pick up and the lowest prices seem to be behind us.

For LNG, the length and intensity of the bust period of low prices is expected to be much more severe. By 2014, a well supplied LNG market became a buyer’s market, resulting in a significant drop in e.g. Asian spot prices in 2014. What is the most worrisome at the moment is the number of LNG projects that are now coming on the market. Global LNG exports are increasing from 233 million tonnes (2014) to 306 million tonnes (2016). The bulk of this increase comes from Australian projects – all destined for Asian markets that are at this moment hardly growing (by about 2% per year only – much less than foreseen 5–10 years ago when these projects were sanctioned).

Jilles gas 2

This oversupply is of such magnitude that it is likely to lead to a prolonged period, at least to 2020, of LNG oversupply and low prices. Following large costs overruns, a recent Australian LNG project such as Gorgon runs the risk of becoming one of the worst projects from a financial point of view in the oil and gas industry since a long time. US LNG projects have a significant cost advantage compared to greenfield Australian projects due to lower construction costs and lower costs of feed-in gas (more than compensating for longer transport), with e.g. Japan delivery costs estimated to be about $11/MMBtu for US projects versus $14.5/MMBtu for Australian ones.

Jilles gas 3

For the future, much will depend on how much output has been tied to the oil price (and of course how oil prices will evolve). In the present world of low oil prices gas spot prices tend to be relatively close to those of long-term contracts. I expect the outlook for oil prices to be better than that for LNG spot prices. More than 75% of all Asian gas import is priced at levels contractually linked to oil prices (versus less than 50% of European gas). In the long term there is a tendency to move away from oil linked prices to spot prices or hybrid pricing. At this stage Asian consumers are reluctant to sign any new oil-indexed NLG contracts. Part of the contracts that are being signed go to portfolio players rather than destination specific end users.

Europe is unlikely to absorb excess LNG on a significant scale. Gazprom is unlikely to cede market share. As a low cost producer Gazprom can undercut on price and it has significant spare capacity (cost levels of about $ 3.5/MMBtu for existing Russian spare capacity, $ 5.5/MMBtu for incremental Russian capacity versus approx $8-10/MMBtu for US LNG). European LNG is going to need strong political support (for environmental or energy security concerns) in order to be successful.

Conclusions

In the long run, gas seems to be systematically less profitable than oil. In the short term, the current low LNG prices are expected to last a lot longer than the current low oil prices. In hindsight the majors would have been better off accepting a shrinking business with a more limited focus on gas and a much more limited focus on high cost LNG.

For a different perspective (but arriving at quite similar conclusions) I would recommend Karel Beckman’s paper on the 2015 World Gas conference. It contains some interesting observations on the oil and gas industry’s groupthink.

Editor’s Note 

Jilles van den Beukel worked as a geologist, geophysicist and project manager for Shell in many parts of the world. This paper was first published on his blog Jilles on Energy.

Comments

  1. Dave Pearson says

    It is reasonable to expect significant decrease in consumption ( or we miss our 2Degree targets). This won’t arise due to supply constraints but a mixture of taxation and carbon quotas, so consumption cost will rise but wholesale cost will fall ( over supply).

    Put another way , 5/6th of the reserves known will have to remain unburnt as the world moves forward on renewable heat
    Eg http://www.tinyurl.com/BBC-Drammen

  2. says

    Dave, so far all the progress on renewables and efficiencies has not compensated for all the people in non OECD countries shifting to a OECD lifestyle. So you see the dilemma for oil companies: plan for a 2 degree target (IEA 450 scenario) or for Business as Usual or anywhere in between? Oil companies do not know either so they include the full range in their scenario planning.

    Politicians are telling oil companies that this time they are serious. They are not telling people to start driving less, flying less, eating less meat. After all these years there is not a substantial carbon tax (something European majors would actually welcome). Are they serious?

  3. says

    I liked this article and If natural gas was the only commodity coming out of the ground in shale gas plays, then the gist of the article might be right. However, I think the author has overlooked the natural gas liquids (NGLs) (ethane, butane, and propane) which also are a part of wet shale gas plays in the U.S. The NGLs fetch a higher price in the market place than natural gas alone. So in wet shale plays, it’s the NGLs that keep the producers drilling, not the gas. Natural gas is really a byproduct. NGL prices are highly associated with crude oil prices and the EIA is seeing growing exports of NGLs. Also the US has the cracking plants to convert ethane to ethylene, which is used to make plastics and a good port network in the US Gulf to get NGLs to overseas markets.

    On Dry Gas plays the drillers can’t rely on the NGLS. But the productivity of the wells is unbelievably high and so the production is maintained. I believe that the biggest secret is the returns on equity of some of the Marcellus shale dry plays in Pennsylvania. If we believe in supply and demand, there should be nothing coming out of the Marcellus. However, the Marcellus keeps on going sol those costs must be much lower. In fact, the production out of the Marcelus has made up for gas declines in other US shale producing basins.

    Finally, I think big oil is making a “big gas play” for environmental reasons. I always thought Shell’s purchase of British Gas was a ling term global play. Just look at some of the dirties cities in the world where coal is still burned in India, because it is dirt cheap compared to natural gas which is $8/MMBtu. Lower natural gas prices are really needed to get countries like India to throw coal under the bus just like the US has and is doing. See http://bloom.bg/1XUxLD8 for India story . More important LNG prices are steadily climbing based on the Singapore LNG index.

    • says

      The majors, like many other companies, have lost quite a bit of money in shale gas and have tried to mitigate things by moving to more liquid rich assets. That does not mean it has become a financial success story.

      I think the recent takeover of the BG group by Shell is more driven by Shell’s low reserves replacement ratios in recent years than by environmental issues. It also implies a series of bets on high oil prices, Brazil and LNG. Oil prices should recover from the unsustainable low levels of the last 2 years but are less likely to go back to the $100 plus levels seen in 2010-2014. Brazil carries political risk and a risk regarding Petrobras’s financial situation and ability to operate a large number of challenging projects. And yet to me the bet on LNG seems the most risky of the three. Being the biggest gas major – by far – does not seem a solid base for improving financial performance.

      • Tilleul says

        Going for natural gas for environment reason would be an even riskier bet…

        If you are a developping country who needs to get away from coal : renewables are cheaper and natural gas needs costly infrastructure which can take ages to build and are quite risky.

        If you are a developped country, you have the infrastructure but then you have plenty of natural gas boilers which are the dirtiest options for heating and will be phased out… So an environmental decisions which will phase out coal in favor of gas will also switch gas in favoir of waste and renewable heat… In the end natural gas consumption goes down…

        • says

          True, in the long run renewables may be cheaper, especially if all you need is electrical energy. Of course this assumes you have the transmission lines to get the power to where it’s needed. However, In the absense of utility scale electric storage, you still need either pumped storage hydro or gas fired units to ramp up when the wind doesn’t blow or the sun is not shining.

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