Unlike the highly liquid global oil market, natural gas has always been traded regionally. Asia, Europe and North America represent three different gas markets with their own unique dynamics.
Regional gas markets
Asia is very reliant on LNG (liquefied natural gas) imports. Natural gas demand significantly outstrips low levels of domestic production. Prices spiked after the Fukushima Daiichi disaster in 2011 when Japan began importing record volumes of gas for electricity generation to replace the output of nuclear power plants that were shut down.
North American gas production has always been strong, but exploded over the past few years. Hydraulic fracturing (or fracking) activity and the discovery of significant shale gas reserves halved North American gas prices between 2010-11. Prices remain at historic lows today. Henry Hub in Louisiana, where North American gas is physically delivered as well as virtually traded, is the world’s most liquid spot and futures market for natural gas. North America’s well-developed pipeline infrastructure also minimises transportation costs and promotes access to the market. And a high degree of competition lowers the barriers to entry.
Europe’s numerous trading hubs are still developing and are yet to match Henry Hub’s liquidity. Until recently the majority of European wholesale gas buyers maintained long-term contracts with mega-suppliers – namely Russia’s Gazprom and Norway’s Statoil. According to the Oxford Energy Institute, 2015 was the first year that more than fifty-percent of gas trades in Europe took place on the spot market. Demand has yet to return to pre-2008 levels and is still soft across the continent, but prices remain consistently higher than in the US.
Gas producers rely on pipeline infrastructure to connect supply with demand centres. This is why North America’s shale gas revolution and the subsequent decline in natural gas prices have not affected European prices – no pipeline crosses the Atlantic. But, LNG can easily be shipped between the continents. Why then are the world’s two biggest gas markets still disconnected?
Intercontinental LNG trade
LNG (liquefied natural gas) is made by cooling natural gas to -162ºC. This transformation to liquid shrinks the volume of the gas 600 times, making it safe and easy to ship. LNG is colourless, odourless and non-toxic. Nevertheless, the added cost of liquefaction, sea transportation in specialised vessels and regasification at the destination has so far limited global arbitrage opportunities.
Yet, a barrage of new LNG investment over the past few years has lead some to speculate that natural gas markets are globalising. The International Energy Agency claims that global liquefaction capacity will increase by forty-five percent between 2015 and 2021, with most of this growth coming from the United States and Australia. If this glut makes enough cheap LNG available then North American and European gas prices might slowly converge.
In February, the Cheniere Energy LNG terminal at Sabine Pass between Texas and Louisiana was the first to begin exporting. In anticipation of a LNG supply glut Eastern European countries, including Poland and Lithuania, have been building regasification terminals. Lithuania is testing floating regasification technology – offshore plants connected by pipeline to the shore. Spain, being part of a peninsula, is isolated from the European continent’s pipeline network. Historically, this has made it an important destination for LNG cargoes. In fact, the economic downturn since 2008 created an opportunity for Spanish buyers to reload LNG cargoes and sell them in Asia where prices are higher. This churn enhances liquidity. Otherwise, LNG is injected into the network all over Europe. There are important regasification terminals in the Mediterranean: Italy, Greece and France, as well as north-western Europe: the UK, the Netherlands and on France’s west coast.
US LNG producers are increasingly flexible too – offering variable volume contracts or FOB (free-on-board) cargoes. Variable volume contracts permit buyers to increase or decrease the amount of gas they take depending on their needs. They may purchase extra volumes to take advantage of high spot prices – reselling the LNG cargo or trading gas locally. Or they may reduce their volume off-take when local demand is low. FOB means a buyer has not yet been found nor locked into delivery. An LNG cargo leaves the liquefaction terminal and can be bought and resold “on board”. The cargo may eventually be dumped in a spot market at a loss if a buyer can’t be found, but LNG suppliers’ willingness to send out FOB cargoes shows liquidity to be improving.
Not yet a single market
European countries are keen to reduce their dependence on Russian gas for political reasons. However, uncertainty remains as to whether US LNG can compete with Gazprom on price. Analysts at the Oxford Energy Institute estimate Gazprom’s cost of delivering gas to Germany to be 3.5 USD per mmbtu (million British thermal unit). Whereas the break-even price for the cheapest US LNG supplies is around 4.3 USD per mmbtu – even with Henry Hub still trading at historic lows. Gazprom, Europe’s largest gas supplier, has significant spare production capacity and some of the lowest cost production in the world. Given these conditions, LNG traders are unlikely to win a price war on the continent.
In sum, greater supply and liquidity in the global LNG market offers some opportunities for arbitrage between the continents and provides European gas buyers with options. This does have the potential to disrupt Europe’s monopolies and introduce greater competition into the market. Yet, LNG and pipeline gas markets are not one and the same. Whilst the price gap persists, gas markets will retain their regional characteristics.