Laszlo Varro is the Chief Economist for the International Energy Agency (IEA).
Hayward: When it comes to global natural gas markets, there’s been a boom in LNG trade and some see overcapacity. Can you give your take on these dynamics?
Varro: There were two major waves of LNG investment in the past decade, which are now affecting markets. The first was in Australia beginning in 2010, and those projects are coming online now. The second wave began approximately 3 years later in the United States, with 2014-2015 marking the wave of final investment decisions. It takes 4-5 years to build a major LNG project, so they will come online near the end of the decade. The first, Sabine Pass, is already online, but it is still undergoing expansion.
They have somewhat different business models, because the Australian projects are classic ones: They are large, conventional gas fields in offshore Western Australia, or Queensland, but in all cases the upstream, the liquefaction, and the shipping are part of a single integrated business model. The typical Australian LNG project is undertaken by a consortium, which includes some of the major IOCs, plus some of the key utilities and some midstream companies from the Asia-Pacific region, which could be Tokyo or Osaka Gas in Japan or the big Chinese oil and gas companies. They typically invest in the equity of the project but also sign a long-term purchasing contract, which provides the long-term financial backing.
The American projects are different. The American gas market is so liquid and so competitive that if you want U.S. gas, you don’t have to invest upstream yourself—you can buy it in the wholesale market. American LNG projects are essentially midstream projects, so typically the the project developer gets the liquefaction fee and the offtaker is free to ship the gas wherever they want. The American developers typically focus on infrastructure capacity and liquefaction.
In the case of Australia, the industry’s development wasn’t a surprise because we have known for decades that Australia has a lot of gas in challenging resources. But Australia is an AAA rated democracy with a strong framework for workflow and regard for the rule of law—in addition to a 100 year tradition of an export-oriented mining industry. So although the geological difficulties were not trivial, once demand growth in Asia-Pacific reached a critical scale and those resources were needed, the industry was actually very comfortable with embarking on large investments in Australia. Australian LNG is actually good proof that it’s not always the most geologically appealing resources that get developed first—it is the resources where the host government offers attractive investment conditions.
The energy business had gotten used to the idea that it had to go to increasingly risky places and face increasing geopolitical and security risks. So the fact that now 85 percent of new supply is coming from geopolitically secular supply sources is a major reassurance for supply security.
In the case of the United States, the acceleration of U.S. shale gas production took global gas markets by surprise. It started on an industrial scale approximately 10 years ago and completely turned the tables—not only eliminating the import needs of the United States, but creating excess production capacity as well as credible prospects for American LNG exports. If you are an LNG buyer, this emergence of a new supply source is good news because it creates a much more competitive and diversified gas market. On the other hand, if you are an investor in a multi-billion dollar Australian LNG project, then the emergence of new competition is a challenge, certainly. But when we look at the functionality of global gas markets, they are more competitive, more liquid, and more transparent than they were, and similar to Australia, the U.S. is also an AAA rated democracy which respects the rule of law. The energy business had gotten used to the idea that it had to go to increasingly risky places and face increasing geopolitical and security risks. So the fact that now 85 percent of new supply is coming from geopolitically secular supply sources is a major reassurance for supply security.
What’s the impact on the market for renewables?
It takes 5 years to build a major LNG project, and during those five years, the rest of the energy system was not idle.
Of course, it takes 5 years to build a major LNG project, and during those five years, the rest of the energy system was not idle. We have seen a huge boom in the production of solar, which brought down the price very significantly. There is also robust investment in wind. For a great number of countries, wind and solar have reached cost efficiency where they can compete with imported LNG without any additional subsidy or carbon pricing.
This is not the case everywhere, and it is not automatic, but what you need for this is a combination of good energy policy that enables investors to build solar projects with an attractive cost of capital, and good resources. Ideally you have a combination of the two, which was the case in the recent growth in Mexico’s solar, and the growth of wind and solar in South Africa. LNG is now facing much greater competition from wind and solar that 5 years ago, and from the point of view of the overall energy system this is truly a very good thing—although it’s a challenge for LNG investors.
In Asia, the switch from coal to natural gas must still be facilitated by energy policy, because liquefying and shipping the gas is expensive. LNG in Asia remains much more expensive than domestic gas in the U.S.
There is other good news for LNG, which is that in many Asian countries, the smog problem is serious and widely known. India has a smog problem, Southeast Asia has very serious air pollution, and a substantial portion is caused by use of coal for power generation. In the U.S., they are shutting down coal-fired power plants and building new gas-fired power plants, and this is primarily happening on the basis of economic competition between coal and gas. In Asia, this switch must still be facilitated by energy policy, because liquefying and shipping the gas is expensive. LNG in Asia remains much more expensive than domestic gas in the U.S.
In the city of Beijing, gas consumption for power generation has doubled in the past four years because city authorities are implementing regulations to constrain the use of coal within the city. Beijing is a gigantic city, so this doubling is not insignificant. It wouldn’t have happened on the basis of standard competition between coal and gas—it needed to be facilitated by energy policy. Such energy policy measures are increasingly in place in many Asian countries and cities.
We’ve discussed Asia but what about Europe—how is greater liquidity in LNG markets impacting European energy security, particularly as it seeks to diversify supply away from Russia?
Russia is a very competitive supplier to Europe, and if you look at the strategy presentations of Gazprom, you can see that they have a clear objective of maintaining market share in European markets. They have strategic willingness to have a commercially flexible strategy to achieve that. Gazprom has a large excess production capacity in Siberia, and Gazprom also owns the sunk-cost pipeline infrastructure to get the gas to Europe. Thus, Russian gas in Europe has a low marginal cost.
European domestic gas production is declining and that’s probably an irreversible decline: There’s no credible prospect in Europe for shale gas repeating its success in the United States. There’s credible supply from the Middle East, but of course, there are a long list of geopolitical and security problems impacting the region. Exports from North Africa peaked about 7 years ago, and are currently below their historical peaks. So, without the emergence of American LNG, Europe would in all likelihood be forced to increase gas imports from Russia quite significantly.
How is the growth of global LNG supply changing the nature of contracts between Gazprom and European buyers?
In the past 2-3 years, Gazprom renegotiated 2,000 contracts with various European buyers.
It’s true that American and global LNG is intensifying competition for the European market. In the past 2-3 years, Gazprom renegotiated 2,000 contracts with various European buyers. These renegotiations are typically confidential, so there’s no precise public information on the outcomes, but there’s a general understanding that the new contracts are favorable for European buyers. Another observation from this renegotiation process is that the overwhelming majority of EU buyers chose to modify rather than cancel their contracts. So eventually, the Russians were able to offer the type of terms and conditions that EU buyers were comfortable with. Therefore, we have seen indications that the commercial behavior of Gazprom changed significantly as the EU region became affected by LNG competition and abundant supply, which is definitely a major positive for European buyers.
Finally, what’s the state of global shale gas production? How does it compare to what was projected in the Golden Age of Gas report?
In the Golden Age of Gas report, if you read the report and you compare the 2015 numbers, in North America, U.S. shale gas production has been even higher than what we predicted, and with better cost efficiency—so the U.S. is beyond the golden age. It’s in a platinum age of gas.
We think that China will eventually tackle shale gas development and have an industry, but it will take 1-2 decades, and we don’t think that China will ever catch the U.S.
But I think it’s fair to say that shale gas development outside of North America is facing serious challenges. There’s a credible effort in China, but the ramp up in China is considerably slower and it’s facing multiple obstacles: More challenging geology and much higher population density. There’s a prospective shale play in Sichuan, where you have enough water, but it’s very densely populated and very important agriculturally. There are also prospective shale plays in Northern China, which have low population density and no agriculture, but they are extremely dry and water availability is a big issue. So, different regions have different standards, but areas like the Marcellus in the Northeast United States—these favorable combinations are very rare in China and elsewhere. We think that China will eventually tackle shale gas development and have an industry, but it will take 1-2 decades, and we don’t think that China will ever catch the U.S.
Aside from China, there is also a credible investment opportunity in Argentina—Vaca Muerta is incredibly good geologically, and up until recently, the investment and tax environment was rather poor, but under the new government it is improving quite significantly. So we are also optimistic on Argentina, because of the openness to investment by the new government, as they will need to maintain the new investment policies to really develop Vaca Muerta and unleash that potential.