What are the potential market impacts of LNG importation in the Western United States?
Significant interest in the development of on-shore liquefied natural gas (LNG) import facilities in the Western United States has emerged in the past several years. This interest has been spurred by the dramatic increases forecast for new merchant generation in the Southwest, and particularly California.
An additional accelerant to this environment has been forecast trends of gas prices above the $3.50 to$4.00/mmBtu range which, if true, increase the economic viability of such facilities versus sustained prices in the $2 to $3 range. For environmental and permitting-based factors, Mexico is emerging as the site of choice for such facilities. Currently, five projects are vying for the rights to build an LNG terminal and vaporization facility in Northern Baja Mexico.
Ready or Not
The drivers for each of these projects are somewhat unique, but all share several common characteristics. Most important of these characteristics is the fact that the gas reserves for these projects are separated from ready markets. These "stranded" fields would require as much or more investment to build the infrastructure to transport to more local markets. Even if the local market can be reached with an equivalent capital investment, the quality of that market is not as desirable as the West Coast of the United States. Despite the uncertainties and risks discussed below, many developers believe the U.S. gas markets are a much more stable environment for investment.
In addition to these developing supply sources, the recent completion of the North Baja pipeline provides developed infrastructure for an LNG project to get the gas to some of the most liquid trading locations in North America. The available capacity and access to existing and growing markets makes a Northern Mexico terminal location uniquely attractive for a developer.
The recognition of the need for additional supply options has intensified with the events that led to the unprecedented situation in the California power and gas markets during the winter of 2000-2001, now referred to as the energy equivalent of a "perfect storm." While some of the enthusiasm for power development has subsided recently with the demise of the merchant generator/trading model, the long-term need for additional generation in the West remains.
LNG Drivers: Power Steps Behind the Wheel
Investments in the electric infrastructure will drive the need for future natural gas investments. As long as regulatory uncertainty remains in the electric industry, natural gas infrastructure to serve the California market will suffer. Figure 1 depicts the expected growth in natural gas consumption in the Southwest.
Power generation in the southwestern United States is expected to drive overall natural gas consumption growth of 5 percent annually through 2015, with its share of total U.S. consumption rising to 14 percent from 12 percent.
Increased power demand alone will not be sufficient to ensure new LNG facilities are constructed and operated. The economics of these facilities require gas prices to be above a certain level. While there is debate as to the exact price point required to make such investments economic, conventional wisdom is that prices above $3.50 are desired.
Currently, near-term and long-term forecasts support the view that prices will be close to a level sufficient to support a Baja-based LNG import facility. As can be seen in the two charts on this page, NYMEX futures for 2003 are currently trading above the desired threshold, and long-term price forecasts are trending toward the desired level, which may encourage investment.
Assuming the gas price and electric driven demand factors support the long-term viability of these facilities, other significant issues may be created by their existence.
California, due to its "end of the pipe" status on the natural gas supply and transportation grid-with the commensurate shortage of options-has been prone to greater price and supply volatility. If one or more of the proposed LNG import projects come to fruition it may permanently alter the gas markets, not only for California, but also for the entire Southwest. Consider first the effect of a decrease in the market share of traditional sources of gas (western Canada, Wyoming, Southwest).
Penetration of the U.S. market by LNG shipped north from Baja California will alter the flow patterns in existing pipelines. Gas that had flowed into Mexico, or that had been expected to flow into Mexico, will be displaced. It, in turn, could displace Canadian or Rocky Mountain supplies. Alternatively, the displaced gas could become a buffering supply, used only in times of shortage, which would reduce the medium-term volatility of gas prices.
The introduction of re-gasified LNG into Western markets will diversify supplies and thus should both increase the reliability of supply and reduce the volatility of gas prices, at least in the medium to long term. Over short periods, gas price volatility may actually increase. That is because until it is re-gasified, LNG is a wasting asset. There is little or no incentive to delay unloading an LNG cargo. Therefore, over the time horizon of a single journey, LNG supply is inelastic. One way to mitigate the impact of this additional inelastic supply would be through the expansion of storage.
Effect of New Transportation Capacity
The LNG projects under consideration range in approximate size from 500 mmcf to 1 bcf of deliverability per day. At the high end this represents 33 percent of the Southern California market and 18 percent of the total California market. Based on past experience in California and the West, adding this amount of new supply with the corresponding increases in transportation capacity could have a significant price impact on traditional supply and transportation providers to these markets.
The traditional manner in the United States to meet this expected increasing demand would be to build pipelines that tie to existing production regions in the United States and Canada. And in fact, numerous pipelines have been proposed just for this reason. Some are progressing and others that would add significant amounts of capacity have been postponed or cancelled. Most of the proposed projects are to bring natural gas down from the Rocky Mountain region, where prices have been extremely favorable lately.
The largest expansion project currently under way is the Kern River Gas Transmission Co. 2003 expansion. The $1.26 billion expansion project will more than double the capacity of the Kern River system to a total daily capacity of 1.7 billion cubic feet. These pipelines will continue to be the primary supply for the needs of the California energy market.
An additional important aspect of the supply portfolio is the possibility of an LNG terminal in Baja California, Mexico. Five separate project sponsors have announced plans to construct terminals in the region: Marathon Oil, Sempra/CMS, Royal Dutch Shell, ChevronTexaco, and El Paso/Phillips. Each of these proposed projects represents a potential new supply source of 500 to 1,000+ mmcf/d.
Until the early 1990s, no interstate pipeline companies operated within California. That changed with the completion of the Kern River and Mohave pipelines. Initially conceived in the late 1980s, when California was concerned there would not be enough interstate pipeline capacity to meet expected gas demand growth for the state, these two pipelines were primarily developed to transport gas for the enhanced oil recovery market in Southern California.
At about the same time, three other pipelines were performing significant expansions. All this development led to more than 2 bcf/d of new capacity to the state between 1992 and 1994. Demand did not materialize as expected, and a glut of pipeline capacity went unutilized, dropping annual average utilization from Southwestern regional basins from 84 percent to 66 percent in the period of 1990 to 1996.
The resulting excess pipeline capacity led to a period of extreme conflict between end users, firm capacity holders, pipeline owners, policy-makers, and regulators over who should be responsible for the costs associated with the stranded investment. Some of these issues continue to be litigated today. Figure 2 shows the basis differential between Henry Hub and Southern California prices during this period.
As can be seen from the data, basis differentials were under extreme pressure during this period, dropping from the +$0.50 to $0.75 range before pipeline capacity increased to -$0.25 to $0.35 range after capacity expansion. This is nearly a $1.00 drop in the California market versus Henry Hub. Although this may appear to have been good in the short term for users in the region, market participants eventually have to recover these investments, and they have been hesitant to repeat this experience. This probably contributed to the issues around the winter 2000-2001 that saw California border prices reach $60/mmBtu.
Alliance pipeline began construction in 1999 and entered commercial operation on Dec. 1, 2000. Alliance is capable of transporting more than 1.3 bcf/d. Alliance operates from Western Canada and terminates in the Chicago area with existing North America natural gas transmission infrastructure. This increased the flow from Western Canadian supplies into the heart of the Midwest markets by 29 percent. How did the markets respond? Basis differentials have continued to climb in the region despite the increase in supply.
Potential Impact of LNG Development and Market Strategies
Overall gas supply in the continental United States and Canada will be adequate to meet demand over the next 10 to 15 years. Although production in Texas and the shallow-water Gulf of Mexico may be declining, these declines will be offset by additional imports for Canada. Any additional capacity and supply must therefore be at or below contemporary prices.
An LNG terminal in Baja California would probably receive gas from South America, which has a low wellhead cost. It would require large capital investments at the producing end in the form of gas pipeline to the port and liquefaction capability, as well as additional capital investment in ships and the Mexican terminal. Gas at the port would have few alternative delivery options.
Furthermore, the economics of the entire operation are partially driven by revenues anticipated from liquefaction byproducts. The cost structure of LNG thus involves high fixed costs and low variable costs further offset by a variable contribution margin from other products. If an LNG project is built and demand fails, LNG shipments would probably continue, which would be very destabilizing to regional gas prices.
Given the tendency of history to repeat itself in the natural gas industry, what is the best strategy to employ in this region? Regardless of whether an LNG terminal is built, there will be adequate supplies in North America. Consider the following base case:
- There will be significant growth in natural gas demand in the Southwest.
- There will be significant increase of pipeline capacity into this region.
- One and possibly two LNG import terminals will reach fruition in the 2005-2010 timeframe.
- Gas prices will remain stable.
The key risk to this outlook is that natural gas-fired power plant construction will slow, relative to forecasts. Certainly construction has already begun to lag, but some of that is probably incorporated into LNG developers' expectations. If the outlook continues to contract, either because of electricity market fundamentals, unavailability of credit to developers, or life extension (or even expansion) of solid-fueled plants, gas prices could collapse again.
If one or more LNG import terminals are to be established, they will have to be base-loaded to ensure consistent deliveries. That would imply that the existing pipelines would become the "swing" load suppliers. It is unlikely that any of the new projects would be willing to accept any of this risk so it would fall primarily to the older more established companies in the region.
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