Gas pricing will impact security

With all the media coverage of climate change, highlighted by the second report of the UN’s Intergovernmental Panel on Climate Change’s Fourth Assessment published last month in Brussels, with a focus on the impacts of climate change, and with the third report on recommended actions being published in Bangkok this month, it would be easy to lose sight of other energy issues, such as supply security. Indeed following a mild northern hemisphere winter that never really tested energy supplies it is perhaps not surprising that security has not been higher on the energy business media agenda.

But a new report from the International Energy Agency last month has reminded the market, and the media, of the perils of ignoring supply security. The report, Energy Security and Climate Policy: Assessing Interactions, assesses the impact of climate policy on supply security and concludes there is a worsening trend for both CO2 emissions and energy security across the countries assessed in the study. In particular the report says that switching from coal to gas in power generation to achieve climate targets, which has been the “conventional wisdom” approach to clean secure energy, has a negative impact on security indicators.

The IEA has urged countries to undertake a systematic review of the energy security implications of their climate policy initiatives, effectively saying that all climate policy should be means tested for security implications, and warning: “The policy cases investigated underline that policies deemed acceptable either to reduce CO2emissions or to improve energy security may no longer hold, when considered through the prism of an integrated climate/energy security policy.”

Clearly in today’s climate aware environment any energy policy has to start with either the objective of supply security or climate security and then make the best fit of the other policy (climate or supply). It is simply not possible to have a convergent energy security/climate mitigation policy that achieves full security and emission removal. There has to be compromises. And with the momentum behind climate action the real concern is that security will be compromised, albeit unintentionally.

One of the most interesting conclusions of the IEA report was its findings on coal to gas generation switching with respect to security. Gas is the primary generation fuel source for the vast majority of countries, followed by coal, and switching between the two is largely contingent on wholesale gas prices. As the gas price increases in relation to coal the coal plant becomes more economical simply because it is the gas price that sets the marginal cost of generation. It can therefore be argued that wholesale gas prices have an impact on supply security.

With this in mind, last month’s meeting of the Gas Exporting Countries Forum, an informal grouping of the world’s largest gas exporting countries, in Doha attracted significant interest from the large gas consuming countries in the west. This interest was generated by a proposal from Iran to create an OPEC-style gas cartel, which if implemented could have an impact on gas pricing.

As it turned out the Forum rejected the cartel proposals, but it is too early to be complacent. The Forum effectively agreed a compromise approach by forming a high-level committee to discuss gas pricing with Russia heading the committee that will also include Iran and Kazakhstan, Algeria and Qatar. Russia’s energy minister Viktor Khristenko said he felt that the forum should remain unchanged. “It should continue existing as such and should keep up its transparent and coordinated position towards consuming countries.”

Some believe this committee will lead to more controlled gas pricing, or at least an attempt to introduce pricing control, and in effect provide for a quasi cartel structure in all but name. While the general consensus is that a gas cartel is difficult to achieve due to the long-term contract structure of the global gas market, any attempt to control prices will almost certainly have a psychological impact on the market.

The decision of the Forum to focus on pricing may well have been prompted by the launch later this year of the world’s first LNG contract on Doha’s IMEX energy exchange. Serving both international and regional participants, IMEX has been designed to attract a wide range of investors by launching new contracts, starting with LNG, and its aim is to increase the level of price transparency and pricing autonomy in the region that is the world’s principal supplier of hydrocarbon.

From an external energy security perspective the Middle East is the primary energy export market for both oil and gas, yet the region has historically not been one of price discovery. Instead the main centres of price discovery have traditionally been in west with the world’s energy futures markets dominated by two exchanges – the New York Mercantile Exchange and the London-based ICE Futures. But with the launch of a sour crude futures contact on the Dubai Mercantile Exchange this month and the Qatar exchange listing LNG later in the year there may now be a gradual shift in the pricing dynamics from the major consuming countries in west to the major producing countries in the Middle East.

The importance of the Middle East to the long-term supply security of the west cannot be ignored. As new export refineries are built, the region will be the largest incremental supplier of petroleum products worldwide by 2010. Collectively, the Middle East boasts 60% of the world’s proven petroleum reserves and 40% of the natural gas reserves, while Qatar has an estimated petroleum reserves of 15.2bn barrels, the world’s third largest reserves of natural gas at 14.9% and is already the world’s leading producer of LNG.

While it is too early to predict the impact of the Qatar and Dubai energy exchanges it is clear they will have a profound impact on pricing and, by inference, supply security. This is particularly true of LNG, which is starting to have profound pricing impacts in end-user markets and the nascent spot LNG arbitrage market is anticipated to grow quickly in the coming years as it will provide a unique platform to manage gas risk and further catalyse the development of the spot LNG market.

Without a pricing reference point for LNG, shipments have tended to divert to those markets with the highest natural gas prices. Last year, with high gas prices in Europe, these LNG shipments were diverted to European markets. But with the crash in European gas prices over the mild winter the forward US gas prices for the autumn and early winter are now at a significant premium to European gas prices, and conventional wisdom suggests that LNG shipments that may been routed to Europe will now be directed to the US market this coming winter. This in turn has a potential impact on supply security.

Market competition and pricing will always have an impact on security. Traditionally this pricing has been managed in the west through the more competitive market infrastructure and the greater pricing transparency afforded by the plethora of trading platforms, both OTC and exchange. The emergence of more pricing transparency in the producing region of the Middle East and Asia, which is the main market for these new exchanges, will have an increasing impact on pricing dynamics in the west as this region becomes ever more dependent on imports from the Middle East. In the longer-term this impact may be party subordinated by increased development of new energy technology to reduce import dependence and mitigate the impacts of climate change, but in the short to medium term the west may well have to address its gas supply security policies.