March 25, 2020
by Nikos Tsafos*
The rapidly evolving COVID-19 crisis presents profound challenges for the global natural gas industry, as it does for the energy system as a whole and the economy at large. Before COVID-19, the gas industry was in the midst of four cycles or transformations, whose trajectory the crisis will alter. First, there was a market cycle characterized by short-term oversupply, low prices, and record-level investment in future supply, which threatened to extend the current overhang into the mid-2020s. That imbalance will get starker in the short term as demand collapses and producers are forced to curtail output, but less bleak in the long term as projects underway get delayed and investment in new projects slows as companies cut spending.
Second, there was a deep structural transformation, whereby the industry edged away from rigid, long-term contacts and prices indexed to oil toward a system where prices reflect real-time fundamentals and where liquefied natural gas (LNG), in particular, responds to short-term market signals. Every crisis brings a reassessment of the structures that the gas industry puts in place to ensure stability—long-term contracts with minimum purchase obligations, complex pricing structures to smoothen volatility, restrictions on how much buyers and sellers can deviate from the plan, and so on. The stark supply-demand imbalance, coupled with a roller coaster in the oil market, will accelerate the usual dynamics that lead to structural change.
Third, gas was struggling to find its bearing in the energy transition, squeezed, on one side, by advocates who wished it went away quickly, and supported, on the other, by those who saw it playing a constructive role in the transition to a low-carbon energy future. Here, the mechanics are less clear. One could see governments falling back on the fuels they know to kickstart economic growth—often, that might mean coal. One could also see investment in renewables cut back, which could help gas. Governments might shower the industry with incentives, again to stimulate economic activity. And gas might prove more resilient than other fuels and thus boost its reputation among skeptical policymakers. It is too soon to tell how these contrasting paths play out.
And fourth, there was a geopolitical transformation that was affecting the trajectory of the other three, shaped by the rise of four large players—the United States, Russia, Qatar, and China—whose strategy preferences were due to play a disproportionate impact on the global gas market. For the suppliers (United States, Russia, and Qatar), the stark questions are, who blinks first, and what political and geopolitical tools might each leverage in this battle. For China, the big questions are, how to exploit the current downturn to renegotiate the terms of its contracted gas supplies and whether it sees an opportunity for a “gas reset.”
In other words, COVID-19 will impact a gas market that was experiencing severe pressure and was undergoing multiple deep transformations at the same time. Here are five specific ways in which COVID-19 might affect gas markets.
Gas Demand in Uncharted Territory
Gas demand will be affected in some obvious ways. Many economies will experience an economic slowdown or contraction that will hit all energy sources. We can also expect some fuel switching: gas prices have fallen but so have prices for other commodities, including carbon. While consumers are unlikely to be stimulated by low energy prices, some energy must be generated anyway, and where gas is competitive placed, we could see an uptick in demand. In 2009, the last major global recession, gas demand fell faster than energy demand overall—2 percent for gas versus 1.4 percent for energy. But 2020 will look very different than 2009.
The main reason is social distancing, which adds an unknown parameter to how we think about gas demand. People consume gas and electricity at home, even though they may no longer fly or drive a car (which hits oil demand). Shutting offices, bars, stores, and restaurants might hurt gas use, but as we move into the summer, gas consumption in buildings falls in the Northern Hemisphere anyway. In industry, some companies might shut down or reduce output, while others will work overtime to supply essential goods. In power generation, there will likely be a decline in demand, but whether gas or other energy sources are hit will vary by location.
Assigning magnitudes to these dynamics is almost impossible right now. In China, electricity demand was down 8.2 percent in the first two months of the year, although there is a gradual rebound seen in real-time data. Some data from Italy show that electricity demand is about one-fifth lower than in earlier years. In gas, the data have yet to show a serious deviation from the pattern of earlier years, although there is a more visible decline in industry, something seen in France as well. In other countries, the evidence is similarly mixed: gas demand in Spain and Greece, for instance, seems within historical norms, although it is always hard to gauge how much of a deviation is random and how much is not. It is just too soon to convert the crisis we read in the news to a real number for gas demand in 2020.
In short, gas demand will be a function of three forces whose direction and magnitude will vary by market and sector: how much is activity falling due to GDP, how much is gas privileged or disadvantaged relative to other fuels, and how will people adapt their behavior to protect their health.
Someone Has to Cut Production
In the short term, gas prices are facing headwinds. Gas prices were already depressed, even before COVID-19 came to dim the macroeconomic environment. For much of 2019, gas analysts were engaged in an elaborate guessing game about which supplier would cut output (no one did). The pressure on suppliers will intensify in 2020, especially as lower oil prices weaken the economics of associated gas. For many producers, prices are trending near or below marginal costs, and the logic of continuing to produce in order to lose money will eventually give way to a more rational economic behavior. In 2019, at least, there was a sense that this was a short-term shock to ride out. It no longer feels that way.
Even though it oversimplifies the complex world of global gas, we can focus our attention on three main suppliers: The United States, Qatar, and Russia. In the United States, low oil prices will take some associated gas off the market. In theory, less gas supply should boost prices and make U.S. LNG less competitive in global markets, which reduces exports. In practice, the price uptick might be slow while news continues to be bearish, and any drop in exports will depress prices and make exports more competitive. This is a mechanism that we do not fully understand yet.
Russia’s strategy is harder to discern at this point, in part because much of its actions in 2019 were done with a fear of a Ukraine crisis hitting on January 1, and so it is not clear whether Russia is shifting its gas strategy or just correcting for an abnormal 2019. But we can say one thing for sure: Russia is unlikely to support prices while U.S. LNG (especially) continues to flow to Europe. If U.S. LNG shifts to Asia, or if more buyers cancel cargos from the United States, Gazprom might be tempted to reduce supply. But Gazprom will not blink first.
Qatar has always been operationally flexible, adjusting maintenance schedules or keeping a few ships as floating storage. But yearly output has always been near its nameplate capacity, and Qatar has recently booked long-term capacity in various European terminals, evidence that it wants to be able to place cargos no matter what. Qatar faces an insurmountable contradiction in its long-term export strategy between wanting to massively increase output while defending prices. But there is nothing to suggest that Qatar will curtail production in the near term.
In short, gas faces a tough 2020 with declining demand and prices and no supplier with a clear impetus to reduce production. We can expect things to get worse for suppliers until someone blinks.
A Challenge to Operations and Construction
COVID-19 adds an operational challenge to short-term supply as well. In Australia, several companies have confronted cases where employees were feared to have contracted the virus. Some operators, including in Russia and Alaska, are adjusting shifts to minimize travel, extending the stay of employees in remote locations. Others have recalled staff from China or Iraq. And the number of incidents keeps rising. So far, these adjustments seem minor, and most companies have robust systems to ensure operations. But if infections spread, it is possible that entire facilities might have to be shut down or, at least, operate at half-speed. It is hard to assign a probability or a magnitude to this risk, but it exists, and it is real.
Operational reliability might also affect the pace of construction. In a North Sea platform under construction, one worker has tested positive for COVID-19. Some companies are already taking precautions: the LNG Canada project cut its workforce in half; in Pennsylvania, Shell has temporarily suspended operations on its massive petrochemical facility. How these adjustments will impact project timetables is hard to know—there is still an incentive to build projects as quickly as possible to start earning a return on investment. But safety concerns might slow things down, and projects might come online later than expected.
A Slower Investment Wave
What COVID-19 means for the project pipeline is harder to gauge at this point. At a basic level, all companies are reevaluating their spending plans for 2020 and beyond. There is far less money to go around and far less ability to borrow. Moreover, the reduction in international travel and conferences means the usual churn that makes deals possible has been severed. That combination alone should mean fewer projects will get the green light in 2020.
Beyond the obvious, we can discern at least three dynamics at play. First, there has been an assumption among analysts that the market now favors companies with strong balance sheets, especially if those companies are willing to build big facilities without the long-term sales contracts that have customarily preceded these investment decisions. The smoke has yet to clear on this crisis, but equity markets are hitting big and small firms alike. We might enter an era where the big balance sheet is a thing of the past. A new pathway will emerge to final investment decisions (FIDs), but we cannot see it clearly yet.
Second, governments will step in and offer concessions to companies to develop resources. Call it a gas stimulus, if you will. In a depressed economic environment, where investment dollars make a big difference, we can expect the negotiating pendulum to swing from sovereigns to corporates. This swing will accelerate a dynamic already underway, as projects were trying to catch what would possible be the last wave of FIDs for major LNG projects.
Third, the stimulus might reach demand as well. In advanced economies, the stimulus might actually point away from gas as governments look for an opportunity to leverage the economic recovery to advance their low-carbon ambitions. But in places around the world where gas use could advance a country’s low-carbon pathway, we can expect power plants, pipelines, and port facilities to get an extra push. Combined with record-low prices, we might see the seeds of future gas demand being sown in 2020.
Growing Pressure for Structural Change
The gas industry is an industry of structure: long-term relationships are codified in long-term contracts that spell out, often in minute detail, what is and what is not possible. When a crisis hits, however, those structured get adjusted: price terms are renegotiated, volume limits are relaxed, rigid destination restrictions might be eased, and so on. In short, the systems that the gas industry puts in place to deal with crisis insulate it from small shocks but not big ones—when a big shock happens, buyers and sellers need to affix a new equilibrium.
In today’s environment, there are two pressure points. The first is China. China has become the indispensable buyer in global LNG markets, and its strategic choices reverberate across the world. Faced with an economic shock, Chinese buyers have two choices: they can try to work within the system, adjusting contract deliveries to match the pace of the economic recovery, or they can push for a more profound transformation in how gas reaches China. So far, the evidence points to the former. But a prolonged crisis will test Chinese buyers and their willingness to abide by terms conceived and created in a market long before they were participants. In theory, a China-led market would have a price that more closely tracked fundamentals in China and volume restrictions that found an acceptable balance between security of supply and flexibility. It is too soon to tell whether Chinese buyers will push for a deeper renegotiation of terms, but it is possible.
The other central node is Qatar. In December 2018, when Qatar said it would leave the Organization of Petroleum Exporting Countries (OPEC), I noted that: “There is one possible long-term outcome from this rift between Saudi Arabia and Qatar that could impact gas markets and LNG: their rift could become a rift between oil and gas . . . If Qatar were to lose faith in oil prices, it could eventually want to free LNG from its tie to oil.” At the time, it was not clear what exactly could lead a major producer to lose faith in oil markets and oil prices. But the latest developments in oil markets are as close as one could get to visualizing such a development.
Whatever one thinks about the oil price war, and my colleagues have written extensively about it, one thing is clear: it is a stark reminder how utterly unpredictable oil prices can be. Of course, the decline in oil prices relieves some pressure from long-term gas contracts indexed to oil. Buyers, who hate oil-indexation when oil prices are high, will remember that oil indexation is not so bad after all. But anyone who takes a real, long-term strategic view of gas markets must be thinking that oil indexation is no way to run a serious industry: if there were ever a time to say enough with riding on the coattails of the oil market, 2020 would be it.
*Nikos Tsafos is a senior fellow with the Energy Security and Climate Change Program at the Center for Strategic and International Studies in Washington, D.C.
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