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Testing times for the European gas sector

The market was already enduring a difficult 2020—and the Covid-19 outbreak will test it to its limits

The gas industry was already facing a quandary at the start of 2020—when it still seemed the Covid-19 outbreak could be contained to China.

Through 2019, the world had begun to struggle to absorb the volume of new gas supply coming to market, as LNG facilities commissioned in response to a long-faded price signal continued to come onstream. Europe helped soak up much of this new supply as it built up storage inventories to guard against a potential flare-up of tensions between Russia and Ukraine over the renewal of their transit arrangements.

But even then, these shipments into Europe were only defraying the losses of the offtakers from these new facilities, with delivered prices failing to offset the considerable sums they had spent to secure the right to lift the cargoes in the first place.

In the event, the feared flare-up between Russia and Ukraine never happened, and transit continued much as it had before. Meanwhile the mildest European winter since at least the middle of the 19th century meant there was little opportunity to run down these additional inventories through the heating season.

With stocks so high at the beginning of 2020, how would the market balance through the summer months? Would Norway or Russia turn down production to help balance the market, as they had in 2016? Or would they wait to see if US LNG production would shut in first?

All of the above

The policies European governments have been forced to adopt to stem the tide of coronavirus infection mean the answer may well be ‘all of the above’. The suppression measures—social distancing in particular—have all but shut down the services sector, with offices, bars and restaurants lying empty across Europe. 

Heavy industry has also been affected. China's lockdown had begun to play havoc with global supply chains even before the virus arrived in Europe, contributing to the decisions of car manufacturers such as Volkswagen, Renault, Daimler and Ford to suspend production in European countries.

The scale of these declines is already greater than the demand lost in the summer of 2009

Italy and, more recently, Spain have ordered energy-intensive industries to reduce activity to a minimum. Since the more stringent restrictions were imposed, gas deliveries to Italian industry have fallen by nearly a third, while total power demand has fallen by a quarter. In the UK, industrial gas consumption has held steady, but aggregate power demand has fallen by about 10pc from seasonal norms, mostly the result of weaker demand from big industrial energy users. 

And across northwest Europe, gas supplied through local distribution networks—mostly for space heating in homes and small businesses—fell by more than 20pc in the last week of March after adjusting for temperature variations.

The scale of these declines is already greater than the demand lost in the summer of 2009, when much of Europe's manufacturing industry was idled for the Great Recession. Across the EU-28, gas demand in April-September 2009 was about 14pc lower than a year earlier, at 183bn m³.

The road back

Much depends on how long the suppression measures must be sustained. In a worst-case scenario, much of Europe's population will need to maintain social distancingperhaps with brief periods of relaxationuntil an effective vaccine can be produced in sufficient quantities. Given the speed of medical testing and the scale of vaccine production involved, this could mean a full lifting of social distancing measures would not happen until sometime in the first half of 2021. 

In a best-case scenario, widespread antibody testing and contact-tracing could allow for the same kind of selective quarantining that has helped Singapore keep the outbreak under relative control, allowing for life to gradually return to normal.

Even in the best-case scenario, the economic impact would be formidable. In a briefing paper for the virtual G7 meeting at the end of March, the OECD warned that GDP in the most developed economies could decline by as much as 20-30pc at the peak of the outbreak—far worse than anything the world saw during the Great Recession.

The nature of the decline in economic activity raises further challenges. In normal market conditions, low prices would help to stimulate new demand that would eventually bring the market back into balance.

This capacity is not infinite, nor is the mechanism particularly swift—the asynchrony between price signals and investment responses accounts for much of the price cycling that the global gas market has experienced over the last 15 years. But this demand-side response will be significantly limited by the suppression measures that have put some 3bn people around the world under lockdown. 

Forward hedges will help to cushion the blow for large thermal generators, who will have only very limited financial exposure to collapsing spot market prices over the next year or two. But for pure gas suppliers, the decline in consumption will be much more challenging. 

Europe's demand-side stabilisers—storage injections and coal-to-gas fuel switching—were already used to their fullest during the summer of 2019, meaning there is little capacity to absorb more this year. The 15bn m³ unused storage capacity in western Ukraine could provide something of a buffer, but even before the Covid-19 outbreak swept Europe this looked like it would not be enough to fully balance the market.

Production restraint will likely be needed. But the collapse in oil prices means that the finances of major producer countries—who are also dealing with economic ramifications of their own suppression policies—will be under extreme strain. State-controlled suppliers may have an incentive to keep output high despite low prices, to try to maintain their contributions to state coffers. Striking a balance between maintaining a crucial income stream but not flooding an already over-supplied market will prove challenging.

 

US response

LNG producers in the US may find it comparatively easier to shut in their production—a possibility that was once dismissed as being largely theoretical but that now looks economically compelling. On a forward basis, the value of LNG loaded free on board (Fob) at US exporter Cheniere's facilities on the US Gulf Coast this summer is less than the cost of the feedgas required for the cargo —115pc of Henry Hub for long-term offtakers and 107pc for Cheniere's own portfolio.

In late February, Gulf Coast Fob prices dipped briefly below the cost of feedgas, just ahead of the nomination window for April-loading cargoes. European offtakers cancelled two of these. And, at the end of March, with forward Gulf Coast Fob prices below the cost of feedgas through to September, Cheniere came to market to buy six LNG cargoes that it could deliver to Europe.

20-30pc – GDP drop in developed economies at Covid-19 peak

This kind of dynamic portfolio rebalancing will only intensify over the coming months. And it hints at what may prove to be the legacy of this tumultuous period for the world's gas industry.

Europe's 2009 demand slump triggered a massive reconfiguration of the way in which the region sourced its gas: buyers needed more contractual flexibility to be able to deal with the resulting supply glut, and major producers eventually recognised that they needed to be more flexible if they were to continue to have customers. Some agreed more readily than others, as Stockholm's arbitration courts can attest.

Similar flexibility will be required for the world to deal with this year's dislocations of the gas market—not so much in European pipeline gas, where it is already well-entrenched, but in the LNG sector, where oil indexation and restrictive contract terms still prevail. 

Matt Drinkwater is senior editor, Gas and LNG, at Argus Media

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