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Russia and coal to set European tone

Gazprom's market share ambitions and the price at which power plant demand soaks up supply are 2019's key questions

European gas prices moved substantially lower in the fourth quarter of 2018 as predictions of a global LNG oversupply ending up in its "sink" market finally showed signs of coming true. With the potential for more of the same in 2019, much focus is on what support levels the European price can find.

The benchmark Ice TTF front month futures contract was just below the €22/MWh (c.$7.50/mn Btu) mark at the beginning of August 2018, although this still reflected price inflation through the first four months of the summer, from levels only just above €18/MWh at its start. The final two months of the summer saw a step-change, though, as the contract shot up to a high of above €29.20/MWh, north of $10/mn Btu, by late September.

A recovering oil market, strong coal and carbon prices, the Netherlands' decision to make further cuts to production at its giant Groningen field, storage inventory levels lagging the average and no decisive sign that the long forecast LNG wave was coming to Europe rather than being absorbed in Asia all contributed to bullish sentiment.

The fourth quarter could hardly have played out more differently, as all but the Groningen factors switched from looking supportive to exerting downward pressure, aided by milder-than-normal weather. Prices dropped precipitously to close the year back below €22/MWh.

The new year has seen a further slight weakeningthe Ice contract was traded just below €21.65/MWh, or $7.25/mn Btu. But, given the expectations of continued high LNG arrivals, most analysts see further downside, particularly given that northwest European gas spent four months of 2017 testing a €15/MWh ($5/mn-Btu) price floor.

As always in gas markets, these assumptions could be derailed by weather conditions. As January entered its final third, northern Europe and eastern North America were experiencing lower temperatures brought on by a North Pole sudden stratospheric warming event, which could bring a sustained period of colder-than-normal weather and play a significant role in absorbing additional LNG deliveries into Europe.

Consultancy Wood Mackenzie forecasts the average 2019 TTF price at $6.90/mn Btu, still above €20.60/MWh at a spot exchange rate. But it has a more bearish figure based on a mild northern hemisphere winter exacerbating the global LNG oversupply and dumping more volumes into Europe, where prices could drop as low as $5.50/mn Btu (€16.45/MWh).

Uncertainty over Russia

And this leads it to ask a question about how Russia will behave, given that European prices would then be moving towards the $5/mn Btu+ cash cost of bringing the highest-priced US LNG to Europe. Could Russia be tempted to compete for market share by forcing US gas out of the European market and, by extension, potentially out of the global LNG market?

"If you look at December, LNG imports into Europe were high, but Russian flows remained robust and Gazprom even sold 1bn m³ of spot gas on an auction basis," says Giles Farrer, Wood Mackenzie's global LNG research director. But, while falling at the end of the year, TTF prices were strong for most of December, averaging above €24.10/MWh across the first 17 trading sessions of the month, so it is potentially dangerous to draw conclusions about Russian intentions should prices move lower.

$6.90/mn Btu 2019 TTF price forecast, Wood Mackenzie

"No one really knows what Russia will do. It could look to compete for market share, or it could look to exercise restraint to protect price. I expect it will adopt a wait-and-see attitude, dependent on how the market evolves," says Farrer.

Other analysts are more sceptical over Russia's appetite to drive prices lower to capture European market share from US, or indeed other sources of, LNG. "I expect Russia will want to preserve its existing market share, but I would not expect them to look to increase it," says Michael Stoppard, chief global gas strategist at consultancy IHS Markit.

The International Energy Agency (IEA) cautions that it is not as simple as Russian pipeline gas competing with non-Russian LNG. While still a fraction
of its over 200bn m³ of pipeline supply delivered to Europe, Russia's LNG supply to the region has increased to 6bn m³ and, in the fourth quarter, it was the fourth-largest LNG importer into Europe by country of origin.

While Gazprom could take a view that its fellow Russian gas firm Novatek, operator of the Yamal facility, is simply another competitor, there may be reluctance to start a European price war that could damage Russian LNG economics. Yamal has recently delivered two new trains with another on the way, while Novatek also aims to take a final investment decision on the 19.8mn-t/yr Arctic LNG project, which may make "Russia Inc" wary of lowering European destination prices.

Transit route variables

On the other hand, IHS Markit's Stoppard says there is a "misconception" that Arctic developments necessarily equal high cost, and in fact Russia's western Siberian LNG export facilities are not among the world's most expensive liquefaction. With their relative geographic proximity to Europe, they could thus be among the more competitive LNG supply sources even if Gazprom decided to try to squeeze LNG out of a European oversupply situation.

Two other uncertainties also surround Russia's pipeline supply to Europe, both around transit routes to market. The first is the timing of two new projectsthe 55bn-m³/yr Nord Stream 2 sub-sea link from Russia to Germany and the 31.5bn-m³/yr Turkstream pipeline under the Black Sea to Turkey. Gazprom is aiming for an end-of-2019 start-up for the projects, but neither is expected to be delivering at anywhere near full capacity within the next 12 months.

Their progress, particularly that of Nord Stream 2, where sub-sea construction has started despite not yet having a confirmed route for the pipeline due to Denmark's concerns on its proposed path through its territorial waters, could have a significant impact on the other uncertainty. By the end of the year, Russia must agree a renewal of its transit agreements across Ukraine, a potentially tricky negotiation at the best of times but even more difficult while Russia continues to hold 24 Ukrainian sailors it accuses of having entered Russian waters illegally.

If Nord Stream 2 progresses well, Russia may be tempted to take a harder negotiating line with Ukraine, although it is unlikely to want to come away without some sort of a deal. Even aside from its routing issues, Nord Stream 2 still faces hurdles with sufficient capacity within, and securing access to, the European network to evacuate significant volumes away from its Greifswald landing point in northeast Germany.

The new Eugal pipeline to take gas away from Griefswald is not expected to reach its full 55bn-m³/yr capacity until 2021, with just under 31bn m³/yr planned for 2020. Even then, two-thirds of this initial Eugal capacity is pointed towards the Czech Republic and onwards to where Wood Mackenzie sees a major bottleneck at Baumgarten on the Austrian-Slovak border (to where Turkstream's transit volumes are also destined). The consultancy suggests a new German pipeline could better direct Nord Stream 2 gas toward northwest European markets, but no such project is particularly advanced, never mind deliverable in the short-term.

And, according to research from German energy thinktank EWI, even if Nord Stream 2 were delivering 35bn m³/yr into Europe in 2020 on its "competitive pricing scenario" (where Russia does not opt to hold back volumes, and sacrifice market share, in order to support price), the European pipeline network's logistics require it to flow 18bn m³/yr through Ukraine.

"Russian exports [to Europe] cannot work without Ukraine. We expect Gazprom to maintain at least a minimum throughput to meet its commitments," says Jean-Baptiste Dubreuil, senior gas analyst at the IEA. "The two sides will agree a new transit-price tariff, potentially through international arbitration, at least in some way that is acceptable at a higher political level."

More European storage?

But the perceived risk of at least a short-term interruption in Russian flows through Ukraine at the start of 2020 will increase if the negotiations are seen to be going badly. And this could encourage European buyers to fill storage through 2019 at higher levels than they would have done without the prospect of an interruption of Russian supply through Ukraine, potentially supporting prices.

"The European Commission should play a critical role in helping to mediate" the Russia-Ukraine negotiations, given their importance to Europe, says IHS Markit's Stoppard. And he sees the risk of a disorderly negotiation thus increased by the fact that the current European commissioners' terms of office will end in October, meaning new faces will be in place for what could be the last few months of talks. Not since Belgium's Etienne Davignon, a former head of the IEA, in 1981, has the European Council appointed an energy commissioner with any noteworthy previous experience in energy matters.

Might Russia compete for market share by forcing US gas out of the European market?

Aside from storage stockpiling ahead of a potential trans-Ukraine interruption, the fate of the Netherlands' Groningen field, which was in January subject to emergency court proceedings, could be a bullish factor for European gas. The field has a permit to produce just under 20bn m³ in the current (October-September) Gas Year, ahead of further cuts in the mid-2020s and a permanent shutdown by 2030, but a Dutch administrative court is expected to rule by the end of January on requests for an immediate cessation.

The end of, or even a greater than planned reduction of, Groningen supply would offer some price support, but, given that the field is now pumping at only just over 35pc of its mid-decade peak, the impact of further cuts will be limited. And the IEA's Dubreuil points out that the Netherlands and some of its neighbours still have customers dependent on the lower-calorific (lo-cal) gas that is produced from the Groningen field and which differs from the higher-calorific (hi-cal) supply across the rest of the European network. As lo-cal Groningen production has been reduced, hi-cal-to-lo-cal conversion capacity has become "highly utilised". With conversion capacity additions not due until 2022, Dubreuil doubts that the Dutch authorities will be willing to countenance further cuts that might leave these consumers stranded.

According to the Norwegian Petroleum Directorate (NPD), Norway's gas production in 2018 was 121.7bn m³, down from 124.2bn m³ in 2017 and below its 124.4bn-m³ forecast for the year. But the dip is relatively immaterial, while Wood Mackenzie expects the end-of-year start-ups of the Aasta Hansen field and the new Polarled pipeline to bolster Norwegian supply in any case.

Algeria renegotiations

Europe's other main pipeline supplier could see more significant changes through the course of 2019. Algeria has contract renegotiations with European pipeline buyers and most analysts expect the result to be Sonatrach ceding a greater proportion of supply to be tied to gas benchmarks rather than oil-linked, and in turn getting volume reductions so it has more gas to supply into the global LNG markets.

This scenario could have two interesting impacts. In a more bullish scenario, where Europe has a very cold second half of the winter and needs significant summer storage levels, having less contractual Algerian pipeline supply on which to call post-renegotiations could offer additional support.

Where Europe is bathed in an LNG wave, and particularly if the oil price rebounds, a further move for the European pricing structure away from oil and ever more strongly to gas-market fundamentals could provide further downward momentum. In this future, it could also further detach the European price complex from Asian oil-linked contractspulling the Asian spot LNG price with it as Asian spot buyers would only need to pay enough to detach more cargoes from Europe, potentially driving greater gas-to-gas pricing in Asia too.

The other key driver for 2019 European gas prices will be coal and, to a lesser extent, carbon. This is because the higher the coal price, the higher the level at which gas will find additional demand by displacing coal for power generation. The rebound in EU emissions trading scheme (ETS) prices after a number of years in the doldrums exacerbate the impact, as coal requires buying more of these higher-priced permits.

In an October 2018 note, when coal was trading north of $100/t, London-based research firm Redburn suggested that the high floor price for gas that higher coal
and carbon was providing could lead to Europe becoming the premium LNG market globally, inverting the usual pattern of Asia as the highest-priced market. Asia does not have a carbon-pricing mechanism as widespread or that values CO2 as highly as Europe, lifting the latter's price floor. Also, Redburn noted that Asian contract gas prices, due to their greater link to fuel oil both contractually and because there are still fuel oil-burning power plants in the region, could be pulled lower as the impending IMO 2020 regulations drive fuel oil lower.

Role of coal

Although coal has since dropped back to under $85/t, lowering Europe's gas-price floor, IHS Markit's Stoppard agrees that another jump in coal could drive TTF prices higher. "We have two scenariosblue bear, where an LNG wave drives gas prices down, but also brown bull, where relatively robust coal and higher CO2 prices support gas in a less abundant supply picture."

The key question is how much coal-fired generation is available to be displaced. The IEA's Dubreuil is doubtful about the size of this demand channel. "It is not comparable to 10 years ago when a wave of Qatari LNG displaced Russian and Algerian gas," he says. "The demand structure has changed; there are a lot more renewables, the UK has a carbon floor price and fewer coal plants, the Dutch are phasing out coal, there is virtually no coal capacity in France and Belgium.

"Utilities with some flexibility remaining in their plant portfolios will arbitrage between gas and coal where they can, but that competition is shrinking," he concludes. If Europe has enough supply to increase all of its available gas-fired plants and still has excess, it could see a significant price move down to levels where its prices need to push LNG to alternative markets. We have not really seen that sort of pricing pressure in Europe since the summer of 2009so long ago, in fact, that the alternative market for LNG cargoes was a pre-shale-revolution US.

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