Supply-and-demand economics are key to meeting energy needs and reducing carbon.
In the global movement toward decarbonization, there are starkly divergent viewpoints about what role natural gas should play.
“In Europe and parts of North America, sustainable energy means moving away from fossil fuels entirely,” says Jonathan Stern, a professor at the Oxford Institute for Energy Studies. “However, in most of the rest of the world, natural gas is part of the sustainable agenda. As a result, this form of energy is going to be important and expand for two decades.”
Natural gas is, in essence, a balancing force between the goals of addressing climate change and satisfying the energy needs of emerging countries. As this plays out, natural gas has evolved beyond a regional product to a global and fungible commodity similar to oil.
“Natural gas is giving way to basic economics,” Stern explains. “The price of a commodity should reflect the supply and demand in the country where that commodity is sold. However, it’s taken the gas industry decades to come to that recognition.” Now, like the oil market before it, natural gas is becoming a worthwhile opportunity for investors to consider—but you should have a clear understanding of how the economics of the gas market is changing.
Traditionally, natural gas was purchased around the world using rigid contracts that ran for decades and priced based on what current oil prices were. These contracts provided no ability to hedge future prices. The linkage was based on the notion that gas was a substitute for oil to generate heating and electricity. Over the years, however, gas and oil have gone down different paths. Oil is now considered a transportation fuel. Gas is dominant in heating and electricity production.
“It became clear the long-term contracts for gas bore no relation to the supply and demand of gas in different countries,” Stern says. “If there is a problem in the Middle East, gas prices shoot up because oil prices shoot up, even though the problem won’t affect gas.”
In the past decade, however, a “spot market” has developed, in which gas that is delivered immediately is priced according to supply and demand. This is called “gas-on-gas pricing” to differentiate it from gas that is based on oil prices. North America and Europe were the first markets to move toward gas-on-gas pricing.
The price of a commodity should reflect the supply and demand in the country where that commodity is sold. However, it’s taken the gas industry decades to come to that recognition.Jonathan Stern, Professor, Oxford Institute for Energy Studies
A central trading point for natural gas is the Title Transfer Facility (TTF) in the Netherlands. Set up in 2003 as a virtual marketplace, it’s become the global benchmark for natural gas in the same way Brent Crude is the global barometer for pricing oil markets. Similarly, the liberalization of the Liquefied Natural Gas (LNG) market and the establishment of the Japan Korea Marker (JKM) as the Asian benchmark helped globalize the market, satisfying energy demand and providing cleaner energy for the fastest-growing area for natural gas use.
In July, it was reported that the first Chinese pipeline contract would be linked to the JKM benchmark. This is significant because China is expected to generate more than 40% of the global gas demand growth over the next four years as the government shifts away from coal to improve air quality.
“When gas prices no longer have an artificial connection to oil prices, people can allocate capital to projects with greater confidence,” explains Gordon Bennett, managing director, utility markets at Intercontinental Exchange (ICE). “They can understand the true economics of these projects and hedge their risk more easily.”
Removing the linkage from oil could allow natural gas to make more headway in regions where it must compete against coal, which has a lower marginal cost. At the same time, Stern points to the balancing act: Natural gas infrastructure projects are costly, and developers must consider the gas price points that are necessary for them to be economically viable.
Energy is in transition on many levels. Over the next decade, a large number of long-term gas contracts in Asian markets will expire. It is expected these contracts will be renegotiated on shorter terms or under more flexible conditions, following the trends that have occurred in North America and Europe. As the natural gas market shifts, greater risk management will be necessary for all stakeholders along the supply chain. This operational efficiency impacts the success of projects and the return for investors.
“The gas market has come into its own as a globally connected market,” says Stuart Williams, president of ICE Futures Europe. “Transparent pricing across energy sources, carbon and green attributes is core to the economics of achieving the dual objectives of increased energy but less carbon.”
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