Looking Ahead: What Lies in Wait for Europe’s Gas Industry in 2016?

Europe’s gas consumers may look forward to another year of relatively low prices. However, on the supply side, gas has lost a lot of ground to cleaner or cheaper sources of energy and there is much for the industry to do to if it is to recover. 

A key need is more effective lobbying for gas to play a bigger role in the power generation sector in particular. In the US, cheaper gas has overtaken coal as the fuel of choice and, given a higher carbon price, the same could start to happen in parts of Europe.

There are grounds for optimism in this sphere. First, wholesale prices could fall even lower, barring a long, cold end to winter pushing up demand. Following last December’s OPEC meeting, global oil production is unlikely to fall. Discussions about an IPO at Saudi Aramco is either proof that the world’s biggest producer will resort to any means to raise money for the government--or a negotiating tactic to bring output down, raise the price and shore up the budget.

There are grounds too for expecting Iran to rejoin the oil market and the US is readying to start exports of crude–not to mention LNG of its own–should the price make it worth the producers’ while. Meanwhile economic data, especially from China but also from the other BRIC countries, are not encouraging: The year has got off to a disastrous start, and oil demand is unlikely to rise to mop up the surplus.

Long-term weakness in prices

This softer oil price, coupled with weak gas demand, is expected to feed into lower global LNG prices and lower European pipeline gas contracts perhaps for as long as another next five or six years. As more liquefied natural gas comes on stream in the Atlantic Basin in the coming month or so, there is the prospect of Europe’s biggest single supplier, Russia's Gazprom, entering into a price war with the new marketers of US LNG.

But if European gas prices remain as low as they are, then it might not be worth exporting LNG to Europe, except at times when demand shoots up. Absent a prolonged cold spell exhausting regional storage facilities and LNG becoming competitive, Asia might be the best option.

And on the subject of storage capacity, one of Europe’s biggest sites, the depleted Rough field in the UK, is no longer able to provide as much to the market as it is required to do owing to aging equipment. The operator, Centrica Storage, has applied to the Competition and Markets Authority (CMA) for approval to reduce the statutory minimum capacity that it sells. The CMA is also poised this month or in early February to publish its findings into the retail gas and power market--dominated by six big retailers--although it has at least given the UK wholesale gas market its approval.

Back in the US, Cheniere too may have to say goodbye to the profits it was expecting to make from producing LNG using capacity it withheld from the market. Having become almost bankrupt by betting on relatively high US gas prices and building import terminals there in the last decade, it is unlikely to lose much money in the opposite direction. Most of its liquefaction capacity was funded on ship-or-pay terms with its customers. But the withheld capacity, which it might have marketed jointly with another company with experience of negotiating sales, would bring in useful revenue.

Production up, profits down

While low prices have led to the deferral of over $200 billion worth of upstream projects over the last year and slow going of many others, new production capacity built before the July 2014 price fall has seen the UK finally reverse a 14-year trend of falling oil and gas production, with Oil & Gas UK forecasting a year-on-year increase not far short of a tenth. The misalignment between investments and price rises means that all this extra output will command a relatively low price but the growth in UK output will nevertheless continue for a few years.

But decommissioning talks will rise up the agenda. The Oil & Gas Authority, the UK offshore regulator tasked with maximising the economic recovery of North Sea oil and gas, will have its work cut out for it persuading some operators of key infrastructure to remain open despite the low price, in order that third party gas may reach the market, or to keep producing at a loss. Key elements of this new approach will be better technology allied with greater cooperation between companies that have so far been at daggers drawn. Third-party ownership infrastructure might become more common, such as Antin Infrastructure’s purchases of stakes in the 20bn m³/yr Central Area Transmission System from BP and BG, with ship-or-pay commitments in place to cover the risk.

Mergers and acquisitions

Shell’s planned purchase of BG seems likely to proceed, with many shareholders owning both sets of stocks. However, it will most likely take longer to recoup the cost than Shell expected at the time. At time of press, BG shares were trading at a discount of 10% against the deal value, reflecting some doubts about how the decision will go when votes are cast at the end of the month.

This was the biggest deal by far to be announced in the sector last year, as the spread between buyers’ and sellers’ expectations otherwise proved unbridgeable. This year though, many sellers both in the UK and the US may be forced to swallow the pill. With the expiry of hedges, their output will be sold at a loss, and it is down to the banks to decide how generous to be.

In the meantime, the exploration and production community will continue to shed staff and make noises about the need for cost discipline; oilfield service companies will have to take more pain, including contract price cuts and the loss of business; mergers could be on the cards in that sector too. But the big merger, Halliburton and Baker Hughes, still has not happened. The companies had hoped it would go through last month, after some disposals to satisfy the competition authorities.

Generation and shale

The price of coal is also very weak and will continue to beat gas in the power sector until the price of carbon is hiked to a level that makes it uncompetitive–which would pose social problems in some of the larger European countries. And despite the UK’s Secretary of State for Energy and Climate Change saying the country would phase coal out altogether by 2025, that day is still a long way off. The decision will depend on the nation’s security of supply being adequate to allow such a step.

The fact remains that, for all its merits in terms of cleanliness and demand responsiveness, gas is still a fossil fuel and so the easy target of groups who depend on public alarm for their survival. Mobilising protest groups has proved easy, and the job is made simpler still by the media’s interpretation of its duty to present a balanced picture.

The UK is one of the few European countries to endorse stiffly regulated hydraulic fracturing. Many other countries have explicitly banned the process, apparently preferring instead to allow gas to be imported from overseas, with all the attendant methane losses and harm to their own balance of payments.

Quantifying these losses is not possible as nobody yet knows what the success rate of shale gas exploration in Europe might be–itself a vague concept given the wide range in costs and risks across the region.

But a higher carbon price would at least raise the break-even costs of production for wells whose output was dedicated to power plants.