Understanding Gas Prices Gasco News; Vol 16 No.

2 Oct 2003 Gregory McGuire

The price of natural gas is poised to oust that of oil as the most important economic variable impacting on the short-term fortunes of the Trinidad and Tobago economy. We

are in the very fortunate position that we can be warned about the possible consequences of this change in advance of its coming. The ability of the key economic agentsgovernment, business and households, - to manage expectations and successfully adjust to the new environment depends in part on their comprehension of the gas market at home and abroad.

Over the last three years, we have witnessed a growing interest in gas pricing stirred by three factors: First is the dominant role that natural gas, particularly LNG, is perched to play in the economy. Gas consumed by LNG currently accounts for 55 per cent of total It is estimated that when Train 4 comes on

gas consumption of about 2,500 mmscfd.

stream in 2007, LNG would constitute about 60 % of a much larger demand of 4000 mmscfd. There is no doubt about the tremendous positive impact such expansion in gas output will have on key macro-economic variables: GDP, Balance of Payments, government revenue and expenditure and the money supply. According to Board of Inland Revenue figures, already natural gas has replaced oil as the leading contributor to Government revenue. The share of gross income from gas in total energy sector income has increased from 10% in 1990 to 61% in 2002. Train 4 will push Government

revenues to a new plateau, which before long, will be matched by an equally explosive growth in expenditure. The flood of commentary that followed the approval of Train 4 demonstrates that there is, at least, an awareness of the positives to flow from the coming golden age of gas. There seems to be little concern, however, that over time, volatility in gas prices could create even more acute dislocation in the fiscal balance than oil.

The second reason for the spotlight on gas prices is the widely reported standoff between Trinidad and Tobago and Jamaica on the price of LNG to Jamaica. The parties are faced with a major challenge of pricing natural gas in an environment in which competitive market forces are absent.

The third factor is the plea from some quarters for greater transparency in gas pricing which they believe can be achieved through an unbundling of NGCs pipeline and merchant business and the liberalization of the gas market.

This essay attempts to fill some gaps in the knowledge, thereby enriching understanding of the variable that would be a major influence on our economic fortunes. It describes various gas pricing models in use at home and abroad, examines the relationship between gas prices in major markets and those in T&T, and distills some implications for policy. First, what are the distinguishing aspects of price determination in the gas market compared with oil? An important facet of the gas market is that there is no international price of gas. Whereas any discourse on global or national economic outlook would invariably mention the price of UK Brent or WTI as benchmark international oil prices, there is no equivalent in the gas market. This is partly because trade in gas is restricted by the physical properties of the product it must be liquefied or piped- and by the expensive limited infrastructure - purpose built tankers or pipelines. The gas industry is still struggling to overcome the tyranny of distance that confines market reach largely to national and regional boundaries rather than global. There are three major regional consuming markets, North America, Western Europe and Asia. With this type of market distribution , gas is in competition only with regional energy references. Thus, a gas price of US $ 10.00 in the USA has no direct effect on gas prices in Japan. Unlike oil, the supply of gas is relatively rigid and cannot respond very quickly to price and other stimuli in geographically distinct markets.

Several factors influence the method of gas pricing used in any particular market. These include available reserves, number of producers, production costs, distribution infrastructure, number of consumers, market size, structure and maturity and end use, cost of competing fuels. Gas price regimes vary across regions and industry, but perhaps can be classified into four main groups: Open Market, Indexation, Netback (Value minus) and Cost Plus. Hybrids of two or more of these archetypes often exist.

An Open Market regime is typically associated with markets in which there is uninhibited gas on gas competition. While a number of countries have launched market liberalization efforts, the North American and British markets are the only one in which open competition exists. These markets are characterized by free competition for supply, based on mandatory non discriminatory open access to the pipeline infrastructure, the unbundling of gas commodity supply and trading from transportation and other services and removal of price controls, at least at the wholesale level. The market forces of

supply and demand determine the price of gas. Conditions of near perfect competition exist.. There are multiple players at each stage of the value chain: producers,

transporters, marketers, and storage companies and consumers in different sectors. No supplier, group of suppliers or group of consumers Henry Hub Henry Hub is a major gas collection and interconnection facility in Southern Louisiana US. Henry Hub is owned and operated by Sabine Pipeline LLC, which is a wholly owned subsidiary of Chevron Texaco. The Henry Hub is physically located at Sabines Henry Gas Processing Plant in Louisiana. The Henry Hub interconnects nine interstate and four intrastate pipelines Collectively these pipelines in the North East, South East and Mid West states. Henry Hub accommodates 1.8 bcfd. 3 can dictate the price. The open market regime is a very dynamic environment ably supported by online information and a clearly defined regulatory policy and institutional framework Federal

Energy Regulatory Commission FERC in the USA, and OFGAS in the UK. The US market is perhaps the worlds best example of open market pricing at work. Gas wholesale prices are referenced to Henry Hub, the

interconnection point for thirteen 13 major US inter and intrastate pipelines. Since 1990, the New York Mercantile Exchange (NYMEX) has adopted Henry

Hub as the benchmark point for gas trading. Marketers and traders therefore purchase wholesale supplies, for immediate or future delivery, on the basis of on line Henry Hub prices quoted on NYMEX. Wellhead prices are usually lower than Henry Hub,

reflecting the cost of transportation to the Hub. The price paid by the final customers in the US market varies across states and sectors., reflecting differential cost of service to get the gas to the customers plant gate. This includes costs of transportation and storage both of which are tightly regulated by FERC. For example, customer in Boston could be paying as much as $5.00 per MMbtu when the wholesale price at Henry Hub is US $ 4.00 per MMbtu. Short term volatility in gas

prices over time reflect the changes in supply and demand factors including weather conditions, the level of storage, production rates, import capacity, and the cost of competing fuels.

Alternative Fuel Indexation is the most common form of gas pricing in markets outside of North America. Under this regime the gas price is comprised of two elements a base price and an indexation formula. The gas price is typically set at a level that is competitive with the markets alternative fuel options. In most instances the indexation formula ties the price of gas to a basket of alternate fuel prices-fuel oils, light oils and coal. The archetypal price formula is in the form: P= Po +.8(Co-C1). Under such

formulas, the price of gas tends to follow that of crude oil with a lag. For example over the first six months of 2003, the average European border natural gas price appreciated by 42 per cent compared with the pervious year mirroring the year on year increase in oil prices. European benchmark prices are quoted on the International Petroleum Exchange. However, the spot market for natural gas in Europe remains undeveloped. Most

European sales are made under long-term contracts that feature take or pay and price indexation clauses to mitigate risks of seller and buyer, respectively.

Netback pricing is a mechanism that shares the end market value of gas with all parties in the value chain. The netback pricing formula is a common feature of most LNG contracts. The wellhead value of gas is the residual amount after subtracting from market

value the cost of liquefaction, transportation and storage and regasification. The market value may be determined by either the indexation formula as in the case of ALNG sales to Spain or by open market forces (USA). In Japan, the worlds largest LNG importer, prices are linked to prices of a basket of crudes imported into Japan.

The fourth broad classification, Cost-Plus pricing, is typically associated with markets characterized by small size, skewed distribution of supply and or demand, geographically remote from major consuming centers and or in relatively early stage of development. Using the cost plus formula, the consumer price will be equal to the

wellhead price plus transportation costs, distribution costs, a return to the seller and taxation. Under these conditions the wellhead price is often negotiated between the producer and the state or directly with the consumer. Cost Plus pricing is associated with the first stage of gas market development. As the market evolves towards a more

competitive structure, indexation and full open market pricing could emerge.

Natural gas pricing in T&T is a hybrid of three models outlined above. The exception is the open market model. This is partly because of the structure of the industry and its evolution. A peculiar feature of the T&T gas market is that, apart from LNG, NGC has historically been the monopoly buyer and seller of natural gas. In the early days, (around 1975), Government negotiated purchase prices with the then sole producer, Amoco and established selling prices for different classes of customers. The skewed distribution of both production and reserves in the hands of one major producer has posed severe limitations on the development of a competitive pricing regime. What then are the prevailing pricing mechanisms in the various sub sectors and how do they relate to the generic classifications and external markets. ?

LNG, now the single largest end user of natural gas is the only sector in which price is directly linked with gas prices in major consuming markets. Both the FOB and wellhead prices of ALNG gas are determined by netback-pricing base on prevailing prices in the USA and Europe (Spain). In the US market, LNG is sold under different contracts

through diverse destination points. The Netback price derived from each regas terminal

could vary by as much as US 60 cents/mmbtu. Similarly, sales to Europe are also reported to have different netback pricing basis including an element of power prices in Spain. In June 2003, netback values for ALNG sales is estimated at US $ 5.41 /mmbtu in Boston USA compared with US$ 3.68 in Spain. The higher US netback represents both the lower freight costs and relatively high gas prices compared with fuel prices in Europe. This suggests that Government revenue from LNG, the bulk of which is derived from netback value of the gas at wellhead , would depend on the distribution of sales and the relative prices in the major markets.

In several ways the monopsony position of NGC in the gas value chain has had a direct bearing on the gas-pricing regime outside of LNG- i.e. petrochemicals, power, heavy industry, light industrial and commercial and transportation. Firstly, producer (wellhead) prices are determined through arms length negotiations with the producers. For NGC, the objective is to keep its acquisition cost at a level that would maintain the competitiveness of T&T gas industry, while granting the producer an adequate rate of return. . On the other hand suppliers seek to maximize returns on the capital invested, but recognize that this cannot be achieved without the market. The derived equilibrium price depends on the bargaining strength of the respective parties and the price paid under existing

contracts. The typical supply contract is of long term duration ( 10-20 years) and the price is comprised of a negotiated base price plus an annual escalator to account for movement in operating costs. Secondly, because Government has chosen to use gas as a catalyst in a definite process of economic development, consumer prices downstream reflect the dual value of natural gas as a feedstock and a fuel. Therefore differential pricing regimes prevail by end use and by sector.

The Petrochemical sector (Ammonia and Methanol) enjoys a unique variation of the indexation Product related pricing. First introduced by NGC in the early 1990s, product related pricing is a mechanism by which NGC shares the market price risks with the petrochemical customers by allowing the gas feedstock price to fluctuate with commodity prices. Feedstock costs account for 65-70 percent of non-debt operating costs of a petrochemical plant. Investors therefore find the risk sharing offered by this pricing

mechanism to be very attractive. The product related pricing formula sets a reference price of gas to a reference product price, based on standard plant operating economics. . A fixed formula then triggers increases or decreases in the price of gas to correlate movement in the price of gas based commodities. (ammonia and methanol). As a result the price of gas could range from as low as US$ 1.10 to over US$ 2.50 when product prices exceed US$ 275.tonne. The gas price to the petrochemical sector therefore has no direct connection with gas prices in Europe or the US. The upsurge in prices in the latter however, has resulted in many petrochemical producers looking to relocate production facilities in gas rich locations, including T&T Qatar, Equatorial Guinea , where prices are lower and not subjected to fluctuation of open markets.

Gas prices for fuel users in heavy industry and light industrial and commercial sectors, are typically determined on a cost plus basis. Contract prices mirror the structure of NGCs purchase prices, comprising a base price plus an annual escalator. The base price reflects NGCs acquisition cost plus the cost of service (transmission distribution and maintenance). Prices to the large users are determined through a process of arms length negotiations. However, for the 100 plus small users- light industrial and commercial a universal gas price is applied. The cost plus approach allows customers, large and small, to benefit from significant discounts in excess of 75% compared with the cost of alternate fuels.

The Government sets the price of natural gas for the power generation and transportation (CNG) objectives. sub-sectors in keeping with its wider economic and social

At least two important conclusions can be drawn. Firstly, Trinidad and Tobago has developed its own unique compilation of gas pricing mechanisms. The system has been heavily criticized on the grounds that there is no unitary or universal price of natural gas. However, rapid expansion of the market attests the fact that these mechanisms have met the requirements of competing interests: producers, customers, central government and its agencies. (NGC). Moreover, structural imperfections on the supply side make proposals

for the adaptation of open market systems premature. Such a mechanism faces myriad implementation risks in an oligopolistic market, including: predator pricing, transfer pricing, and limitations to down stream options.

Second, close correlation between gas and oil prices means that LNG expansion has increased exposure of Government revenue to the vagaries of the international commodity markets. Given the dominance of LNG in overall output, there is the

potential for deep swings in Government revenue from year to year, suggesting the need for Government to adopt a smoothing mechanism that would mitigate the impact of such fluctuations. Several options are available, including heritage fund, stabilization fund, fixed price budgeting or any combination, it would be interesting to see which approach, if any, is taken.