SPE 24238 An Emerging Economic View of World Natural Gas Demand and Supply

W.H. Dorsett*, Chevron Corp., and G.B. Ackerman, Decision Focus Inc.
*SPE Member
Copyright 1992. Society of Petroleum Engineers, Inc. This paper was prepared for presentation at the SPE Oil & Gas Economics. Finance and Management Conference held in London, England. 28-29 April 1992 This paper was selected for presentation by an SPE Program Committee following review of information contained in an abstract submitted by the author@). Contents of the paper, as presented, have not been reviewed by the Society of Petroleum Engineers and are subject to correction by the author@).The material, as presented, does not necessarily reflect any position of the Society of Petroleum Engineers, its officers, or members. Papers presented at SPE meetings are subject to publication review by Editorial Committees of the Society of Petroleum Engineers. Permission to copy is restrictedto an abstract of not more than 300 words. lllustrationsmay not be copied. The abstract should contain conspicuous acknowledgment of where and by whom the paper is presented. Write Librarian. SPE, P.O. Box 833836, Richardson, TX 75083-3836 U.S.A. Telex, 730989 SPEDAL.

ABSTRACT N a t u r a l g a s i s s w i f t l y moving from a l o c a l l y t r a d e d co-dity i n regional markets t o a q l o b a l l y t r a d e d commodity. his describes a numerical model of i n t e r n a t i o n a l g a s t r a d e which e v a l u a t e s t h e e f f e c t s of interand i n t r a - r e g i o n a l g a s t r a d e on demand, s u p p l y and p r i c e . Preliminary evidence i n d i c a t e s n a t u r a l gas p r i c e s a r e 15 t o 3 0 % lower i n r e a l terms when i n t e r - r e g i o n a l trade o c c u r s and l o c a l consumption of n a t u r a l g a s increases r e l a t i v e t o f u e l o i l i n t h e l o c a l market. Natural gas developers o r marketers t h a t e x p l i c i t l y consider t h e inter-regional impacts o f g a s t r a d e w i l l have a g r e a t e r l i k e l i h o o d of u n d e r s t a n d i n g t h e r i s k s i n m a r g i n a l p r o j e c t s and are more l i k e l y t o embrace economic p r o j e c t s and eschew noneconomic p r o j e c t s .
VALUE

rnurkets. ... The forms of contracts employeci, the ease of access of new entrants to the gas business, the pricing formulas and the use that both suppliers and consumers can make of gas transmisswn and distribution systems will all affect the terms under which old and new gas comes to the marketplace. All these facbrs will have a major impact on whether gas use picks up an4 if so, at what pace" '
Many c o u n t r i e s w i t h undeveloped indigenous n a t u r a l gas resources are a n x i o u s t o d e v e l o p new markets f o r t h e i r g a s . These c o u n t r i e s recognize t h a t d e l a y s i n developing these resources r e s u l t i n a large f i n a n c i a l c o s t , s l o w i n g t h e i r own development as a n a t i o n . For t h i s reason, many a r e now o f f e r i n g f i n a n c i a l i n c e n t i v e s , such a s t a x holidays, grants, loan guarantees, reduced r o y a l t y and a c c e l e r a t e d c o s t r e c o v e r y t o p r i v a t e and p u b l i c companies t h a t w i l l d e v e l o p and market their indigenous gas resources. While natural gas importing c o u n t r i e s would p r e f e r t o d e v e l o p t h e i r own r e s o u r c e s and a v o i d c a s h outflow t o exporting countries, t h e y must a p p r e c i a t e t h a t reduced

GLOB&

OF INTERNATIONAL COMMUNITY

GAS

TRADE

TO

"For both economic and environmental reasons, natural gas is becoming the fuel of choice in many
-

References and charts at end of paper.

SPE 2 4 2 3 8

W.H.DORSETT an in A m e r i c a ( f r o m Canada t o t h e lower 4 8 S t a t e s of t h e U.S,A.); t o North America from A f r i c a and Norway; t o Western Europe from A f r i c a , E a s t e r n Europe, and t h e former S o v i e t Union; and to Japan from A u s t r a l i a , t h e U.S., Indonesia, Malaysia, and several other c o u n t r i e s -- are e v i d e n c e t h a t n a t u r a l g a s m a r k e t s are becoming more g l o b a l .
An economic view of g l o b a l markets

c o s t s of imported gas affords opportunity t o i n v e s t t h e savings developing o t h e r resources.

In addition t o c o s t savings i n t h e t o t a l energy b i l l , i n t e r - r e g i o n a l t r a d e which c a p i t a l i z e s on lower n a t u r a l g a s c o s t s o u t s i d e t h e i r boundaries, h e l p s c o u n t r i e s d e v e l o p more d i v e r s i t y and s e c u r i t y of supply. With n a t u r a l g a s r e p l a c i n g f u e l o i l f o r t h e non-core market, t h e r e s h o u l d be less dependence on t h e v o l a t i l e world o i l market. Environmental l e g i s l a t i o n i s e s c a l a t i n g i n many p a r t s of t h e world, w i t h some c o u n t r i e s r e q u i r i n g u s e of n a t u r a l g a s a s a replacement f o r f u e l o i l and n u c l e a r energy i n t h e electric g e n e r a t i o n market. This c o u l d be m i s i n t e r p r e t e d a s meaning t h e s e c o u n t r i e s would b e w i l l i n g t o pay h i g h e r p r i c e s f o r u s e of i n d i g e n o u s g a s only. I n a world of i n c r e a s i n g t e c h n o l o g y and lower c o s t s of d e v e l o p i n g g a s r e s o u r c e s , consuming c o u n t r i e s need t o e v a l u a t e t h e economic b e n e f i t o r c o s t o f i n t e r r e g i o n a l g a s t r a d e a s compared w i t h d e v e l o p i n g i n d i g e n o u s r e s o u r c e s . To do o t h e r w i s e c o u l d l e a d t o poor economic i n v e s t m e n t s and h i g h e r c o s t o f e n e r g y f o r a l l consumers.

r e q u i r e s u n d e r s t a n d i n g t h e impacts of i n c r e a s e d c o m p e t i t i o n on t h e supply of natural gas; and e s p e c i a l l y t h e impacts o f i n t e r r e g i o n a l n a t u r a l g a s t r a d e on a region's domestic natural gas demand and p r o d u c t i o n . The f i r s t p a r t of t h i s d i s c u s s i o n f o c u s e s on t h e market e f f e c t s o f greater competition within a given region, and t h e second on t h e e f f e c t s of increased n a t u r a l gas imports i n t o a region. There are few g l o b a l r e g i o n s , e x c e p t i n t h e U. S. , where n a t u r a l g a s i s s u b j e c t t o c o m p e t i t i o n among gas supplies emanating from d i f f e r e n t subregions. Indeed, even i f n a t u r a l g a s i m p o r t s from Canada and A l g e r i a w e r e s h u t o f f , a strong competitive environment would remain i n t h e U.S., where i m p o r t s a c c o u n t f o r less t h a n 2 TCF ( 5 6 G m3) of a 1 9 TCF ( 5 3 8 G m3) market. s h o u l d be a x i o m a t i c t h a t f o r "free-market" c o m p e t i t i o n t o e x i s t w i t h i n any r e g i o n , t h e r e are t h r e e necessary conditions:
It

THE ROLE OF COMPETITION

Almost a l l g e o g r a p h i c r e g i o n s of t h e world have some n a t u r a l g a s . O f t e n t h e gas i s a s s o c i a t e d with crude o i l o r liquid products and therefore, is considered a by-product for which p l a n n e r s s t r u g g l e t o f i n d l i k e l y markets. The e x t e n t t o which a r e g i o n ' s i n d i g e n o u s gas s u p p l y i s c o m p e t i t i v e w i t h i m p o r t s i s t h e f o c u s of t h i s p a p e r . How much l o c a l l y produced gas can a local market economically a b s o r b ? What are t h e p r i c e r e s p o n s e s a t t h e w e l l h e a d and b u r n e r t i p when inter-regional supplies are introduced? Traditionally, the energy industry t h o u g h t of n a t u r a l g a s a s a b a l k a n i z e d commodity -- t h a t i s , a p r o d u c t n o t widely t r a d e d a c r o s s c o u n t r y o r r e g i o n a l Y e t , i n t h e l a s t two decades, borders. i n t e r - r e g i o n a l g a s t r a d e -- w i t h i n North

-gas-on-gas markets ;

c o m p e t i t i o n a t end-use

- t r a n s p o r t a t i o n systems t h a t o f f e r open a c c e s s t o sellers, t h i r d p a r t y s h i p p e r s , and b u y e r s ; * u n r e g u l a t e d w e l l h e a d p r i c i n g and production o p p o r t u n i t i e s available t o a l l parties. The first condition

is

often

EMERGING ECONOMIC VIEW OF WORLD NATURAL GAS

SPE 24238

confused with gas-on-oil competition, or gas-on-coal competition. When natural gas is only competing against another fuel, then prices tend to maintain parity with that fuel. This cross-fuel substitution provides a ceiling price, which the price of natural gas rarely exceeds. Open competition occurs when natural gas competes not only with oil and coal, but also with other sources of natural gas from different regions which have different production and transportation costs (the combination of production, transportation, and distribution costs is referred to herein as the net-forward marginal cost)

Many North American natural gas projects to add production or pipeline capacity could be in jeopardy of financial failure if natural gas imports continue to exert downward pressure on prices. The economic viability of some projects depends upon natural gas prices reaching parity with fuel oil, escalating each year at 1 per cent (real) or more. The same degree of uncertainty could occur in Western Europe where several new mega projects have been announced. And, the same scenario can be constructed among LNG production facilities supplying natural gas to Japan, Korea, and Taiwan. The consumer benefits of aggressive competition -- whether from intraregional or inter-regional trade include lower end-use prices and more natural gas products among which consumers may choose. This may not be good news for the gas producers, since their economics might have been based on less competitive markets. This is not always the case because producers' profitability does not always increase or decrease at the same rate as end-use prices.

Intra-regional trade among gas producers is necessary to obtain a competitive market. The degree of competition among gas producers is a function of the access which the intra-regional pipeline system affords producers. Hence, the existence of natural gas competition, and the benefits thereof do not depend solely upon the existence of inter-regional trade. Competition within a region depends upon the rules governing the process of moving natural gas from underground reserves to the burner tip. In the mature competitive markets of the U.S., natural gas imports were previously considered marginal supply sources used only during peak demand periods. But, during the 1980s the import picture changed dramatically such that relatively inexpensive imports from Canada became an infra-marginal source or a part of the base load demand. Domestic producers in the lower 48 states of the U.S. have been forced to compete with the prices and terms offered for these Canadian supplies. Over 75 TCF (2,123 G m3) of relatively inexpensive proved reserves are in the Province of Alberta, which will become available to the U.S. market as more natural gas pipeline capacity is added. The potential competitive impact is immense. For either marginal producers ( high-cost producers) or marginal pipeline projects, the economic impact could be devastating.

--

Requirements for Analvzinq InterReuional Gas Trade Inputs to the model of intraregional and inter-regional competition in natural gas trade include : -exploration and development cost supply curves for major reserve bas ins ; =transportation tariffs for movement of natural gas via pipeline and LNG production, shipment, and re-gasification; -natural gas demand for core users (i.e., no fuel switching capability) and non-coreusers ( fuel switching capability available).

SPE 24238

W.H.DORSETT induce resource owners to deplete reserves sooner. Demand curves in the model are segmented as shown in Figure 11. Competition between natural gas and oil results in a chair shaped demand curve. The seat of the chair is at parity price of natural gas and competitive fuel oil. If the net-forward marginal cost of natural gas drops below the price of the competitive fuel, the non-core or fuel switchable portion of the demand curve begins switching to natural gas. Conversely, natural gas prices higher than competing fuel oil prices means that only the core segment of the market utilizes fuelnatural gas, and the switchable market eschews natural gas in favor of competing lower cost fuel oils. In the model, the non-core market is represented in two distinct parts: Utility Electric Generation (UEG), and all other non-core A constant ratio of UEG demand. maximum natural gas demand relative to all non-core maximum demand was assumed for each region. Finally, the model representations of distribution and transportation costs were simplified. Sufficient data was assembled to estimate the fixed dollar markup and fixed percentage fuel efficiency to bring natural gas from the aggregate wells in each region, to the respective burner tips. LNG costs, and long-haul natural gas pipeline tariffs were more difficult to estimate. However, a tariff structure was assembled by conducting a series of trial-anderror experiments using sensitivity runs of the model to examine volumetric flows between regions under different tariff assumptions.

To study the interactive aspects of these requirements, an economic computer model was developed in 1990. The objective was to develop a simulation tool which would use supply, transportation, and demand data from a comprehensive data base, and allow regional demand and supply forces to interact then estimate the prices and volumes of natural gas within and between regions. The authors recognize that simulation tools cannot model complex political interactions and realities precisely. But, careful use of simulation tools such as this model can reveal relationships which deserve examination and explanation.
MODEL DESCRIPTIOIP

The model was designed to simulate the economics of the world markets and to equilibrate the demand and supply for gas at each location and point in time. The demand for natural gas varies with the price of natural gas and with the price of competing energy sources. Natural gas producers are assumed to try to maximize the wealth of the resource owners, who determine the quantity of gas to sell from each resource. ( Table I is a listing of the Global and Local regions and output reports which are available.) Supply cost curves for over 200 natural gas basins around the world were estimated using publicly available data. A proto-typical supply cost curve for any resource is in Figure I. The two-dimensional mapping of costs in 1991 dollars per MCF (35.3 k m3) against cumulative production sets the supply curve with which the model begins to iteratively solve the equilibrium As a result of using this balance. paradigm, cheap resources get sold first. Exhaustible resource prices tend to increase over time (absent technological change). Resource prices are usually higher than actual production costs due to economic rent and value based assessments. These higher prices result in rates of return on investments which

EMERGING ECONOMIC VIEW OF WORLD NATURAL GAS

SPE 24238

CASE STUDY EXAMPLE: IMPACT OF INTER-RgGIONAL TRADE ON WESTERN EUROPE

Two states of world gas trade were constructed for the purpose of conducting the case study. The purpose of creating these two states of the world is to identify and isolate the supply, demand and price effects of inter-regional versus intra-regional trade. inter-regional t r a d e c a s e , free In the competition is assumed in natural gas markets within the region. This allows imports into and exports from the region. All producers are globally competing for the highest return on investments, and all consumers are buying the lowest-cost supplies, regardless of where the supplies originate. In the indigenous supply case, it is assumed that Western European supplies are the only sources to satisfy Western European natural gas demand. That is, all natural gas imports from any other region are choked off using an extremely high tariff rate. In both cases Western European natural-gas exports are not economic. All other assumptions in the model are identical between the two cases. Once the conditions are set, the model iterates to find a supply/demand equilibrium. Natural gas prices fluctuate, and both core and non-core demands (UEG and all other non-core demand) are allowed to respond according to assumed short-term and long-term price elasticities encoded in the model. Standard reports are produced for each state-of-the-world case, and are compared and graphed using a spreadsheet program. Figure 111, entitled Western European Natural Gas Wellhead Prices, compares the two cases. Whereas the beginning and early year price spreads between the two cases is very small, by the year 2000 the price difference is 38C per MCF (35.3 k m3) in 1991 U.S. dollars. A price change of this magnitude is worthy of notice. In differential addition, the price increases with time. An increase in price might be expected, but the magnitude of the difference is

more important than the price increase itself. Certainly, constraining Western Europeans to consume only natural gas from within the Western European connnunities induces higher natural gas prices. But now, we are able to examine the downward pressure natural gas imports can have on prices that producers map obtain under an open-trade state-of-theworld. Many natural gas producers regard inter-regional competition as affecting only the end-use price of natural gas, but not the average wellhead price. The indigenous supply case suggests that some marginal producers in Western Europe may not be able to compete when open trade is allowed. These producers should be keenly aware of wellhead prices not only in Western Europe, but also global prices that represent potential competitors, now and in the future. There is a surprise, however, when Western European production profiles are compared under the two cases. Figure IV shows the fiveyear snapshots of natural gas production for the two cases. Between the years 1990 and 2000, Western Europe enjoys a higher a maximum production profile production of about 9 Tcf (2,549 G when there is interm3) in 1995 regional trade and a lower profile when trade is restrained.

--

--

After the year 2000, however, the profiles switch. Open trade results in Western Europe producing less than if no natural gas trade were allowed. Figure V offers an explanation of this outcome. Comparing non-core natural gas prices (average enduse) to non-core oil prices (exogenously assumed and the same in both cases) shows the following: -With inter-regional trade, the

SPE 24238

W H DORSETT
CONCLUSIONS

..

end-use prices of natural gas and oil are roughly at parity, yet before the year 2000 natural gas is slightly cheaper than non-core oil. After the year 2000, noncore oil is relatively cheaper than natural gas. *Without inter-regional trade, natural gas end-use prices are higher relative to non-core oil.

1. ) The economic viability of a project cannot alone be judged simply on intra-regional supply and demand balances for natural gas.

A reason for this is, in the indigenous supply case, the non-core markets move exclusively to oil because high natural gas prices reduce non-core demand in industry and electric generation markets. But, in the w i t h inter-regional trade case, the non-core markets are almost equally divided between natural gas and competing fuel oils.
Figure VI provides the demand and production profiles for Western Europe under the w i t h inter-regional trade case. This demonstrates that supply tracks demand with regularity. Due to the relative gas/oil prices in the w i t h inter-regionaltrade case (see Figure V) , Western European natural gas demand increases in the first decade because gas is less expensive. Then it decreases significantly in the second decade due to lower priced fuel oil, and begins a slow ascent in the later years as total energy demand increases. Natural gas production follows the same pattern, suggesting that incremental supplies for Western Europe are embedded in part of the indigenous Western European supply, whereas natural gas imports are entirely base load. During this time, imports remain at a relatively stable amount between 3 and 4 TCF (85 to 113 G m3) per year. Figure VII provides additional insight by plotting the indigenous supply case supply profile between the Figure VI demand and supply profiles. Since supply equals core demand in the indigenous supply case, it seems that European production after the year 2000 w i t h inter-regionaltrade is less than the core demand for natural gas1

2.) Increased inter-regional gas flows will closely follow the global energy economy that presently exists for crude oil and refined products. 3 . ) The degree to which natural gas markets are competitive depends on the rules by which producers, shippers, and end-users are allowed access to different gas supplies, and intra-state transportation. 4.) Inter-regional gas trade applies competitive pressure on natural gas markets but, interregional trade is not sufficient by itself to change a monopolistic or monopsonistic natural gas market into one which is more fully competitive. 5. ) As inter-regional gas trade opens up gas markets in a region, there may be more natural gas supply sources than were previously considered.
6.) The higher cost domestic producers are likely candidates to be eliminated from the competitive queue.

7.) Relatively high-cost producers could quickly change from base load production to swing producer.

8.) The idea that inter-regional natural gas imports only serve to meet incremental growth in natural gas demand, or swing demand should be re-considered.

0 ' ' cubic feet TCF = 1 x 1 G m3 = 1 x 1 0 ' cubic meters MCF = 1,000 cubic feet k m3 = 1,000 cubic meters 1 cubic foot = 35.315 cubic meters

8
ACKNOWLEDGEMENT

EMERGING ECONOMIC VIEW OF WORLD NATURAL GAS

SPE 24238

The authors wish to thank R. D. Samuelson for his assistance in running the model examples,. Also thanks to the management of Chevron Corporation and Decision Focus Inc. for permission to publish this work.
REFERENCES

1. International Energy Agency, Natural Gas Prospects and Policies, Organization for Co-operation and Development, Paris, France, pp.9-10.
TABLE I
WORLD GAS MODEL REPORTS

I. GLOBAL and LOCAL REGIONS: A . North America, 14 Local Regions; B. Latin America, 6 Local Regions; C. Western Europe, 5 Local Regions; D . USSR + East Europe, 6 Local Regions; E . Africa, 4 Local Regions; F. Middle East, 6 Local Regions; G. Mainland Asia, 7 Local Regions; H . Pacific Rim, 7 Local Regions; I. World Total. 11. AVAILABLE FOR EACH REGION: A. Local Production; B. Prices; C. Imports; D . Exports; E . End Use Demand, Prices, Core, Non-Core,UEG; F. Liquified Natural Gas, Source, Price, Trade; Oil/Gas, G. Non-Core Consumption and Prices.

Cost $

Cumulative Production

FIGURE I

TYPICAL RESOURCE SUPPLY VS COST CURVE

.............. .. .. .. .. .. .. .

Natural Gas Composite Demand Curve

.. .. .. .. .. .. .. . .. .. .. .. .... .... .... .... ... ... ... . .. .. .. .. .. . . .

FIGURE 11

NATURAL GAS DEWUUD CURVE VS PRICE

1990

1995

2000

2005

2010

2015

2020

2025

2035

Year

FIGURE I11

WESTERU EUROPE NATURAL GAS WELLHEAD PRICES

1990

1995

2000

2005

2010 Year

2015

2020

2025

2035

FIGURE XV

WESTERU EUROPE UATURRI. GAS PRODUCTIOU

17 - - Western Europe Non-core Oil

...................

..................................................

..................................
............................

1990

1995

2000

2005

2010

2015

2020

2025

2035

Year

FIGURE V

WESTERN EUROPE OIL AND NATURRL GAS PRICES

Supply w/ Inter-regionalTra
1990

Year

FIGURE VI

WESTERN EUROPE NATURAL GAS DEMAND AND PRODUCTION

'CFIY ear

Indigenous ,ply wl Intel

F IGURE VI I WESTERN EUROPE NATURAL GAS DEMAND AND PRODUCTION

INDIGENOUS SUPPLY AND INTER-REGIONAL SUPPLY