The future looked bleak for liquefied natural gas (LNG) in early 2009. Its appeal seemed obvious: The product of cooling a gas, typically methane, to liquid form at about -162 degrees Celsius, it promised to be a flexible and relatively green fuel that could be easily transported over long distances.
But the global recession stalled rising energy prices, driving demand into a tailspin just as 60 billion cubic meters of new LNG capacity came online. Import cuts by Japan and South Korea, Asia’s largest consumers of LNG, pushed the global industry into a severe state of oversupply.
“We’ve seen LNG demand in Asia – other than China – either flatline or go backward over the last 18 months,” said Nik Burns, senior analyst for oil, gas and energy at RBS Morgans, a brokerage. In China, the LNG market is heating up as Beijing seeks substitutes for oil and coal. Natural gas – a cleaner-burning alternative, producing just over half the carbon dioxide of coal and around 80% less carbon monoxide – fits the bill, and hopes are high in the LNG industry that China may come to its rescue.
In early April, Li Hualin, vice president of PetroChina (PTR.NYSE, 601857.SH, 0857.HK), predicted natural gas will make up 10% of China’s energy consumption by 2020, from 4% today.
"It is future demand from China that is driving the hunt for natural gas, and concerns for the environment are what drive the development of a natural gas industry in China," said Macquarie oil and gas analyst Laban Yu in a March 25 note.
Searching for supply
China’s consumption of natural gas is set to reach 110 billion cubic meters in 2010, up 37% on 2008 levels. This figure is expected to more than double by 2020, but Chinese supplies are already projected to fall short of demand by 20 billion cubic meters this year. Anticipating this, Chinese firms have been on a buying spree. For the right price, they are ready to sign the long-term supply contracts that typify LNG development.
A recently completed US$70 billion LNG deal between state-owned energy firm China National Offshore Oil Corp (CNOOC; CEO.NYSE, 0883.HK) and British-owned BG Group (BG.LSE) will supply 3.6 million tons of LNG annually to China. The new deal complements CNOOC’s existing multi-million-ton long-term contracts with Qatar.
In March, PetroChina partnered with Royal Dutch Shell (RDS.A.NYSE, RDSA.LSE) in the US$3.2 billion acquisition of Arrow Energy, an Australian firm with multiple potential LNG production assets. This followed a US$41.1 billion agreement between PetroChina and Exxon Mobil (XOM.NYSE) in 2009.
Flexible and not so flexible
While long-term contracts that tie the price of LNG to crude prices are the status quo, LNG has some flexibility as a fuel source. During times of domestic shortfall or demand spikes – as in China’s recent bitter winter – additional cargoes can be purchased on a short-term basis.
But LNG is not without its disadvantages. Pipeline gas may be less flexible, but it is safer, and the compression process to produce, transport and store LNG as much as doubles its cost relative to pipeline gas. Furthermore, due to LNG’s transportation over sea routes, its usage remains chiefly in coastal Chinese cities. Its impact on the country’s overall energy mix is limited.
Rising petroleum prices may change this situation. Although natural gas is priced too highly to compete effectively with coal for electricity production, it is competitive with petroleum and liquefied petroleum gas (LPG) for residential and commercial uses. "At the moment, there is some substitution going on of oil-based fuels, or coal gas and LPG … but at the same time there’s just outright growth in the overall gas market," said John Harris of IHS CERA.
Any increase in demand must be big enough to justify the large sums of money – not to mention long-term risk – typically involved in LNG projects. With this in mind, perhaps the most important factor for the future of LNG is encouragement from Beijing. "In areas like pricing and infrastructure, there have been clear signals of the government’s intentions of increasing [LNG] use," said Gabriel Wayne, LNG market analyst at energy consulting firm Wood Mackenzie.
Beijing would prefer to obtain most of its natural gas domestically, mitigating concerns over transportation of supplies, and maintaining a "cost-plus" system of pricing that sets a fixed margin of profit. However, it will need to increase natural gas imports – including LNG – as demand for energy rises and as China pulls away from other fossil fuels. It will also need to reform product pricing, a move analysts expect to come later this year.
A more market-based retail pricing system should simplify the structure of Chinese demand for natural gas supplies, but it’s too early to pin all hopes of resolving global LNG oversupply on an ascendant China. Rising prices will not only make the margins more attractive to state-owned gas importers, but also justify developing new domestic production.
"In broad terms, there should not be an LNG supply constraint should China choose to increase the amount of LNG in its supply mix," said Harris at IHS CERA.
Chinese energy firms like CNOOC and PetroChina are nevertheless gearing up for LNG, expanding their storage and regasification capabilities. PetroChina will build four new LNG terminals, two of which are now underway in Jiangsu and Liaoning provinces.
New supply is already expected from projects in Qatar, and Chinese shipbuilding companies are quickly establishing themselves as builders of China’s LNG carrier fleet. However, pipeline competition will strengthen with the completion of a 40 billion cubic meter Central Asian pipeline in 2011, while domestic pricing issues will continue to linger. In addition, the International Energy Agency estimates that global gas supply and terminal overcapacity will reach at least 250 billion cubic meters by 2015, squeezing international prices.
"It’s going to be a few years before we get back to the level we were at," said Jonty Rushforth, senior Asia LNG editor at energy information provider Platts. He expects a four- to five-year wait before prices return to pre-crisis levels.
This leaves plenty of time for Chinese firms to sign long-term supply contracts and develop infrastructure to help them take advantage of short-term spot purchases; but the scale will remain relatively small. Until the market finds a spark to turn natural gas from merely a substitution fuel into a major energy source, China’s LNG demand will simply be a matter of bargain hunting – not the sustained demand the global industry seeks.
Gu Anzhong, a professor at the Institute of Refrigeration and Cryogenics at Shanghai Jiao Tong University, says LNG’s potential is significant, but he’s not holding his breath. "If LNG wants to become the best choice for China’s energy needs, it still has a long way to go."