Bespoke alternative investment solutions for institutional investors

# Natural Gas Dynamics

## The objectives of this research paper

This research paper is an extension of an earlier research paper on oil (see Paradigm Shifts in Oil, dated 14 July, 2015), but the two can easily be read independently of each other. Whereas the earlier paper looked at the global oil price outlook, this paper will focus on natural gas prices.

We publish investment strategies and opportunities in our research papers. This research paper is available to professional investors as part of ARP+ subscription.

## The variation in regional gas prices is significant

Natural gas prices are, unlike oil prices, not global in nature. Prior to the financial crisis most gas prices traded in a relatively narrow range; however, around 2010, as the global economy began to recover from the great recession, natural gas prices began to diverge quite significantly (chart 1). The U.S. proxy (Henry Hub) has traded at the bottom of the range in recent years – almost certainly due to the shale gas revolution. The Japanese, on the other hand, have suffered from very high gas prices in the aftermath of the Fukushima disaster, when the Japanese closed all their nuclear facilities and, as a result, became more dependent on coal and natural gas to fuel their power plants.

Here in Europe we also appear to have paid ‘over the top’ for natural gas in recent years – at least when compared to U.S. prices. (For our UK readers, we note that NBP in chart 1 are UK gas prices.) Apart from the annoyance associated with paying substantially more than our U.S. friends for heating our homes, the higher gas prices in Europe have a serious economic effect, and one that is not good for Europe. Natural gas is a major source of fuel for power plants all over the world, so higher natural gas prices here in Europe translate into higher electricity prices (chart 2). Needless to say, electricity is a major cost in many industries, and therefore the price of it affects competiveness.

Chart 2 only reflects what households – not industry - pay for electricity, and local taxes may explain part of the price variations - not that it makes the loss of competitiveness any less painful, but that is another story. For example, in my home country Denmark (which for a change is no. 1 in an international league table – just not the sort of league table you want to be leading), household use of electricity is taxed.

Having said that, no electricity taxes are large enough to fully explain the massive difference in electricity prices across the world (or so we have been informed). Of great significance is the big spread in fuel costs.

## The correlation between oil and gas prices

Historically, oil and gas prices have been quite highly correlated (chart 3). They are both important heating fuels and, until relatively recently, both oil and gas have been significant fuels in power plants, which is one of the key reason why the two have correlated as much as they have.

Having said that, since the first oil crisis in 1973, the use of oil in power plants has been on a near constant decline. In 1973 25% of all power generated globally was based on oil. Today the same number is 5%, and in many OECD countries it is below 1%.

Around the financial crisis certain things happened. The powerful rally in energy prices in 2007-08 kicked off the shale gas revolution in the United States. We note that, since 2009, the use of coal as a fuel in U.S. power plants has fallen 10% whereas the use of natural gas has increased more than 20%.

In the spring of 2011 the Fukushima earthquake and tsunami rattled Japan. All but two nuclear reactors were shut down within 12 months, and the remaining two have since been closed. In Germany the government decided to phase out nuclear power over 10 years - 8 of 17 reactors have since been closed and the government is committed to closing the rest by 2022.

The result?

Gas prices have not participated in the recent oil price slide due to the combination of more widespread use of natural gas in the U.S., much stronger demand from Japan and somewhat stronger demand from Europe.

## The Russian bull

Russia exports substantial amounts of gas to Europe every year, accounting for almost 30% of total consumption across Europe (chart 4). We note that the corresponding number for the EU is 43% (in 2013).

The overall (political) relationship with Russia has deteriorated in recent years, following the Russian involvement in the civil war in Ukraine. 50% of Russian exports to Europe run via pipelines in Ukraine, putting nearly 15% of European gas supplies at a serious risk.

This raises the relevant question(s) whether one can trust that Russia will honour its contractual obligations and whether we should consider other options here in Europe?

The obligations first. Almost all Russian gas exports to Europe are sold on long-term contracts - varying from 10 to 35 years in length. The contracts are legally binding and subject to international arbitration. All contracts contain a take-or-pay clause which requires buyers to pay for a minimum annual quantity of gas, irrespective of whether they take delivery or not. Post 2008 the take-or-pay level in many of these contracts was reduced from 85% to 70% (chart 5).

At an assumed 70% take-or-pay level, in 2015 European buyers are committed to purchase more than 125 billion m3 (bcm) of gas from Russia. There are significant limitations on the options to reduce the volumes in these contracts, or to terminate contracts before expiry.

As a consequence, in the short to medium term, dramatic changes are unlikely. Russia is likely to continue to deliver gas to Europe. If nothing else, they desperately need the income – oil and gas exports to Europe account for over 50% of Russia’s federal budget income. On the other hand, Europe is likely to continue to buy its gas in Russia despite all the shenanigans in the ongoing verbal war between the two. In the short to medium term, there simply are no alternatives.

## The long-term alternatives to Russia

In the long run, several things can happen as a result of recent events; the nuclear deal with Iran probably being the most significant development in more recent times. Iran – not Russia as many believe – has the largest gas reserves in the world, and a more cordial relationship between Iran and the West could open for a new pipeline to Europe.

There is already a pipeline between Tabriz in Iran and Ankara in Turkey (which does not cross ISIS controlled country). The Iranian ambition is to extend that pipeline to Italy and from there to the rest of Europe (see for example here). An extension of the Tabriz-Ankara pipeline alone would allow Europe to import 30-40 bcm per year from Iran and would cost €6 billion to build.

According to estimates from the European Parliament, Iran would be capable of exporting well over 150 bcm per year, as long as the required pipeline network is available, rivalling Gazprom’s 140 bcm annual exports to the EU. An Iranian entry into Europe would seriously weaken Russia’s hand in the ongoing negotiations with Europe.

We also note that Azerbaijan – another major proprietor of gas reserves - has long been talking about improving its network of pipelines. Azerbaijan happens to be located right next to Iran (to the north), and the two could possibly work together on the extension of the Turkish pipeline – also known as the Persian pipeline (see here).

Increased competition from Iran and Azerbaijan would most likely lead to a meaningful fall in the premium on natural gas prices in Europe and will be the last thing the Russians would want. Two things can happen as a result. Either the Russians will do anything conceivable to obstruct the construction of such a pipeline, or they will become more cooperative in the talks with Europe, trying their very best to keep a valuable client.

Perhaps Russia has already spotted the writing on the wall and realise that they should not rely on Europe for such a major share of income. Moscow recently signed a contract with Beijing, providing China with 30 years of energy supplies and Russia securing $400 billion of income. The deal with Beijing will allow Moscow to be more aggressive vis-à-vis the Europeans in Ukraine. We also note that the contract was signed before the breakthrough in the talks between Iran and the West. ## The consequence for gas prices Almost whatever way the Russians decide to respond to the Iranian/Azerbaijani pipeline plans, the long term consequence would probably be a lower price premium on natural gas in Europe v. Henry Hub. However, the short to medium term implications could be vastly different. In the July research paper on oil we concluded that oil prices are likely to trade in a relatively narrow range going forward, and we estimated that range to be$50-80 per barrel approximately. (Note: We should probably point out that we always refer to Brent when we refer to oil prices). As far as natural gas prices are concerned, we draw precisely the opposite conclusion. We think there are enough incidents ‘in the pipeline’ for natural gas prices to prove unusually volatile over the next several years.

The incidents we are referring to may impact the price of natural gas both positively and negatively without necessarily having a major effect on oil prices (a potential war between Sunni Saudi Arabia and Shia Iran being the main exception) and could include (Note: NG meaning natural gas):

• An escalation of the Ukrainian crisis (NG prices in Europe to rise – possibly dramatically so).
• A reversal of the non-nuclear strategy in Japan and/or Germany (NG prices in Japan and/or Europe to fall).
• A sudden deterioration in the relationship between Iran and the West after a period of normalisation (NG prices in Europe to rise).
• An escalation of the crisis between Sunni and Shia Muslims, which could ultimately lead to a war between Iran and Saudi Arabia (NG and oil prices to rise).
• An ISIS led attack on the gas pipeline infrastructure, which would have far greater implications than an attack on an oil tanker (NG prices in Europe to rise).
• A significant drop in U.S. shale gas production (NG prices in the U.S. to rise).
• Further development of recently established shale gas deposits in the Surrey Hills (NG prices in the U.K. to fall).

In addition to these ‘one off’ incidents, it is also possibly (actually quite likely) that European politicians will become increasingly creative in their desperate attempt to create renewed economic activity, as the demographic landslide sinks European GDP growth to new depths. One such initiative may be to improve competitiveness across the European Continent through lower electricity prices, and this would open the door for Iran to supply natural gas to the Europeans.

Obviously, none of these incidents may ever happen, but it could also be that they will all happen. As you can see from chart 6, neither European nor U.S. natural gas prices have, in any meaningful way, reacted to the sharp recent decline in oil prices, causing oil to be cheaper now than natural gas in Europe on a BOE basis.

Along the same lines, we also note that coal is now cheaper than natural gas in Europe after having been more expensive for a number of years. The global trend has been, and continues to be, in favour of using less polluting natural gas instead of oil or coal, but recent price swings may change all of that. This could make for an exceedingly interesting few years until markets ultimately find what we would call post-shale equilibrium prices on both oil and gas, and that may take quite a while yet.

As we know, commodity trading strategies thrive on volatility (unlike equity strategies most of which prefer low volatility), and we therefore think natural gas offers even better trading opportunities going forward than oil does, even if they both look quite interesting – provided the manager in question can go short as well as long.

Unless oil prices fall even further relative to natural gas prices, there is no reason to believe that oil will reverse its multi-year decline as a heating and power plant fuel. Natural gas burns much too cleanly for that to happen at the current price differential. As a result, unless the price differential widens substantially, we expect the low correlation between the two to continue, which will only increase the number of trading opportunities in the energy space.

Niels C. Jensen

5 August 2015