UnderstandingGasPrices

GregoryMcGuire

The price of natural gas is poised to oust that of oil as the most important economic variableimpactingontheshorttermfortunesoftheTrinidadandTobagoeconomy.We areintheveryfortunatepositionthatwecanbewarnedaboutthepossibleconsequences of this change in advance of its coming. The ability of the key economic agents government,businessand households,tomanageexpectationsandsuccessfully adjust to the new environment depends in part on their comprehension of the gas market at homeandabroad.

Overthelastthreeyears,wehavewitnessedagrowinginterestingaspricingstirredby threefactors:Firstisthedominantrolethatnaturalgas,particularlyLNG,isperchedto playintheeconomy.GasconsumedbyLNGcurrentlyaccountsfor55percentoftotal gas consumption of about 2,500 mmscfd. It is estimated that when Train 4 comes on stream in 2007, LNG would constitute about 60 % of a much larger demand of 4000 mmscfd.Thereisnodoubtaboutthetremendouspositiveimpactsuchexpansioningas output will have on key macroeconomic variables: GDP, Balance of Payments, government revenue and expenditure and the money supply. According to Board of InlandRevenuefigures,alreadynaturalgashasreplacedoilastheleadingcontributorto Governmentrevenue.Theshareofgrossincomefromgasintotalenergysectorincome has increased from 10% in 1990 to 61% in 2002. Train 4 will push Government revenuestoanewplateau,which before long,will be matched byanequallyexplosive growthinexpenditure.ThefloodofcommentarythatfollowedtheapprovalofTrain4 demonstratesthatthereis,atleast,anawarenessofthepositivestoflowfromthecoming goldenageofgas.Thereseemstobelittleconcern,however,thatovertime,volatilityin gaspricescouldcreateevenmoreacutedislocationinthefiscalbalancethanoil.

The second reason for the spotlight on gas prices is the widely reported standoff betweenTrinidadandTobagoandJamaicaonthepriceofLNGtoJamaica.Theparties

are faced with a major challenge of pricing natural gas in an environment in which competitivemarketforcesareabsent.

The third factor is the plea from some quartersfor greatertransparency in gas pricing which they believe can be achieved through an unbundling of NGCs pipeline and merchantbusinessandtheliberalizationofthegasmarket.

Thisessayattemptstofillsomegapsintheknowledge,therebyenrichingunderstanding ofthe variablethatwould bea major influenceonoureconomic fortunes.Itdescribes variousgaspricingmodelsinuseathomeandabroad,examinestherelationshipbetween gaspricesinmajormarketsandthoseinT&T,anddistillssomeimplicationsforpolicy. First, what are the distinguishing aspects of price determination in the gas market comparedwithoil?

An important facet of the gas market is that there is no international price of gas. Whereasanydiscourseonglobalornationaleconomicoutlookwouldinvariablymention 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 consumingmarkets,NorthAmerica,WesternEuropeandAsia.Withthistypeofmarket distribution , gas is in competition only with regional energy references. Thus, a gas priceofUS$10.00intheUSAhasnodirecteffectongaspricesinJapan.Unlikeoil, the supply of gas is relatively rigid and cannot respond very quickly to price and other stimuliingeographicallydistinctmarkets.

Severalfactorsinfluencethemethodofgaspricingusedinanyparticularmarket.These include available reserves, number of producers, production costs, distribution infrastructure, number of consumers, market size, structure and maturity and end use,

costofcompetingfuels.Gaspriceregimesvaryacrossregionsandindustry,butperhaps canbeclassifiedintofourmaingroups:OpenMarket,Indexation,Netback(Valueminus) andCostPlus.Hybridsoftwoormoreofthesearchetypesoftenexist.

An Open Market regime is typically associated with markets in which there is uninhibitedgasongascompetition.Whileanumberofcountrieshavelaunchedmarket liberalizationefforts,theNorthAmericanandBritishmarketsaretheonlyoneinwhich opencompetitionexists.Thesemarketsarecharacterizedbyfreecompetitionforsupply, based on mandatory non discriminatory open access to the pipeline infrastructure, the unbundlingofgascommoditysupplyandtradingfromtransportationandotherservices and removal of price controls, at least at the wholesale level. The market forces of supplyanddemanddeterminethepriceofgas.Conditionsofnearperfectcompetition 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 can dictate the price. The open marketregimeisaverydynamicenvironmentablysupportedbyonlineinformationanda clearly defined regulatory policy and institutional framework HenryHub HenryHubisamajorgas collectionandinterconnection facilityinSouthernLouisianaUS. HenryHubisownedandoperated bySabinePipelineLLC,whichis awhollyownedsubsidiaryof ChevronTexaco. TheHenryHubisphysically locatedatSabinesHenryGas ProcessingPlantinLouisiana. TheHenryHubinterconnects nineinterstateandfourintrastate pipelinesCollectivelythese pipelinesintheNorthEast,South EastandMidWeststates.Henry Hubaccommodates1.8bcfd. 3 TheUSmarketisperhapstheworldsbestexample of open market pricing at work. Gas wholesale prices are referenced to Henry Hub, the interconnectionpointforthirteen13majorUSinter andintrastatepipelines.Since1990,theNewYork MercantileExchange(NYMEX)hasadoptedHenry Hub as the benchmark point for gas trading. Marketersandtradersthereforepurchasewholesale supplies, for immediate or future delivery, on the basis of on line Henry Hub prices quoted on NYMEX. Wellhead prices are usually lower than Federal Energy

Regulatory Commission FERC in the USA, and OFGASintheUK.

HenryHub,reflectingthecostoftransportationtotheHub. ThepricepaidbythefinalcustomersintheUSmarketvariesacrossstatesandsectors., reflecting differential cost of service to get the gas to the customers plant gate. This includescostsoftransportationandstoragebothofwhicharetightlyregulatedbyFERC. Forexample,customerinBostoncouldbepayingasmuchas$5.00perMMbtuwhenthe 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 competingfuels.

AlternativeFuelIndexationisthemostcommonformofgaspricinginmarketsoutside ofNorthAmerica.Underthisregimethegaspriceiscomprisedoftwoelementsabase price and an indexation formula. The gas price is typically set at a level that is competitivewiththemarketsalternativefueloptions.Inmostinstancestheindexation formula ties the price of gas to a basket of alternate fuel pricesfuel oils, light oils and coal. The archetypal price formula is in the form: P= Po +.8(CoC1). Under such formulas,thepriceofgastendstofollowthatofcrudeoilwithalag.Forexampleover the firstsix monthsof2003,theaverageEuropean bordernaturalgaspriceappreciated by42percentcomparedwiththeperviousyearmirroringtheyearonyearincreaseinoil prices.EuropeanbenchmarkpricesarequotedontheInternationalPetroleumExchange. However, the spot market for natural gas in Europe remains undeveloped. Most European sales are made under longterm contracts that feature take or pay and price indexationclausestomitigaterisksofsellerandbuyer,respectively.

Netbackpricingisamechanismthatsharestheendmarketvalueofgaswithallparties in the value chain. The netback pricing formula is a common feature of most LNG contracts.Thewellheadvalueofgasistheresidualamountaftersubtractingfrommarket valuethecostofliquefaction,transportationandstorageandregasification.Themarket valuemaybedeterminedbyeithertheindexationformulaasinthecaseofALNGsales

toSpainorbyopen marketforces(USA).InJapan,theworlds largestLNGimporter, pricesarelinkedtopricesofabasketofcrudesimportedintoJapan.

The fourthbroadclassification,CostPluspricing,istypically associatedwith markets characterized by small size, skewed distribution of supply and or demand, geographicallyremotefrom majorconsumingcentersandorinrelatively early stageof 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 producerandthestateordirectlywiththeconsumer.CostPluspricingisassociatedwith the first stage of gas market development. As the market evolves towards a more competitivestructure,indexationandfullopenmarketpricingcouldemerge.

NaturalgaspricinginT&Tisahybridofthreemodelsoutlinedabove.Theexceptionis the open market model. This is partly because of the structure of the industry and its evolution.ApeculiarfeatureoftheT&Tgasmarketisthat,apartfromLNG,NGChas historicallybeenthemonopolybuyerandsellerofnaturalgas.Intheearlydays,(around 1975),Governmentnegotiatedpurchasepriceswiththethensoleproducer,Amocoand establishedsellingprices fordifferentclassesof customers.Theskeweddistributionof 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 dothey relate tothe genericclassificationsandexternalmarkets.?

LNG,nowthesinglelargestenduserofnaturalgasistheonlysectorinwhichpriceis directlylinkedwithgaspricesinmajorconsumingmarkets.BoththeFOBandwellhead pricesofALNGgasaredeterminedbynetbackpricingbaseonprevailingpricesinthe USA and Europe (Spain). In the US market, LNG is sold under different contracts throughdiversedestinationpoints.TheNetbackpricederivedfromeachregasterminal could vary by as much as US 60 cents/mmbtu. Similarly, sales to Europe are also reportedtohavedifferentnetbackpricingbasisincludinganelementofpowerpricesin

Spain.InJune2003,netbackvaluesforALNGsalesisestimatedatUS$5.41/mmbtu inBostonUSAcomparedwithUS$3.68inSpain.ThehigherUSnetbackrepresentsboth thelowerfreightcostsandrelativelyhighgaspricescomparedwithfuelpricesinEurope. This suggests that Government revenue from LNG, the bulk of which is derived from netbackvalueofthegasatwellhead,woulddependonthedistributionofsalesandthe relativepricesinthemajormarkets.

InseveralwaysthemonopsonypositionofNGCinthegasvaluechainhashadadirect bearing on the gaspricing regime outside of LNG i.e. petrochemicals, power, heavy industry,lightindustrialandcommercialandtransportation.Firstly,producer(wellhead) pricesaredeterminedthrougharmslengthnegotiationswiththeproducers.ForNGC,the objectiveistokeepitsacquisitioncostatalevelthatwouldmaintainthecompetitiveness of T&T gas industry, while granting the producer an adequate rateof return. . On the otherhandsuppliersseektomaximizereturnsonthecapitalinvested,butrecognizethat thiscannotbeachievedwithoutthemarket.Thederivedequilibriumpricedependson the bargaining strength of the respective parties and the price paid under existing contracts. The typical supply contract is of long term duration ( 1020 years) and the price is comprised of a negotiated base price plus an annual escalator to account for movementinoperatingcosts.Secondly,becauseGovernmenthaschosentousegasasa 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 pricingregimesprevailbyenduseandbysector.

The Petrochemical sector (Ammonia and Methanol) enjoys a unique variation of the indexation Product related pricing. First introduced by NGC in the early 1990s, productrelatedpricingisamechanismbywhichNGCsharesthemarketpriceriskswith the petrochemical customers by allowing the gas feedstock price to fluctuate with commodityprices.Feedstockcostsaccountfor6570percentofnondebtoperatingcosts ofapetrochemicalplant.Investorsthereforefindtherisksharingofferedbythispricing mechanism to be very attractive. The product related pricing formula sets a reference priceofgastoareferenceproductprice,basedonstandardplantoperatingeconomics..

A fixed formula then triggers increases or decreases in the price of gas to correlate movement inthepriceofgasbasedcommodities.(ammoniaand methanol).Asaresult the price of gas could range from as low as US$ 1.10 toover US$ 2.50 when product pricesexceedUS$275.tonne.Thegaspricetothepetrochemicalsectorthereforehasno directconnectionwithgaspricesinEuropeortheUS.Theupsurgeinpricesinthelatter however, has resulted in many petrochemical producers looking to relocate production facilitiesingasrichlocations,includingT&TQatar,EquatorialGuinea,wherepricesare lowerandnotsubjectedtofluctuationofopenmarkets.

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 NGCspurchaseprices,comprisingabasepriceplusanannualescalator.Thebaseprice reflects NGCs acquisition cost plus the cost of service (transmission distribution and maintenance).Pricestothelargeusersaredeterminedthroughaprocessofarms length negotiations.However,forthe100plussmalluserslightindustrialandcommerciala universalgaspriceisapplied.Thecostplusapproachallowscustomers,largeandsmall, tobenefitfromsignificantdiscountsinexcessof75%comparedwiththecostofalternate fuels.

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

At least two important conclusions can be drawn. Firstly, Trinidad and Tobago has developed itsownuniquecompilationofgaspricing mechanisms.Thesystem has been heavilycriticizedonthegroundsthatthereisnounitaryoruniversalpriceofnaturalgas. However,rapidexpansionofthemarketatteststhefactthatthesemechanismshavemet therequirementsofcompetinginterests:producers,customers,centralgovernmentandits agencies.(NGC).Moreover,structural imperfectionsonthesupply side makeproposals fortheadaptationofopenmarketsystemspremature.Suchamechanismfacesmyriad

implementation risks in an oligopolistic market, including: predator pricing, transfer pricing,andlimitationstodownstreamoptions.

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 potentialfordeepswingsinGovernmentrevenuefromyeartoyear,suggestingtheneed forGovernmenttoadoptasmoothingmechanismthatwouldmitigatetheimpactofsuch fluctuations. Several options are available, including heritage fund, stabilization fund, fixedpricebudgetingoranycombination,itwouldbeinterestingtoseewhichapproach, ifany,istaken.