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As the era of increased liquefied natural gas (LNG) penetration into North America is considered more carefully, the inevitable, ubiquitous questions arise:
How much would the injection of a representative regasification facility of LNG (e.g., 750 mmcfd) depress natural gas prices in a venue like Baja California, Los Angeles, California, or anywhere on the North American continent?
What would be the price of natural gas pre- and post-LNG in and around the point of importation or injection?
After the price depression, would there be enough money to repay the LNG provider his capital and operating cost plus give him a return?
Such questions have become critically important of late. Unfortunately, some companies have used static North American gas market models, which because of their structure do not contain long run supply/depletion logic or data, to approach the question of how much price depression will accompany the introduction of LNG. The vast majority of such static models result in diametrically wrong answers. In this article, we will show:
The flaw in static models
The right models to use
The nature of the correct answer
The size of price depression
The Flaw in Static Models
Static approaches (linear programming is a static approach) represent domestic supply using only short term “wellhead deliverability” curves instead of long term domestic resource supply curves. Long term domestic supply curves are an absolutely essential prerequisite to getting the right answer regarding how much price depression the entry of LNG will cause, which is not much as we show shortly.
Users and developers of static models have wanted to believe, based on results of those “snapshot” models containing only short run deliverability curves, that the injection of significant quantities of LNG will depress North America gas prices substantially. The static “large price depression” view is not consistent with the more bearish conventional resource assessments emerging from the United States Geological Survey (“USGS”), the National Petroleum Council (“NPC”), and various presenters at the California Public Utilities Commission (“CPUC”) in San Francisco recently. Static models contain an incorrect, highly misleading structural view of the market and of the impact of LNG thereon.
The Right Models to Use
In sharp contrast to static approaches, zero arbitrage models with long-term domestic resource supply curves categorically show that the introduction of LNG into North America will cause minuscule price depression over a rather wide range of LNG injection quantities.
Let us discuss the impact of the long-term domestic resource supply curves on price and the value of LNG entry. Figure 1 graphically depicts the proper view of the North American demand and conventional natural gas resource base before the injection of any new LNG. The low cost conventional natural gas supply is limited in magnitude, as evidenced by the proximity of the supply curve to the vertical axis in Figure 1. The estimated magnitude of remaining lower cost resource has been decreasing in recent years, in significant part because recent drilling activity has been steadily less productive.
By contrast, the higher cost conventional and unconventional portion of the North American resource base is not as well articulated or as broadly considered. Because of the structural inadequacies of static models, higher cost resources often slip silently under the radar screen and are ignored in short term deliverability estimates. What does the higher cost portion of the North American resource base look like? Figure 2 summarizes using a diagram by Dr. Donald Gautier of the USGS, which holds that remaining low cost domestic resource lies at the “tip” of the pyramid and is rather limited in quantity, but the remaining high cost domestic resource lies at the “base” of the pyramid and is much larger in quantity.
The base of the pyramid in North America according to Dr. Gautier is comprised of six categories of gas:
High cost, very small field conventional gas
Western Canadian Sedimentary Basin gas (declining estimates in recent months)
Coalbed methane
Tight sands
Arctic gas from Canada and Alaska
Exotics such as coal gasification or methane hydrates
Ignoring exotic sources of gas, which virtually everyone believes are so expensive as to be entirely out of the immediate picture, what can we say about the former five categories? We know the volumes of such gas are very large but that the production cost is rather high (e.g., between $4.00-4.50/Mcf at risk free prices and risk free discount rates or perhaps higher). It is clear that there is a very wide and flat supply tranche that begins at approximately $4.00-4.50/Mcf wellhead marginal cost and does not tilt upward very rapidly over a very large volume of resource in place. Emerging resource assessments (e.g., the USGS and the NPC) would seem to support this perspective—there is elastic supply at a wellhead marginal cost of $4.00-4.50/Mcf (in real terms). If that is true, the aggregate North American supply curve for both the lower and the higher cost resource in aggregate appears exactly as shown in Figure 1—a rapidly increasing tranche followed by a higher flat tranche. While there may be debate about the size and production cost of the rapidly increasing leftmost tranche, resource assessment people agree that it is indeed limited and therefore relatively narrow. Only models that properly graft the broad, flat, high cost supply curve on the right representing high cost conventional and unconventional gas onto the narrow tranche representing the remaining low cost conventional gas can provide a realistic forecast of gas prices and the incremental impact of LNG on those prices.
The Nature of the Correct Answer
What does the narrow-low-tranche/wide-high-tranche configuration of North American supply in Figure 1 mean? What is means is that a high cost domestic source of gas will be the marginal source of supply in North America with or without LNG over a fairly wide range of uncertainty regarding the conventional resource base and over a fairly wide range of LNG imports. There is not enough domestic low cost gas for low cost gas to remain at the margin, meaning that there must be drilling for higher cost unconventional gas and that unconventional gas will set the price of all gas on the continent.
What would happen to the diagram in Figure 1 if 750 mmcfd of LNG were introduced into North America at a location such as Baja California? The answer is depicted in Figure 3. As the LNG enters, the entire supply structure from Figure 1 is displaced horizontally to the right by 750 mmcfd as shown in Figure 3. The position of the demand curve after the LNG entry in Figure 3 will be unchanged from Figure 1 because such entry does not “create customers.” The demand curve, constant both before and after the LNG entry, is the solid demand curve in Figure 3. As indicated in the diagram, the LNG tranche will be inframarginal. Once all the LNG supply chain costs are sunk, LNG regasification units are going to dispatch and are going to deliver 750 mmcfd to the market. Such deliveries will occur no matter what the domestic price (unless the domestic price falls below pure variable operating cost of the LNG supply chain, which will be a rare or nonexistent event). If built, LNG will come.
In order to compare the “without LNG” case to the “with LNG” case, we have plotted as a dotted demand curve the position of the demand curve on the original plot in Figure 1 without the entry of LNG. That is, the dotted demand curve in Figure 3 crosses in exactly the same point as the solid demand curve crossed the supply curve in Figure 1. The rightmost point in Figure 3 where the dotted demand curve crosses the supply curve is the market clearing situation in the “without LNG” market equilibrium from Figure 1, and the leftmost point where the solid demand curve crosses the supply curve is the “with LNG” market equilibrium. The difference between the two crossing points contains the sought after answer—how much does LNG depress the price of gas in the region where the LNG enters or more generally throughout North America?
The Size of Price Depression
The key insight and implication is now obvious from Figure 3. Figure 4 repeats Figure 3 but emphasizes what the market clearing price is in the absence of the LNG injection (the higher horizontal price line) and in the presence of the LNG injection (the lower horizontal price line). Notice that the two lines are virtually coincident. The difference between the market price in the “without LNG” case and the market price in the “with LNG” case is rather small. The entry of the LNG does not depress the price of gas in North America very much at all. Models that say it does are incorrect. Static models (e.g., linear programming models) dramatically overestimate the price depression from LNG entry. There is, and should be, a very small difference in the price of gas in North America with and without the LNG.
The reason for the very small price depression from rather large LNG injections is clear from Figures 3 and 4. Notice that the marginal source of supply in the “without LNG” case is a high cost source of conventional/unconventional/Arctic gas, precisely the same as the marginal source of supply in the “with LNG” case. With or without the LNG, the marginal source is going to be a high cost domestic source of gas, precisely the type of source articulated in the new resource view. Because the marginal source of gas is unchanged across a wide range of LNG capacity entry scenarios, the price that will be received by an LNG terminal will be the same across a wide range of LNG capacity entry scenarios.
Our finding that the entry of 750 mmcfd or more of LNG will not depress the price of gas at any point in North America very much is profoundly positive for LNG, much more positive than static models are projecting. As we have shown, LNG will not cannibalize itself, depressing price by virtue of its entry. LNG entry will not erode its own margins. The second and third LNG entrants see virtually identical, undepressed price and therefore make almost the same amount of money as the first LNG entrant as long as one accepts the bearish conventional resource base scenario. There is not nearly as much price depression risk attendant with LNG as many think. Introduction of significant quantities of LNG will not depress domestic prices very much.
In summary, the key issue regarding LNG is this: What is the long run marginal cost of higher cost gas in North America? The answer is unconventional gas, Arctic gas, etc. These supplies set the price of domestic gas.
For information on purchasing reprints of this article, contact Tim Tobeck ttobeck@energycentral.com. Copyright 2010 CyberTech, Inc.
The strength of your analysis lies with economics while the weakness is with the geology.
Your key assumption, that there is a long, flat supply curve beyond conventional gas, is your weakest, or is at least is undocumented and controversial. References and links would be appreciated. One wonders how Matthew Simmons of Simmons and Company or the Association for the Study of Peak Oil would rebut this assertion.
Likewise, models that forecast LNG at the receiving terminal at $5 a MMBTU assume wellhead prices that are ridiculously low relative to barrels of oil equivalent. Your analysis offers no dynamic supply curve for LNG in what looks to be a rapidly evolving, even exploding, new market. Of course you did state your premise of a single terminal with a hidden assumption that gas at the liquifaction plant is on long term, fixed price contract.
With all that criticism, I still believe your result - a single or a few LNG terminals will not crash the price of natural gas at the point of end use. While good news for the project participants, why should public decision makers endorse LNG if it offers little price relief to the public?
Dale Nesbitt 6.14.04
The geology is not particularly controversial, uncertain, or disputable, nor is it undocumented. I would refer you to the series of United States Geological Survey national resource assessments and all the updates that have been made. Those estimates are extremely well documented, published, and distributed. (The USGS has estimated that there are 5000 Tcf of gas in the tight sands formations in the Green River Basin alone. The critical question is not the volume but rather the sustained wellhead price relative to the production cost of that gas, which indeed is uncertain. In short, there is little uncertainty that there is a long, flat supply curve in North America. There is major uncertainty in how high the production cost is, i.e., how high that flat curve is above the horizontal axis.) The authors would refer you to the recent National Petroleum Council report, which articulates well over 1000 Tcf of natural gas available (technically) to be produced in North America.
Not articulated in the paper is the fact that the authors have built and operated a world gas model that enumerates every existing and prospective resource basin in the world, every existing and prospective pipeline and LNG supply chain, and every existing and prospective demand region and segment in the world. We are confident of our resource, LNG supply chain, and cost information, and we are confident of the long run marginal costs of LNG implicit in the article. The statement about a single terminal to which you refer is surficially correct. However, a single terminal is included so as to simplify the discussion and obviate a broader international and North American LNG source discussion. The argument generalizes to multiple terminals at multiple locations.
Implicit in the final statement is why policy can go so wrong. By analogy to your comment about LNG, if nuclear power plants do not change the price of power (after all, they do not change the marginal power plant very much), why should public decision makers allow nuclear power plants to be built at all? Why should public decision makers allow Alaskan oil to be drilled? After all, oil price is set on world markets, and Alaskan oil wont change the price. Why should public decision makers allow new semiconductor fab lines to be built? After all, each new fab line does not affect price. Farms in Salinas do not decrease the price of lettuce; why should public policy makers let them persiste? The answer in all cases (including LNG) is this: Producer profits (producer surplus) is every bit as contributive to economic efficiency and overall economic benefits as low prices to consumers (consumer surplus). Low prices are NOT and should NOT be the sole and intrinsic goal of public policy. Low prices are not intrinsically good. GNP is the sum of producers plus consumers surplus. To disallow producer profits is to constrain the United State to a lower GDP growth path. Public policy makers allow profitable facilities and industry profits to augment national wealth and income.
Joseph Somsel 6.16.04
Dr. Nesbitt,
The USGS study certainly carries the imprimatur of the US government but it is a mischaracterization to imply that it is not controversial. Criticism I’ve read focuses on both the concepts used in estimating future deliverability and on the logical inconsistencies contained within its predictions. I’m not ready to believe the most pessimistic predictions either but the critics have cast substantial doubts on the USGS’ optimism.
For example, the California Energy Commission recently forecast a need for Pacific Gas Transmission to increase pipeline capacity from Alberta into California by 2013. (I believe they used the NARG model.) Yet, the Alberta provincial government just released data (I’m told) showing that gas production declined 2.9% in 2003 in spite of 46% more wells being completed. Even allowing for production delays for new wells, depletion looks like a real phenomenon not yet properly accounted for in most general models.
The debate over predictions of natural gas supplies is worthy of a separate set of articles. As to LNG terminals and economics, requesting the approval of one’s permit application will be so much easier to justify it one can demonstrate a measurable public good would result. Simply predicting that a proposed LNG terminal will neither suffer a loss for its owners nor will it lower gas prices to the public won’t buy you much in the legitimate public debate over permits. Personally, I don’t see how California can avoid importing LNG but overcoming the objections of the NIMBYs will require stronger arguments.
Rodney Adams 6.16.04
Dr. Nesbitt:
As a long time Chesapeake Bay sailor, I take a little historical issue with the following assumption from your article:
If built, LNG will come.
The Cove Point LNG terminal was constructed before I entered college in Annapolis in the late 1970s. If I am not mistaken, it is still not accepting regular shipments, more than 25 years later.
History indicates that there is a significant probability that sunk costs in LNG infrastructure will not result in physical gas shipments.
Rod Adams
Dale Nesbitt 6.17.04
Mr. Adams:
Where LNG is concerned, we have not made the argument:: “If we build it, they will come.” On the contrary, if we look at real North American gas prices from 1970 to the present during the time you have floated on the Chesapeake (i.e., the cost of the marginal source of gas), there was a brief era during which gas price was above the full incremental cost of LNG (namely the late 1970s and early 1980s). During that rather brief period of time, there was a flurry of interest in LNG, and Cove Point, Elba Island, and Lake Charles germinated or partially germinated (as was the case with Cove Point). Thereafter, gas prices fell chronically below the incremental cost of LNG (even below the completion and commissioning cost of facilities such as Cove Point), where they remained until approximately the turn of the century. Keep in mind, oil price fell to $11 per barrel in 1998 and gas price was in the low $2 range. No one would have dedicated investment or dedicated LNG cargoes to that type of a market, and consequently during that time you did not have to dodge LNG tankers while you floated around on the Chesapeake.
Geologists (e.g., USGS, NPC) perceive the world of abundant low marginal cost domestic gas (which is the world that kept the LNG tankers off the Chesapeake) has passed and that North America faces dwindling availability of low marginal cost gas. To be clear, I am not saying “dwindling availability of gas.” I am saying “dwindling availability of low marginal cost gas,” i.e., dwindling availability of gas in large, concentrated, low cost deposits. This is one of the key findings of the NPC upstream groups as I observed it. It is this new world of higher marginal cost domestic gas that draws LNG in, and as it does so the price of gas sits at its new, higher level and doesn’t budge as more LNG comes in. Your precis of history is a correct one and reflects the geology and economics of the past three decades in North America. The issue is how and whether that geology has changed by virtue of depleting 20 Tcf per year times 30 years with 10 years proved reserves left to go.
You might want to get a darn good radar set for your boat, and keep your eyes peeled! If the maritime traffic gets too heavy, you might want to switch to Orioles games on weekends. Best of luck, and enjoy yourself.
