Opportunities in the Tightening Gas Market
Daniel Yergin and Michael Stoppard wrote recently in “The Next Prize” about an emerging natural gas shortage in the United States and the growing dependence of gas-consuming countries on a small number of gas producers much as exists currently with oil. The tightening gas market in the US has set off a flurry of development of new terminals for regasifying natural gas that is shipped to the US in large tankers in liquid form. A panel at the Chadbourne conference in June talked about the ramifications for the US power industry — most independent power plants built in the 1990’s run on natural gas — and for participants in the project finance market, many of whom are hoping for opportunities to finance LNG terminals.
The speakers are David Hauser, group vice president and chief financial officer of Duke Energy, John Holcomb, vice president of Pace Global Energy Services, Alycia Lyons Goody, vice president and managing counsel of Calpine Corporation, Steven S. Greenwald, managing director of Credit Suisse First Boston, Robert Drumheller, vice president for finance of the Overseas Private Investment Corporation, Leocadia I. Zak, general counsel of the US Trade Development Agency, Noam Ayali, a partner in the Chadbourne Washington office, and Christopher D. Seiple, director for global power at Cambridge Energy Research Associates. The moderator is Kenneth Hansen, a partner at Chadbourne and a former economics professor and former general counsel of the US Export-Import Bank.
MR. HANSEN: Prices for natural gas today are roughly 20 times higher than in the 1970’s when gas prices remained regulated. There are predictions they could rise to 30 times that, although there may be limits on how high prices can go, at least in the longer term. Escalating prices are a sign of an emerging shortage. The experts predict a continuing tightening in the supply over time in the United States. At the same time, there is excess supply in Europe.
If even half of the LNG regasification projects that are proposed for the United States were actually built, we would be in an overbuild situation like we went through recently with merchant power plants. In the 1970s, four LNG terminals were built in the US and, in due course, all of them were mothballed for lack of need. It is hard to believe that would happen again, but it sets the stage for some of the issues this panel will explore today. The first question is for David Hauser. From your vantage point at Duke, is it your expectation that the experts are right — we face a long-term tightening of gas supply in the United States?
MR. HAUSER: We see demand continuing to increase. Duke has two pipelines heading up into the northeast from the Gulf. One is Texas Eastern that heads up to the area around New York City, and the other is Algonquin that goes up toward the Boston area. Texas Eastern had nine of its 10 heaviest days ever last winter in terms of traffic, and Algonquin had seven of its 10 heaviest days ever last winter. Demand on both pipelines is continuing to rise. Part of that is due to weather. Part is due to generation from power plants in the northeast. The trend is up. We see more demand for infrastructure in the region and, as a consequence, we are very interested in the LNG business.
MR. HANSEN: So you see a tightening of the market coming from the demand side. How about the ability of the domestic supply side to respond?
MR. HAUSER: Supplies from the Gulf will begin soon to taper off. New LNG terminals are a way to add to supply. We think the Gulf area is a logical home for such terminals for two reasons. The infrastructure for them is already in place; you have pipelines in place that are ready to move the gas away from the Gulf to the northeast and Florida. Environmental issues are less of an obstacle because the area already has a fair amount of visual pollution associated with derricks and similar equipment.
MR. HANSEN: John Holcomb, any thoughts about the ability of domestic capacity to respond on the supply side?
MR. HOLCOMB: North American gas production will start to decline in a few years. One wild card is the Rocky Mountains, but the problem with looking to the Rocky Mountains for supply is access. Pipelines would have to be built to move the gas to market. Nevertheless, they could help fill the supply gap in the medium term.
Large Gas Users
MR. HANSEN: Alycia Goody, how does a company with a big fleet of gas-fired power projects deal with the coming shortage?
MS. GOODY: We have seen an increase in demand and, for us, that translates into an increase in pricing. We were expecting $6 gas in the first quarter of 2004. Last year, I think our average cost was $5.50 and, in 2002, it was $3. So we have seen an increase in price and, for us, that has an effect on our spread.
We do have a large fleet, as you mentioned, of gas-fired plants. We have 88 plants in all. Of those, I am guessing that 68 or 70 are gas-fired and, of our 24,000 megawatts of supply of electricity, I suspect 21,000 of that is gas-fired. Gas prices are a big issue for us.
Fortunately, we have 800 bcf of proven reserves that we own. We put some of the reserves recently into a natural gas trust in which we retain a 25% ownership interest. Our reserves represent roughly 20% of our gas requirements.
That still leaves a large amount of gas that we have to buy. Calpine operates on a system-wide basis for both fuel and electricity. It gives us more flexibility. For example, when selling electricity, we do not do it on a unit contingent basis, but rather we trade around our assets, dispatch the most economic plants first, shut down plants that are not economic, sell the gas that we have from those plants, and purchase power in the market, if necessary, as cover. We can avoid imbalance charges by using system planning for our gas supplies, as well. I think this gives Calpine an advantage.
That is how we operate currently. We are constantly looking for ways to improve operational efficiency and to improve our technology. We are looking at LNG as an option. We were involved in an LNG project in California, but withdrew due to local opposition. We are investigating possibilities in the Alaskan north slope. We have the supplies we need for now. We are doing prudent planning for the longer term.
MR. HANSEN: So your focus is on managing the source of supply rather than on changing the composition of your demand from gas to other fuels?
MS. GOODY: Yes. In fact, at a recent meeting, the Calpine board took the unusual step of committing not to invest in any baseload power production facilities. What we want to do is restrict our investments to facilities whose emissions are low or lower than the most efficient combined-cycle power plant.
MR. HANSEN: So you will be going heavily into nuclear? [Laughter.]
MS. GOODY: I don’t think that’s what the board had in mind.
MR. HANSEN: More seriously, if there are sustained high gas prices for a substantial period, then one would expect a shift on the demand side into fuels other than gas — coal, nuclear, renewables. David Hauser, is this occurring at Duke?
MR. HAUSER: Our regulated utility is big in nuclear and coal, and it has some gas and hydro. We just joined a consortium to look at nuclear. If you had asked me five years ago whether another nuclear power plant would be built in my lifetime, I would have said, “No way.” But the world is changing. There is a very real possibility we will see construction of new nuclear power plants within the next 10 years.
The challenge with coal is that the price of it is also going up dramatically. The chemical factory you have to put on the back of a coal plant is incredibly expensive. Some new coal plants will be built. The truth is it will take a mix of all the fuels you mentioned to supply the electricity this country needs. The news media tend to focus on one thing at a time. The talk this past year has been about nuclear power. Before that, we were focused on coal and, before that, it was natural gas. You need all of them because each will have its moment of supply disruption and spiraling prices.
MR. HANSEN: My guess is there are not a lot of new projects being developed this week, but the overcapacity in electricity generation will pass.
MR. HOLCOMB: If consumers start thinking that $6 gas is here to stay for the long term, then they will start looking at other options. The options include moving factories to other countries. Look at US aluminum companies that are looking at building their new smelters in other countries. You will start to see the same thing on the power generation side.
MR. HANSEN: Any change in the market gives rise to opportunities. Steve Greenwald, what do you see as the business opportunities coming out of the circumstances in the gas market?
MR. GREENWALD: In terms of financing opportunities for people in this room, I think they are fairly limited because the super majors are doing most of their financing on balance sheets.
Taking regasification terminals first, let us say six or seven of them are built. Shell will not use project financing. Neither will Exxon. Chevron will not use project financing. I see few opportunities in the regasification area for classic project financing. A few will be done that way, but very few.
If you move away from regasification, many upstream deals are being project financed in one way or another. All the Qatari deals appear ripe for project financing. Qatar Petroleum has about a $20 billion plus capital expenditure program over the next four or five years. Qatargas 2 is being project financed. The company has announced that a regasification terminal in the UK will be project financed. The project is at least a year away from financing. Rasgas 2 will be project financed. Rasgas 2 is five times the size of the deals that have been done to date, so the numbers are just staggering. Many of these deals are going ahead without the kind of offtake contracts that we are used to seeing. What happens is a super major takes the price risk. Qatargas 3 will attempt a financing into Henry Hub with price risk here in the US. It is the same thing with the UK deal with Qatargas 2 where the price risk will be on the lenders. Rasgas 2 will be moved from Exxon Mobil’s account and financed into the US.
The bottom line is there will be opportunities on the upstream side, but I see much more limited opportunity on regasification.
MR. HANSEN: David Hauser — opportunities?
MR. HAUSER: Another opportunity is in financing shipping capacity. The LNG tanker fleet will have to expand significantly in order to bring all the liquefied natural gas from overseas to the US. Those tankers are expensive. They run upwards of $200 million a ship. There are not many shipyards that can construct them.
MR. HANSEN: Robert Drumheller?
MR. DRUMHELLER: Let me supplement what Steve Greenwald said. I am Rob Drumheller from the Overseas Private Investment Corporation. In the last couple months, a number of project developers have talked to us about financing for projects in countries in which financing is historically a little bit more difficult to arrange. OPIC is open in 156 countries; Qatar unfortunately is not one of them, but I think we may be open in Qatar by the end of the year.
We have had several people talk to us about some of the projects that Steve Greenwald mentioned. We have also had conversations recently about a potential project involving Repsol in South America. Repsol has gas in Bolivia and is looking at a possible liquefaction project in Chile. It will pipe gas to the coast and then deliver it to the western US coast.
We have had two people talk to us about projects in Africa. One is in Angola and would involve most of the upstream producers there — Exxon, Chevron, people like that. One is a British Gas project in Ecuador. British Gas has an offtake contract for the gas and has plans to bring it to the United States.
All of this has happened in just the last eight to 10 months. After seeing no liquefaction projects for several years, there is clearly growing interest in developing such projects and doing so in a range of markets in addition to the huge number of LNG projects that are in Qatar.
MR. HANSEN: Thank you. Robert is head of structured finance at OPIC. We also have the general counsel here from a sibling agency of OPIC — the US Trade Development Agency. Lee Zak, what are you seeing by way of interest in such projects?
MS. ZAK: We are seeing the same thing that OPIC is seeing, only we are a little farther forward on the front line. What our agency does is provide grant assistance in connection with project planning, so we have been spending time on gas projects for at least the past year if not longer. We are seeing an interest not only in liquefaction projects, but also in pipelines all around the world. Receiving terminals are needed in Asia to handle all the Qatari gas. There are opportunities in this hemisphere in Trinidad and Tobago for pipelines and terminals to supply gas to the US market.
MR. HANSEN: Bringing the focus back to the US, the Asian and European markets are characterized by long-term contracts against which one can lend or in which one can take a security interest. The US has been a short-term spot market kind of place in which the financiers don’t have the same sort of assurance going in that the debt can be repaid. One could infer that might be one reason why the major oil companies have to make this happen. Anyone else trying to raise financing for a regasification terminal will not be able to do it. My question to you, Steve Greenwald, is whether that is right? How would anybody else — if he cannot do it entirely with equity — get such a project in the US financed?
MR. GREENWALD: It comes down to what the bankers believe is the breakeven price. I heard numbers today for a delivered price in the US of $4 for gas from Qatar. I suspect most banks will be unwilling to assume that gas will always be at $4 or above. That number probably includes a reasonable return on the equity. Therefore, if you take out that return on equity and focus on what is available to amortize the debt and pay interest on it, the number is lower. I don’t know how far down it goes, I have heard numbers at three to three-and-a-half dollars on a cash breakeven basis including debt service.
I question how many banks are going to lend against three or three-and-a-half dollar gas. Memories are a bit long these days. It was not so long ago that gas was selling in the US for less than $3. What will be interesting, at the end of the day, is the extent to which the super majors will be willing to take some of the price risk off the table.
Exxon Mobil took $200 million of price risk off the table when it did the Rasgas 2 financing. That goes back seven or eight years. The export credit agencies are looking at the Qatargas 2 project with Exxon Mobil into the UK. It raises the same question about price risk. Conoco will face the same issue with Qatargas 3. I know that we would not lend against three-and-a-half dollar gas, but it will be interesting to see at what number the financing can be done and how the price risk is shared among the parties.
MR. HANSEN: John Holcomb, back to you. Going overseas again, there are rumors of a European gas bubble. Is that a passing phenomenon, or more broadly, what do you foresee in Europe and Asia — a shortage like that here or an excess supply situation?
MR. HOLCOMB: I do not expect the European gas bubble to last very long. At the same time, you have Russia with the ability to serve the entire market. Moving to Asia, demand for gas in China is increasing so rapidly that it is driving world prices. China will continue to be a very intensive energy user.
MR. HANSEN: On the supply side, there has been speculation about the possibility of a gas version of OPEC. Noam Ayali, do you want to say anything about the prospects for a gas OPEC?
A Gas OPEC?
MR. AYALI: I am not sure what acronym will end up being used, but it is clearly no longer mere speculation. The organization is in the works. There have been meetings recently in Cairo. To me, the interesting question is whether the predictions that people are making about future gas prices have adequately taken this possibility into account. A gas exporting country organization could try to establish a price range for gas — both through a floor and a cap — to ensure that LNG liquefaction plants are economical. It is a wild card.
MR. HANSEN: Chris Seiple, what assumption is Cambridge Energy Research Associates making about cartelization of the supply side?
MR. SEIPLE: We do not see a GOPEC playing a substantial role in the global natural gas business as OPEC plays in the oil business. In part, that’s because many of the main oil suppliers are concentrated in the Middle East. Although many of the same countries are also large gas suppliers, so is Australia. It is not clear that the interests of the large gas suppliers line up in the same way as those of oil producing countries.
The second factor is the Middle East is the low-cost supplier of oil. In the LNG business, given many of the places where supplies will be moving, the Middle East is more likely to be the high-cost producer. That creates a slightly different dynamic in terms of the ability of the Middle Eastern countries to influence prices.
All of that said, one should not lose sight of the fact that some of the countries where the larger LNG projects are being developed are politically unstable. The risk is not so much that we will see a GOPEC able to control prices, but that political turmoil will disrupt the supply of LNG to the gas-consuming countries. This suggests strongly that US policy should be to develop a diversified portfolio of supply and not to rely too heavily on just a handful of jurisdictions.
MR. HANSEN: Here is an in-the-spirit-of-times-of-terrorism question. After September 11, the Boston harbor was closed for quite a while to LNG tankers. There have been rumors that Algerians, in particular, have been stowing away on such tankers as a way to gain entry into the US. Steve Greenwald, do you see the risk of terrorism as a factor that could impede financing of these projects?
MR. GREENWALD: I do not think the threat of terrorism, per se, would affect the financing of a regasification terminal in the US. Such a threat could have an indirect effect by making it harder to get permits for a project. Two years ago, there was a financing in connection with the British Gas contract at the Lake Charles refinery. Terrorism was obviously on everyone’s mind at the time, and yet the financing was done. I believe it was December 2001. The big issue was the ability to buy insurance. As long as insurance can be purchased, terrorism should not be a problem. Permitting will be the biggest issue.
On the upstream or liquefaction side, only in extreme cases do I see terrorism as a major concern.
MR. HANSEN: This is the last question, and it is for the whole panel. Politicians talk from time to time about energy independence. Should the United States make energy independence a goal?
MR. HAUSER: Energy independence is something at which Duke looks, but we do not believe it is real world. We are trying for now to figure out how to make the LNG business work. It will help bring additional supplies to the US market.
MS. GOODY: I would echo what David just said. It is something at which Calpine looks, but I question whether it is a realistic goal within our lifetimes.
You said something earlier about the heyday of natural gas-fired power plants having passed. We may be at the nadir of the heyday. I suspect that the obituary is being written prematurely. There will always be room for natural gas-fired power plants. When I started some years ago in the energy industry, nuclear power was the answer; it was going to be too cheap to meter, and we see where it has gotten us. I grew up with Seabrook. Nuclear may have a future, but terrorism and waste management are issues with it. Coal certainly is an important part of the US energy portfolio, but emissions are a problem and new coal sources will be an issue. There will still be room for natural gas in the mix.
MR. HANSEN: Any comments from the floor?
MR. SEIPLE: I have two points. First, an interesting trend over the last 20 years has been the convergence of generation technology costs. It now costs approximately the same thing to build a coal facility, a wind facility, a nuclear facility, and a gas-fired power plant. The specifics differ from region to region, but it is approximately the same, which is interesting. It makes us think that we will see greater diversification of technology as we go forward and that government policy can play a much more substantial role in tilting the balance in favor of one technology over another because it does not have to spend as much to tip the scale.
Second, on the question whether US energy independence makes sense, I think it is important to keep in mind that if a single tanker blows up somewhere in the world in the LNG business, we will be talking more firmly about energy independence. Whether we like it or not, tanker safety is a big issue. An explosion could radically change the way we look at LNG.