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investors CHRONICLE: Shell’s LNG bet looks sound despite glut

Mark Robinson

When Royal Dutch Shell (RDSB) launched its £35.6bn bid for BG Group, it was easy to appreciate the strategic rationale. At a stroke, the Anglo-Dutch energy giant not only bolstered its reserves, but also shored-up its position in a global liquefied natural gas (LNG) market which had grown rapidly since the turn of the millennium.

Shell wasn’t alone in increasing its exposure to the sector, but investors may now be questioning whether long-term prospects in gas markets warrant the massive capital allocation. A supply glut, most noticeably in the US Permian basin, weighed on gas prices last year, and there are few signs of respite as new fields in Australia and Russia come online.

The oil majors have been feeling the pinch. Exxon Mobil (US:XOM), Total SA (Sp:FP) and BP (BP.) all reported a marked fall-away in prices through the final quarter, although the impact on the bottom line will be largely determined by the extent to which their gas sales are indexed with crude oil. You certainly wouldn’t feel comfortable in the knowledge that your sales were predicated on North American Henry Hub prices.

In December, Chevron (US:CVX) announced that it would take a minimum $10bn (£7.7bn) charge to reflect a deteriorating outlook on fossil fuel prices, more than half of which related to natural gas properties in Appalachia. The average Henry Hub price registered a multi-year low through 2019, down by around a fifth on the prior year, while a recent assessment from the Federal Energy Regulatory Commission (FERC) points to major declines for US fossil fuels and nuclear power alongside strong growth in renewables over the next couple of years.

Chevron now plans to cut funding for several natural gas projects across North America in response to near-term supply-side issues, but presumably it must have factored in the rapid growth of the renewable energy complex. But has Chevron’s management acted hastily?

Although the federal agency forecasts an increasingly rapid uptake in wind- and solar-powered technologies, it also predicts a large increase in natural gas capacity. The implication is that a rising proportion of renewable energy sources within the US energy mix will come at the expense of thermal coal and oil volumes, rather than gas.

This certainly chimes with the experience of energy markets in Western Europe, although it could be argued that the transition there was aided by the move away from crude oil indexation in favour of hub pricing mechanisms, which take account of regular supply/demand dynamics. However, foreign buyers in markets such as the US and Europe still generally opt for long-term indexation contracts – it’s a question of predictability.

There have been parallel attempts to establish a meaningful spot price for LNG and it could be argued that Europe is becoming the global benchmark due to the liquidity of continental gas hubs and the trading opportunities that affords. A wider recourse to spot pricing would almost certainly increase the number of market participants, improving price discovery and reducing volatility.

It used to be the case that price spreads for LNG were much wider than for those of other fossil fuel commodities, but with the development of new industry infrastructure, arbitrage opportunities have reduced significantly. Through much of last year, they were effectively non-existent between the Atlantic and Pacific basins because the spread rarely exceeded the extra cost of shipping to Asia – a reflection of moribund pricing in Asia and elsewhere.

Investors won’t be encouraged by any of this, although Shell’s big bet on LNG may start to pay off sooner than some analysts expect. Internal analysis suggests that more than three-quarters of supply-side growth from liquefaction projects commissioned prior to 2015 is already online.

It still means that LNG supply will be around 50 per cent in advance of 2015 levels, although China – which accounts for 70 per cent of LNG export growth – is rapidly transitioning away from coal-fired power stations in a state-sanctioned bid to improve air quality.

The consensus seems to be that LNG supply will exceed demand for the next couple of years before the market tightens in 2022. Trading patterns certainly suggest that the big Asian buyers in the market – Japan, South Korea and China – are increasing the average duration of contracts, implying that they are less confident of securing adequate supply from the spot market.

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