Tuesday, March 27, 2012

Chilling Jitters: Should the U.S. Export Natural Gas?

In an energy landscape full of oddities, U.S. producers salivating at the prospect being able to export natural gas at European or Asian prices is the latest. A supply glut along with record low natural gas prices domestically have led at least three U.S. liquefied natural gas (LNG) terminals – Sabine Pass, Freeport and Lake Charles – to apply for export licenses. Several others are in various stages of doing so. It has given rise to a national debate over the impact of exports with at least one lawmaker proposing to ban exports of natural gas from the U.S. (Under the Natural Gas Act of 1938 any import or export of natural gas requires approval by the Department of Energy.)

Attempts to control exports by major producers of commodities are nothing new. Motivations can vary from using the country’s chokehold on production as a tool of foreign policy to avoiding price spikes for its consumers. India cited the need to keep prices down for its cotton mills as the reason for its recent cotton export ban (since revoked); in 2010, China imposed restrictions on the export of rare earths, ostensibly, to protect the environment (critics say it was a retaliatory move against Japan, the largest importer of rare earths, in a territorial dispute).

Two major concerns driving the domestic debate over LNG exports are natural gas price volatility and the convergence of U.S. and global natural gas prices, which happen to be much higher.

The fear that LNG exports could bring about increased natural gas price volatility stems from not recognizing the difference between short- and long-term price elasticities of natural gas. Demand for natural gas, and generally energy, is inelastic in the short run but significantly more elastic in the long run. An implication of short-term demand inelasticity is that prices soar quickly when faced with seasonal demand fluctuations, supply disruptions, or any storage operation interruptions. When supply is unable to keep pace with a sudden rise in demand, prices spike. Almost all the high price volatility periods between 2000 and 2008 were due to the vagaries of the weather: winter 2000-2001 (extremely cold winter and record low storage levels), winter 2003 (extremely cold winter), and fall 2005 (busiest hurricane season on record).

By contrast, when changes in supply or demand are planned or well-anticipated, consumption patterns adjust, alternatives are found and new supplies are brought online with far less economic disruptions. LNG export terminals are likely to increase natural gas demand only gradually and in known quantities. This is because they are long-term projects that require careful planning and permitting over a number of years before they are able to export the first cubic foot of gas. By affording supply capacities ample time to develop, additional demand from the LNG export terminals will avoid supply and demand mismatches, the main cause of price volatility.

The convergence of U.S. and global natural gas prices, similarly, is unlikely to materialize as a result of LNG exports alone. The three LNG terminals, together, will be able to export some 6 billion cubic feet per day by 2016, less than 10% of total U.S. demand in 2011. By 2035, assuming LNG is exported at the maximum permitted level, they will have generated an additional demand of about 53 trillion cubic feet (tcf). This will shift the equilibrium (point at which the demand and supply curves meet) slightly to the right. But because the supply curve is relatively flatter in the middle (the U.S. is projected to consume just over 600 tcf between 2012 and 2035), this slight rightward shift of the demand curve will have a muted incremental impact on the price of natural gas. The U.S. Energy Information Administration projects an impact of between 10-14% on wellhead prices. Deloitte Center for Energy Solutions, a consulting firm, estimates lower impacts on citygate prices at between 5 and 22 cents per MMBtu (1-3%) between 2016 and 2035.

In theory unlimited exports can cause U.S. natural gas prices to approach European and Asian levels. But for such price parity to hold liquefaction, shipping and regasification costs have to be negligible. This is hardly the case. Unlike oil, natural gas is not a fungible globally traded commodity precisely because transporting it is very expensive – it costs between $4 and $5/MMBtu to deliver U.S. natural gas in Europe. In other words, natural gas prices in export markets must be at least $5/MMBtu higher than U.S. prices for LNG exports to be economic.

There are additional reasons to think that U.S. natural gas, while abundant, may struggle to compete in international gas markets. The link between natural gas and oil prices in Asia, and, to a lesser degree, in Europe, a major reason for higher prices in those markets, is slowly beginning to fray. As natural gas is increasingly priced independently of oil the gap between U.S. and global natural gas prices, a key motivation for U.S. LNG exports, will narrow. Furthermore, unlike international LNG export projects, which are usually standalone terminals sited where the gas is, exports from the U.S. will use existing import terminals after the addition of a liquefaction facility. As a result, they must rely on pipeline natural gas for exports. Since pipeline natural gas is dry, U.S. LNG export projects will not be able to take advantage of the naturally occurring liquids (ethane, propane and butanes) to improve project economics. These liquids, which more closely follow the price of oil, are highly profitable and have recently been trading at a significant premium (as high as $15/MMBtu above U.S. natural gas prices).

Is banning LNG exports then the right policy response? Probably not. Exports are unlikely to add to natural gas price volatility. Capacities for which export permits have been applied are too small to result in any significant long-term price impacts. And, even if unlimited exports were possible structural factors suggest that U.S. LNG exports may not be high enough to put meaningful pressure on domestic natural gas prices.

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