by Herve Wilczynksi
The worldwide demand for liquid natural gas has been increasing steadily due to economic growth, a renewed interest in cleaner sources of energy, and declining production of indigenous natural gas in the largest demand centers. In the U.S., the anticipation of increased LNG imports has created a surge in regasification capacity; at the same time, investment costs have risen, prices have softened, and Europe is successfully competing for LNG shipments. To manage market uncertainty and mitigate risks, importers must control capital and operation costs. In addition, successful companies—eager to improve their return on assets and reduce overall financial exposure—are integrating marketing, trading and operations.
State of the market: new demands spur competition
The worldwide demand for natural gas has been growing steadily at an annual rate of almost 4 percent for 26 years. In the U. S., LNG imports almost tripled between 2002 and 2004, from 226 Bcf per year to an average of 600 Bcf. Over the next two decades, U. S. demand is expected to grow by 0.56 Tcf annually. At the same time, domestic production will continue to decline—and unconventional reserves, such as coal bed methane, will only partially offset that decline.
Thanks to technological advances, LNG is now a cost-effective solution even when natural gas reserves are far from their point of consumption. (LNG becomes more competitive than pipeline gas beyond 1,600 miles.) Moreover, LNG export is the only viable (and now economical) route for reserves that were previously deemed as “stranded,” including those in Trinidad and Tobago, West Africa, and the Northwest Shelf of Australia.
Increased demand for LNG in the U. S. is mirrored in Europe. While Asia Pacific accounts for 65 percent to 70 percent of global LNG demand today, scenarios from Booz Allen Hamilton’s global gas model project that by 2015, the combined demand from the U. S. and Europe will exceed that of Asia. Not surprisingly then, the LNG industry is experiencing a large wave of capital investment worldwide, both on the liquefaction and regasification sides. (See Figure 1.)
Although the long-term picture for LNG appears rosy, U.S. importers face a number of market challenges that threaten near- and medium-term profitability
Over-capacity of regasification: With expectations of steady growth in demand for natural gas, the industry has invested aggressively in regasification facilities. In the U. S., which currently has five facilities, more than 40 gasification terminals have been proposed and 17 of those have been approved. Most of those LNG facilities will come on line in 2012. However, inventory levels of natural gas are already at record highs, and regasification capacity utilization is forecasted to average only 60 percent.
Competition for cargoes: U. S. importers are in competition with Asian and European markets, where natural gas prices track the price of oil more closely and therefore, as long as oil prices are high, provide higher netbacks. In the U. S. over the past three years, increasing unconventional production combined with flattening growth in demand (mostly due to offshoring of industrial customers) has led to relatively soft prices for natural gas, averaging about $6.30/Mcf. This means that, contrary to practices in other markets, U. S. gas prices are no longer coupled with oil prices. As a consequence, LNG exports to the U. S. declined by 10 percent between 2004 and 2006.
Increasing landed costs: Several factors are driving higher landed costs for importers entering new supply contracts: high transportation costs due to skyrocketing oil prices; increased liquefaction project costs; and delays in completing projects. For every million metric tons of annual production, capital costs increased from about $200 million in 2000 to as much as $600 million today. The time required to build liquefaction facilities jumped from three to at least four years.
Regasification project challenges: Regasification projects are impacted by the costs of material and services, which have escalated rapidly over the past three years due to global supply constraints. In addition, political sensitivities and permitting challenges delayed or shelved a number of projects, notably Shell’s proposed project in Mare Island and Chevron projects on Coronado Island and in Baja, California.
Dynamic market structure: The pipeline and storage infrastructure necessary to transport gas from its point of production or import is rapidly developing. For example, pipeline capacity increased 50 percent from 2005 to 2006. As a result, the basis differential to Henry Hub is being altered dramatically in some regions of the U. S. (See map.)
Toward business and operational excellence
While the current U. S. market is challenging, importers can take steps to improve performance and set the stage for long-term success.
Be a great operator. In an uncertain market environment with high capital intensity, the name of the game is cost control. Managing capital projects effectively is a priority for both existing and planned assets. Existing plants require less investment, while new construction projects represent bigger bets. A recent Booz Allen study revealed that central coordination of project activity significantly improves performance, especially in larger projects. (See Figure 2.)
Central coordination enables strong project execution in many areas—best practices are more easily shared, engineering resources can be used more effectively, designs are standardized across the project, and the supply chain can be better managed. Often, central coordination requires the creation of a number of elements: internal capabilities, including fit-for-purpose project-management processes (tailored for large and small projects); a structured organization with clearly defined roles and responsibilities; and well-defined performance- and knowledge-management systems that focus on proactively managing deviations. In our experience, best practices can lead to dramatic performance improvement (e.g., cost reductions of 20 percent to 30 percent and cycle time reduction of as much as 25 percent).
Managing assets efficiently is also important because staffing, maintenance, and energy consumption can be key areas of improvement. Terminal operators and marketers can learn from other industries, such as the automotive industry, that have successfully adopted tools such as lean and Six Sigma to highlight inefficiencies and eliminate waste. Moving to predictive maintenance programs can reduce costs by 20 percent to 30 percent as well as cut forced outage rates. Similarly, we have seen lean initiatives at power plants that have cut material handling costs by 10 percent to 20 percent and at the same time reduced energy consumption by 1 percent to 2 percent. More disciplined planning and execution of outages can cut expediting costs and reduce the duration of the outages.
Be a great marketer. International competition in a commodity market creates substantial market price volatility, which can be viewed as a threat or an opportunity. Leading refiners took on the challenge when, in response to decreasing margins, they developed robust marketing and trading capabilities, allowing them to hedge risks and optimize margins, leading to an uplift of $0.50/bbl or 10 percent at typical margins.
In the LNG industry, the environment is ripe for extracting value via marketing and trading for two reasons. First, pricing arbitrage between Europe and the U.S.: Because shipping distances have curtailed worldwide liquidity of LNG, Europe and the U. S. actively compete for the gas shipped to the Atlantic basin. As demand grows in Europe, European gas prices, due to contract mechanisms, closely track oil prices. Pricing differentials between Europe and the U. S. are creating arbitrage opportunities in which companies can optimize the flow of LNG to markets with the highest netbacks.
The second reason is flexible supply contracts. Traditionally, the LNG regasification market has relied on long-term contracts. Now contracts are becoming increasingly flexible. Currently, more than 10 percent of the volume of the LNG trade is based on short-term contracts, up from 5 percent in 2000. This opens the door for increased trading activity on the spot market for cargo coming from producing countries.
Some companies have already recognized the challenge and opportunity. Phil Ribbeck, director, LNG North America for Repsol YPF, said, “If there are other markets that have incentives that are greater than the market that you’re going to with your LNG initially, why are you going to supply a guy for less money?” Repsol YPF is backing (75 percent) Canaport LNG, a project sited in Saint John, New Brunswick, Canada, with Irving Oil Ltd. (25 percent).
The super majors have a strong position in regasification. They also have sophisticated marketing and trading capabilities. However, many importers are smaller companies with less sophisticated capabilities in this space. Marketing and trading can have different objectives, ranging from correcting supply and demand imbalances to mitigating risks, to maximizing margins through make vs. buy decisions. Regardless of the strategy, the LNG business will require robust marketing and trading capabilities to secure supply, fully leverage existing assets and maximize margins.
To be successful, importers need to nurture and develop this capability. Typically, companies with assets and customers that are geographically concentrated are the best candidates for building in-house capabilities since this approach capitalizes on proprietary market information. On the other hand, companies with scattered or few assets tend to outsource to third parties with established expertise.
Today, the LNG industry is in an exciting phase, with significant uncertainties and potential. To realize the potential, companies must focus not only on managing their capital and operating costs, but also on developing a commercial mindset that goes beyond building facilities and securing supplies via long term contracts. This will position companies to reap benefits from market volatility.
Herve Wilczynski is a vice president at Booz Allen Hamilton, based in Houston. He specializes in strategy setting operation excellence and large transformations in the energy industry. His experience also includes capital project effectiveness, innovation, supply chain management and manufacturing strategy across various capital intensive industries. Contact Wilczynski at Wilczynski_herve@bah.com or (713) 203-8143.