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An extraordinary counter-cyclical build is under way in the
world's liquefied natural gas (LNG) industry. Over the last year, a
surplus has emerged and global spot prices for both gas and LNG
have more than halved. Aside from the usual disclaimers about
market uncertainties, the current market weakness is widely
expected to continue in 2020 and possibly beyond.
Yet producers are not deterred. On the contrary, they are
showing a willingness, indeed a determination, to look beyond the
present cycle and invest for the future in the belief that the
long-term demand for their product is growing and robust. The year
2019 set a new high-water mark for the volume of global LNG
capacity reaching final investment decision (FID). A further
substantial tranche is expected in 2020.
For those who decry short-termism in business decisions, this
should be welcomed. It is unusual and striking to see companies
able to allocate big capital expenditure budgets at a time when
current earnings are under pressure and there is a focus on capital
discipline and returning money to shareholders. However, it takes
approximately four to six years to build a new LNG train from the
point of FID to the point of commercial start-up, so it is
unquestionably correct that today's market environment is of little
relevance for future projects and their returns.
Success will depend on the ability to read and ride the
cycles—both the cost cycle during construction and the price
cycle during operation. LNG is a high-capex business. Historically
LNG has been able to avoid or moderate excessive price cycles
because of a reliance on rigid long-term contracts. Investments in
LNG were only made after demand was committed through a 15- or
20-year purchasing contract. Customer demand effectively rationed
supply. This is changing as the industry commoditizes, companies
make speculative investments, and short-term trading grows.
Therefore, LNG is likely to see many of the cyclical features of
other high-capex businesses, such as refining, petrochemicals, and
oil.
The question comes to the fore: Is the counter-cyclical build a
wise strategic move to position for the future? Or is it simply
setting up the next boom and bust?
Going contract-free
In early 2018, the LNG industry was at an investment impasse.
IHS Markit put forward three pathways:
Buyers returning to the long-term contract market
An investment freeze
Sellers moving forward without long-term contracts
In the last 12 months, the investment impasse has been broken
dramatically. Buyers have partially returned. We have seen projects
move forward with traditional long-term contract backing by buyers,
most notably in Mozambique and the US (Calcasieu Pass LNG and
Cheniere Energy). Perhaps more striking is that the three largest
FIDs of the last year or so (LNG Canada, Golden Pass, and Arctic
LNG 2) have been made largely in the absence of long-term
contracts. IHS Markit has revised our supply and demand outlooks -
both upwards. However, based upon the investment boom of 2019 -
which is forecast to continue in 2020 with impending Qatari
expansion - we continue to anticipate supply outpacing demand.
Based on our expectations for FIDs until the end of 2020, our
analysis suggests that no further FIDs would be required for the
following three years in order for demand to catch up with supply.
This halt to new project investment will not happen. The momentum
and strategic drivers behind many of the world's LNG projects mean
that there will be continued investment, although at a much slower
pace. (see Figure 1).
Figure 1: Liquefaction FID forecast
The Qatari bombshell
The risk of future oversupply increased in late November 2019
following a major announcement in Qatar. Qatar currently supplies
about 77 metric tons (mt) of LNG, about 20% of global LNG. Qatar
Petroleum (QP) announced that the country will
increase—again—its LNG output target. In 2017, QP stated
that it would raise capacity from 77mt to 100mt. The following year
it raised that target to 110mt. In the November 2019 statement, the
target was further raised to 126mt, an increase of 64% by 2027 over
today. As the low-cost producer, the Qataris are apparently
undeterred by risk of cycles and oversupply; indeed, they may see a
strategic imperative to pre-empt and choke off higher-cost
competitors. It is important to recall that a self-imposed
moratorium on expansion by Qatar in 2005 was what partly enabled
Australian and US LNG to become major players.
The headline announcement of an increase in LNG capacity
investment was accompanied by a second far-reaching development. QP
announced an effective doubling of their gas resources from just
under 900 trillion cubic feet (Tcf) to 1,760 Tcf. It is mportant to
emphasize that the degree of appraisal of these reserves is
unclear, and it is not known to what extent they have been
externally certified. They may not reach the standard of certainty
to be classified as "proven reserves." Nevertheless, the reality is
that Qatar is signaling a newfound confidence and desire to expand
on a huge scale. The new target of 126mt may be just the first step
in a new drive upward. One consequence is that the cyclical global
investment is happening in reverse - in the sense that the
higher-cost projects have gone forward first, and the lower-cost
projects (including the Russian Arctic) are piling in later.
Building demand
One possible positive scenario is that the producers will use
the time that they have between project FID and project start-up to
"build demand," by which we mean investments downstream including
regasification, bunkering, and power generation. However, the
experience to date of forward integration has produced limited and
disappointing results, despite efforts by leading international oil
companies. The large growth in LNG demand in recent years was a
policy-driven demand shift in China, which led to exceptional
buying from Chinese importers. This unexpected or exogenous factor
was much more significant than the results of downstream
investments by the industry across Southeast Asia, for example. On
the assumption that demand cannot be firmed up more quickly, it
appears that the industry could be set for a second cycle, with
surplus capacity emerging around 2025.
This second cycle of surplus capacity will be different from the
current one. In the first oversupply period of 2019-20, it is
primarily the off-takers/buyers who are exposed. In the second
cycle, increasingly it will be the producers who face any exposure.
This shift in exposure should be seen as normal in the transition
to a commoditized market.
How will the market balance?
As traditional long-term contracts play a less important role
and as buyers assume less volume risk, the LNG market will need to
find a new mechanism for balancing supply and demand.
With most commodities, storage plays a fundamental role in
matching supply and demand. For LNG and gas more generally, storage
post-liquefaction is in relatively short supply and at high
cost.
In practice, the global LNG market is balancing seasonality in
Europe, using European gas storage and coal-to-gas switching in the
power sector. However, surplus LNG capacity will be difficult to
place fully in the European market. IHS Markit continues to believe
that during periods of trough demand, the highest cost or most
flexible supply may be forced to ramp down. We have already seen
several sell-side tenders cancelled because of low prices. A large
proportion of this swing capacity is likely to be located in the
United States, because of its ability to arbitrage sales between
the large US gas market and the international LNG market. But other
plants around the world may also have a swing role, such as the
coal-seam gas projects in Eastern Australia and aging depreciated
plants with declining upstream gas reserves such as those in
Indonesia.
Therefore IHS Markit is expecting swing supply to become a new
feature of the market. It is the logical outcome of the shift away
from relatively rigid long-term contracts with high take-or-pay
obligations to projects without any underlying long-term
commitments. And cycles look set to be a structural feature of the
industry.
Michael Stoppard is a Chief Strategist for Global Gas at
IHS Markit and vice chairman for CERAWeek.