A spate of events in the past month has shaped the natural gas markets for years to come. These are the announcements of the supply of Russian gas via the South Stream to Europe and China domestic price initiatives.
A major energy security issue pertaining to the EU has been the supply of gas from Russia. This gas transported via pipelines transit through Ukraine and Belarus. Disputes between Russia and these countries over gas pricing and siphoning have led to temporary shut-downs/ reduction in the gas flow in 2006 & 2007 directly threatening the flow of natural gas to the west European countries.
Since then, a new pipeline the North Stream with 20 bcm/ year capacity was laid on the Baltic Sea bypassing Belarus with a first delivery in Nov 2011. Agreement for a second pipeline between Russia and Turkey, the South Stream has also been reached this week. This is expected to bypass Ukraine in transit and underlie the Black Sea transporting 63 bcm/year from 2015. For a long while, this was an impasse with Turkey with the EU-backed Nabucco pipeline in the sidelines. The Nabucco pipeline was meant to transport natural gas from the Caspian region to Europe and reduce its energy dependence on Russia.
However, Azerbaijan and Turkey have signed a gas supply and pipeline contract this week. This is to supply 16 bcm/ year of gas via the Shah Deniz fields via the Trans-Anatolia pipeline, of which 6 bcm/ year is meant for Turkey own domestic consumption. This pipeline is expected to defer the costlier Nabucco project. Further, China and Turkmenistan have signed gas supply and pipeline contracts last month to supply 65 bcm/ year through its remote Northwest. This effectively curtailed the potential supply of gas from the central Asia region to Europe.
This sequence of events has actually lifted Russia’s hand in its gas supply to Europe and shifted its dependence away from the transit countries Ukraine and Belarus. What will be the impact of these moves? Firstly, the monopoly held by Gazprom (Russian main state owned gas company) is expected to strengthen its hands in ongoing negotiations to move away from oil-indexed pricing for gas. Secondly, it will actually hasten the growth of alternative energies in western Europe and may even prompt an unthinkable re-think of the nuclear policy. A third unintended result is the reliance on Iran as the only feasible supplier on the Nabucco pipeline with the ripple effects of potential UN sanctions hanging over.
Another event is China liberalising its well head costs at gas fields and piloting a scheme to liberalise its city-gate gas prices this week. Whilst China has just recently secured a gas supply agreement with Turkmenistan, its phenomenal rate of growth in natural gas use is expected to outpace supply. By liberalising the well head costs at natural gas fields, it is encouraging domestic investment into shale gas and other unconventional gas sources. An EIA survey in 2011 has indicated that China holds probably the largest unconventional gas reserves in the world.
Its pilot scheme in Guangzhou and Guangxi pegs city gate prices to a combination of fuel oil and LPG prices (both liberalised markets in China). Presently, city gate prices are fixed atop a margin on production costs. These city gate prices apply to both domestic and imported gas. These recent measures by China are expected to increase its domestic production much as what USA did over the past 3 years. This can shift its dependence away from imports from Russia and other countries and significantly impact world gas markets. Price reforms are also expected to reduce potential future gas shortages seen in its oil markets.
Back in July 2008, oil prices slumped dramatically from the 140s to the 40s in a space of 6 months. Whilst not as dramatic, oil prices have fallen for some $20 over the past few weeks but have started to stay up this last week. With the world possibly on the cusp of a recession, it takes a little imagination to compare then and now.
What does the industry say?
With just three months before 2012, most banks have lowered their forecasts of Brent by some $10 to $110-115/bbl. Noteworthy is Citibank calling for a price drop by a further 10-20%. This time round, both the fundamental and speculative factors are at work – albeit differently.
Supply and demand driven
Both OPEC and the IEA have lowered forecasts of oil demand in the OECD countries by an estimated 300 kbbl/day. Whilst this demand is forecast to decrease, the oil demand growth in China and other developing countries is more than enough to make up for it. The growth in the developing countries is expected to reach 1.4 mb/day, topping overall growth forecasts to 1.1 mb/ day in 2011. Back in 2008, overall global demand destruction was about 1 mb/day.
The coming online of Libya and Kuwaiti crude, and supply curb lifts in non OPEC crude in the later part of this year are expected to add some 1 mb/day crude. In all, spare oil capacity is expected to be near 4.5 mb/ day, a level much higher than the 2008s.
Elasticity tug of war? Rangebound prices amid the tightness?
In a scenario of tight fundamentals, the price elasticity1 of oil is normally driven by its demand elasticity. However, the present scenario sees both supply and demand elasticity of oil playing a part. On one hand, the slower economic growth and increased supplies drive down prices, Yet from a global point of view, global demand continues to grow. It pays to realise that WTI prices in the USA have been some $20 lower than the global brent benchmark consistently. Such lower prices mean no further demand swing destruction in the world largest oil market.
Regulatory landscape change
In an earlier article, the author likened oil prices to be running on gears. Perhaps the oil prices are running on a lower gear now with more regulatory oversight and transparency by the CFTC? Yet aside from higher margins requirement and more transparent reporting, the regulatory landscape has not changed much. The debate to implement position limits on funds/ banks – maybe the most stringent measure has been held back pending further analysis.
1- Notwithstanding supply has been maximised in a tight scenario and there are no more ‘surprises’ from sudden disruptions to existing infrastructure.
China is now the second largest consumer of crude oil after the United States, consuming an estimated 9.6 million barrels of crude a day this year. Up to 55% of this is imported.
An understanding of how China prices its oil products is important as it determines the elasticity of its price demand. The regulation of oil products prices (in general prices of basic necessities) is performed by the National Development Reform Commission (NDRC ) a state owned body in the Chinese legislation. In many parts of the world, oil prices are subsidised to control inflationary pressures and maintain social stability. This gives a skewed picture of demand which persists even as international prices are rising. This is the case in many parts of Middle East.
Oil product prices regulation in China
An excellent historical write up of oil products regulation in China is here. Since 1998, China has regulated oil product prices (in particular gasoil and gasoline) to maintain inflationary pressures, maintain demand and supply balance and smooth out price volatilities from international markets.
In almost all measures it adopted, it adjusted its wholesale (ex refinery prices) when international prices move beyond a certain band over a certain number of days. This band and number of days have been reduced progressively in the past to tighten its linkage with international price. It however proved inadequate as it was too broad and transparent. When international prices rose too quickly, it encouraged speculative hoarding (and oil exports). Or when international prices fell too quickly as during the summer of 2008, it encouraged smuggling into the domestic markets as prices did not react as quickly to international prices). Such scenarios caused a temporal disruption in supply which has occurred as lately as Oct 10, when international prices fell too quickly.
Why China differs?
Comparing the typical income elasticity of oil between China and the developed world indicates the following:
Two features stand out – the income elasticity of China takes a shorter time to reach the peak and then decreases gently from this peak. The first is presumably to the greater technological knowledge and efficiency available to nations which modernise later. This peak then takes a longer time to decrease due to the wide income disparity between the inland and coastal regions of China. Its population size of 1.2 billion people is another factor as wealth spreads across its populace. This observation is also commented by the respected Hamilton in his paper Understanding Oil Prices.
Further China tax on oil products is minimal 20% compared to many developed countries. (300% in France, 120% in Japan and 20% in USA) effectively lowering its absolute oil prices.
Although China does not directly give out fuel subsidies, it however compensates its two largest oil companies Sinopec and PetroChina on its refining losses. For the 3rd consecutive year, Sinopec has received compensation for its refining losses, with the latest being in Dec 2010 of $1.74b.
In conclusion, the oil price regulation in China needs to be seen as a bespoke case compared to the rest of the world. These regulations shift temporal demand rather than make an absolute impact on its oil demand.