Streetwise Professor

February 4, 2022

When It Comes to Energy, Post-Religious Europe Can Do Little But Pray

Filed under: Commodities,Energy,LNG — cpirrong @ 2:50 pm

Although conditions have eased somewhat, Europe’s energy situation is still fraught. It has experienced a winter of extremely high power prices and natural gas prices. Some luck with weather in January brought some relief, but who knows what the next months have in store.

As if demand and non-Russia supply fundamentals didn’t pose enough difficulties, Russia has proved a gas supply riddle, mystery, and enigma. The Ukraine situation has only made the situation more fraught, with a prospect that things could get very cold in Europe if the conflict between Russia and Ukraine goes hot.

In anticipation of this, the Biden administration has played its by now familiar role of supplicant, appealing to major LNG suppliers–notably Qatar–to increase output and divert supplies to Europe, and to major buyers (e.g., Japan) to direct supplies to Europe.

Good luck with that. There is nothing that can be done to augment global supplies in the short run, let alone by enough to address a material loss of gas from Russia.

The world LNG industry is operating at effectively full capacity. Although supplies produced anywhere can physically go anywhere, there are no more additional supplies to be had. So if Russian gas exports decline, LNG cannot fill the gap.

This is illustrated by the US, which recently became the world’s largest supplier of LNG. Note how US exports have remained essentially constant (at about 300 bn cubic feet/month) since around March 2021, despite skyrocketing prices for gas:

There’s another way to see that liquefaction capacity is the bottleneck. This is the spread between the price of LNG in Asia (JKM) and Henry Hub NG:

My teaching mantra (repeated last night to my Energy Derivatives students!) is that spreads price bottlenecks in the transformation process. The spread depicted here captures two potential bottlenecks in transforming US produced gas into gas delivered in Asia (or Europe): US liquefaction capacity and shipping costs. Shipping costs have increased, but not nearly enough to explain the rise in the spread in 2021, especially the explosion starting in mid-September. This is a clear indication that US liquefaction capacity is a binding constraint. The extreme volatility in the spread also demonstrates this. Shocks to demand in Europe or Asia can’t be accommodated by adjustments in supply, so all the burden falls on the spread. Thus, even slight demand shifts can lead to big spread moves.

As for reallocating supplies between Europe, Asia, and South America, Mr. Market can handle this, and is indeed handling it to a considerable degree. As the demand balance shifts between Asia and Europe, LNG carriers are changing destinations in mid-voyage. In an extreme case a ship that had already transited the Panama Canal en route to Hawaii reversed direction, transited the canal eastbound, and delivered its cargo in the UK. In short, what is going on is a classic example of how the price mechanism allocates resources to their highest value use, and how commodity traders optimize flows. (It also largely validates the predictions of my 2014 white paper on LNG.)

The main impediment appears to be contractual. Specifically, destination clauses in legacy contracts, specifically those for Qatar Gas. These clauses prevent the buyer from reselling the cargo to other markets.

Perhaps the administration was begging Qatar to relent on these, but if so, their appeals appear to have fallen on deaf ears (despite the US promoting Qatar to “major non-Nato ally). Qatar says it views its contractual commitments as sacrosanct:

“Keeping our contractual word is sacrosanct in Qatar,” said Kaabi, implying that it will not be possible to divert to Europe gas shipments already contracted for delivery to other countries without their consent.

This smacks of dishonesty. It is not the buyers‘ consent that matters here: if the price is right, Asian buyers would be happy to ship contracted gas to Europe if the price is right. And it appears that the price is right: the “arb” between Asia appears open (i.e., the TTF price is above JKM by more than the cost of shipment). So what’s stopping it from being closed? Almost certainly Qatar’s failure to consent to waiving the destination clauses (in its supersekret contracts). (Destination clauses limit the ability of the buyer to divert cargoes to other locations, and are basically a means of price discrimination.)

Relatedly, Qatar has said it is willing to sell gas to Europe . . . as long as the Europeans consent to destination clauses. Oh, and Qatar is exploiting Europe’s straits by demanding Europe “resolve a long-running EU probe into Qatar’s long-term gas contracts, for the EU to be less dependent on spot sales and more on long-term contracts to boost its energy security.”

Kind of Russian, when you think about it. When you have them by the short ones . . . . With “allies” like these!

In brief, Europe is SOL, especially if there is a material disruption in Russian gas supplies. The world capacity of LNG is maxed out and cannot fill any supply void. The market is working to allocate supplies efficiently, but that process is impeded by an opportunistic actor that really doesn’t want the spot market to work.

Meaning that the best that post-religious Europe can do right now is pray for balmy weather, high winds, and Russian forbearance. Good luck with that.

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  1. What advantage (real or imaginary) does Qatar see in preventing its clients from reselling gas? This seems reminiscent of the Saudi’s long-time insistence that buyers of its crudes never resell cargoes into the spot market. For that reason, Dubai became the benchmark crude for the Gulf during the 1980s rather than Saudi Light, as it likely would have been had the Saudis not insisted on destination clauses. As far as I was able to tell, crude buyers paid a regular premium for Dubai cargoes over the virtually identical Saudi Light for years and years.

    Comment by John McCormack — February 4, 2022 @ 4:30 pm

  2. This has been ten or twenty years in the making. Demonise big Oil, effectively ban new domestic production, treat nuclear power plants as unexploded bombs under the bed, and the result should come as no surprise.
    Yet a majority of British respondents to a recent poll blamed “profiteering” by gas companies. And the government is considering a “windfall” tax.
    I think I’ve fallen down a wormhole and encountered an alternative unreality. Please help, send money!

    Comment by philip — February 4, 2022 @ 4:51 pm

  3. “a majority of British respondents to a recent poll blamed “profiteering” by gas companies”: the trouble is that most people are stupid. Things that are clear to a bright lad of thirteen or fourteen are an impenetrable mystery to more than half the adult population. Given that thirteen and fourteen year olds still live in a world that’s partly imaginary it rather suggests that many adults do too.

    Comment by dearieme — February 4, 2022 @ 5:41 pm

  4. You forgot to mention that Europe could, in addition to praying for climate change, also make use of a recently finished brand-new pipeline…

    Arbitraging different locations will help prevent eggregiuous spikes, but won‘t do much to lower the average price level due to the LNG capacity constraint you mention- asia needs that gas too….
    (the US is also a high cost LNG producer, if I am not mistaken, so there you also have a structural issue of relying on that supply source even in the longer term)…

    Given that it is unlikely that significant amounts of russian gas will flow through Ukraine or Poland in the forseeable future, The „normative kraft des Faktischen“ will prvail in the end…

    Comment by Viennecapitalist — February 5, 2022 @ 2:24 am

  5. addendum: due to the most recent developments in Kazakhstan, it is questionable whether reactivating nuclear would mean less dependency on Russia….

    Comment by viennacapitalist — February 5, 2022 @ 12:42 pm

  6. David Middleton has an illuminating take on US NG exports.

    His bottom line is, “The price in Europe for imported Russian pipeline gas is currently about the same as LNG. Europe imports most of there natural gas and pays about 10 times as much per mmBTU as the world’s leading natural gas exporter.

    The world’s leading natural gas exporter is the US. David’s case is that NG exports means production exceeds domestic demand = lower gas prices at home.

    David is a petroleum geologist working out of Houston.

    Comment by Pat Frank — February 11, 2022 @ 6:08 pm

  7. I understand that in Europe people do not own the mineral rights to their own land. Where’s the incentive for a property owner to want fracking or drilling? Near me in Pennsylvania many people have become very wealthy when shale oil was found under their fallow farm property. Personal wealth and thousands of jobs. What a concept.

    Comment by Dave Kelly — February 13, 2022 @ 10:10 am

  8. Test! I understand that in Europe people do not own the mineral rights to their own land. Where’s the incentive for a property owner to want fracking or drilling? Near me in Pennsylvania many people have become very wealthy when shale oil was found under their fallow farm property. Personal wealth and thousands of jobs. What a concept.

    Comment by Dave Kelly — February 13, 2022 @ 10:12 am

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