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Energy markets in transition with a focus
on LNG:
Growing pains, new technologies and new tradingarrangements

Peter R Hartley
IAEE Distinguished Lecturer, 2016
George & Cynthia Mitchell Professor of Economics andRice Scholar in Energy Studies, James A. Baker III Institute for Public Policy, Rice University
BHP Billiton Chair in Energy and Resource Economics
University of Western Australia

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Outline of Talk



Economic growth and energy demandTechnological change and fossil fuels

Alternative energy technologies

Modeling the transition process

The future role of natural gas



LNG market developments

The value of long-term LNG contracts

Indexing in long-term LNG contracts

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RICE UNIVERSITYTOPIC 1
Economic growth and energy demand

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Economic growth and overall energy demandAccess to modern energy is essential for economic growth

Access to non-human/non-animal energy sources was an essential ingredient in theindustrial revolution

Fossil fuels are relatively dense energy sources:

Gasoline 46.9GJ/t by weight, 34.6 MJ/L by volume; Diesel 45.8 GJ/t, 37.3 MJ/L

Filling a car, flow rate is ~ 40L/minute = 83 GJ/hour = 23 MW power plant output

Power of average human worker is about 75W, so 2000 hours of work per year
delivers 150 kWh = 540 MJ = energy in about 15 L of diesel

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2011 TPE/capita versus GDP/capita

Source: Gapminder

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TPE demand growth

Source: EIAIEEJ：May 2016 © IEEJ2016

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Higher growth tends to more unstable

Source: EIAIEEJ：May 2016 © IEEJ2016

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Growth and the pattern of energy use
Economies tend to undergo a predictable pattern of energy use as they develop:First, industrial and construction sector use grow most rapidly, especially via
construction of infrastructure, which is very energy and material intensiveCommercial and residential energy use increase next

Rapid increase in energy use for transportation occurs later, and does not attain thegrowth rates of industrial or commercial, but…



But industrial use eventually declines in per capita terms as economy matures

Transportation eventually becomes the largest component of final energy demand

The share of primary energy used to generate electricity grows over time
Environmental concerns increase as people get wealthier, favouring natural gas
especially at the expense of coal

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Future sources of energy demand growth?
Extraordinary feature of the recent episode: High growth combined with highpopulation








Rapid Chinese growth stressed not only energy but also other commodity markets

Sources of rapid economic growth:Movement of labour from agriculture to industry

Investment in physical and human capital

Adoption of technologies from more developed economies

Eventually countries converge to the long run growth path of the leading nations
Very high growth rates get more difficult to achieve as a straight numerical issueCountries at the frontier can no longer take new technologies “off the shelf”

In particular, Chinese growth is unlikely to return to its previous highs

Might India or SE Asia, which also have high populations move into the highgrowth phase?

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Energy supply also affects growthIn addition to economic growth affecting energy demand, energy availability, or
especially lack thereof, can affect economic growth
Many major post-WWII recessions have been associated with a preceding, andapparently precipitating, constraint on energy supply
Major reasons for macroeconomic impacts of energy supply constraints:
Energy is an essential inputMore expenditures on energy imply less available for consumption or investment

Energy/capital input ratios are relatively fixed in the short run
Reducing hours of operation is the main short-run response to high energy prices
 If price changes are perceived as permanent, capital can be replaced with a moreenergy efficient alternative, but this is also disruptive in the macroeconomic sense

Other attempts to economize on energy use also come at some economic cost

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RICE UNIVERSITYTOPIC 2
Technological change and fossil fuels

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Technological change and fossil fuelsDespite repeated fears of exhaustion, technological change has continually
uncovered new resources, reduced the cost of extracting “difficult” resources,
and increased EUR from previously exploited sources








While total fossil fuel resources are finite, the known resource base is vast
Even the amount that could be recovered with current and reasonably foreseeable
technologies is more than 2000 times current annual production
We will never “run out” of fossil fuels – rather at some point the remaining resources
will cost more to extract than the cost of alternative energy sources

The production of natural gas, and then light oil, from shale is just the latest“revolution” in fossil fuel technology

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Source: Mike Vincent, “Five things you didn’t want to know about hydraulic fractures”

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Increased energy efficiency
Increased end-use energy efficiency also extends fossil fuel resources

By allowing the same energy services to be produced with less primary energy input,
fossil fuel resources are exploited more slowly

Costs of production then will not rise as fastThis is a version of the “green paradox”

Technologies increasing substitution between different fuels also extends resource life

Other innovations – most especially the production and long-distancetransmission of electricity – have increased the value of energy services
Economic growth beyond middle income levels also tends to reduce the energy
intensity of GDP
This is simply the result of the changing composition of GDP toward sectors –especially services – that are less energy intensive
This, as more countries become high income, economic growth can continue without
requiring the same increases in energy input

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RICE UNIVERSITYTOPIC 3
Alternative energy technologies

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Non-fossil fuel energy technologies


Fossil fuels currently supply more than 90% of the world’s primary energy



Nuclear power and hydroelectricity supply more than 8%Other modern non-fossil energy sources are used mainly as a result of subsidies


Example: The DSIRE database currently lists 28 US Federal policies and 2,613
policies at the state and local level (including Washington DC) promoting renewableenergy and energy efficiency technologies

While these other sources are called “renewable” in practice they also are limited
in supplyThe energy source (basically sunlight) that is converted to energy services by sources
such as wind, solar or hydroelectricity is essentially unlimited

However, suitable sites for constructing harvesting infrastructure are limited in supply

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Renewables – cost disadvantages



Relative to combined cycle gas turbines, the per kW of capacity capital cost of

onshore wind is about 2x

offshore wind is about 4x

solar is about 5.5x

Low average capacity utilization for renewables further raises costs per kWhRenewables also often need transmission upgrades


These also are used at a low capacity factor

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Example generating plant cost calculations (r = 0.075)
Gas turbine

NGCC

Coal

NuclearOnshorewind

Pumpedstorage

Capital cost per MW($m/MW)

0.676

1.023

2.934

5.53

2.213

5.288

Fixed O&M($m/MW)

0.00704

0.01537

0.03118

0.093280.03955

0.01800

Variable O&M($/MWh)

10.37

3.27

4.47

2.14

0

0

Fuel
($/MWh)

46.31

30.54

19.36

2.88

0

0

Heat rate(MMBTU/MWh)

9.75

6.43

8.80

10.45200

Fuel price($/MMBTU)

4.75

4.75

2.20

0.28

0

0

Load factor

0.1

0.7

0.8

0.9

0.3

0.1

Plant life

30

30

50

50

25

50

Levelised cost(¢/kWh)

13.01

5.04

6.05

7.09

9.06

48.58

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Renewables – other issuesWind power output fluctuates frequently and substantially

For wind speeds 10–30 km/h, output varies as the cube of wind speed (next slides)

Ancillary services are needed to maintain network stability



Added thermal plants then are not used when the wind blows

Also peaking gas turbines are less efficient and more costly than NGCC plantsCurtailing base load thermal plants reduces their efficiency and can raise pollution

In many locations, wind also is strongest off-peak, weakest in peak hours
Best sites for wind and solar are often remote from major consuming locations

A large fraction of wind capacity increases the chance of inadequate capacity at peaks

Expensive new transmission lines with low capacity factors are needed

Wherever wind has been forced into the network via subsidies and mandates wehave seen substantial rises in prices and deterioration in supply quality
Wind and solar farms also have a large land and environmental impacts

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RICE UNIVERSITYWind production SE Australia 14/10/15

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RICE UNIVERSITYWind production SE Australia 15/10/15

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RICE UNIVERSITYResources

The “valley of death” for new energy technologies

Existing
technical
and market
research
resources

DiscoveryValley of Death
Gap between opportunity
discovery and productdevelopment

pre-NPD

New product development (NPD)

Existing resources forcommercialization

Commercialization

Claimed paucity of funding for commercializing new technologies relative tofunds for basic R&D

Discussions typically focus on remedial policies

Why are apparently profitable opportunities ignored?

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Previous explanations for the valley


Informal justifications include:












Information asymmetries, uncertainty about viability, and financial and productmarket volatility that make it hard to “sell” the project to investors
Higher costs of early plants make initial prototypes unprofitable even if the technology
would be viable in the long run (an “infant industry” argument)
Inability to use many assets (especially intellectual property, patents) as collateral

But one would think that most of these problems would be more severe at the“discovery” phase than at the “new product development” stage
A 2009 paper argues that a “non-economic” motivation (public subsidies) for
R&D at stage 1 alone can lead to more stage 1 than later stage projects
Information spillovers that make it hard to capture benefits of R&D

Actually, more subsidies for stage 1 research could be efficient if more basic research
has more extensive spillovers that are hard to monetize

Another issue: why energy but not pharmaceuticals or IT, for example?

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RICE UNIVERSITYTOPIC 4Modeling the transition process

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A model of the transition process

In a recent paper, we use a dynamic intertemporal model to calculate an efficienttransition between energy sources
The model distinguishes several types of investment:

R&D into both fossil fuel and non-fossil energy technologies



Capital is used to produce final output, with energy services as another essential inputEnergy services are produced using two types of non-substitutable capital

We assume learning by doing and explicit R&D are both needed to reduce thecost of new non-fossil energy productionSuch a “two factor” learning model has been estimated for progress in solar and windand other energy technologies

Technological progress in fossil fuel technology makes it harder for non-fossil
alternatives to compete

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The valley of death in this model












The early stage of development largely involves cost reductions through R&D
expenditure and learning

The “commercialization” phase involves building physical capital to supply
energy services using the new technology
Capital used to produce energy services from fossil fuels is a sunk cost, so it will
be used so long as the energy price covers short-run operating costs

Until fossil fuels are abandoned the energy price is less than even the operating
costs of the alternative energy technology
Investment into R&D and development of new technologies starts long before
the technologies are deployed commercially
Furthermore, the new technologies will be used to supply energy services before
the energy price is sufficient to cover their long run costsThe full long-run costs are not covered until some time after fossil fuels areabandoned

Big difference between energy and IT or pharmaceuticals: only energy requires
large investments in infrastructure to deliver final product after the R&D phase

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An “optimal energy crisis”
The transition path between technologies that we calculate is efficientThat path involves an “energy crisis” – slower economic growth and especiallyreduced consumption and a lower standard of living – around the time T oftransition between fossil and non-fossil energy sources












As the cost of fossil fuel production begins to rise, it becomes optimal to invest morein fossil fuel R&D (including new field development) to keep costs under control
Also as T approaches, substantial investment in infrastructure to supply energy
services from non-fossil sources is required
It also becomes more worthwhile to accelerate R&D investment into alternative
energy technologies as T approaches
Investment into fossil fuel energy supply infrastructure ceases before fossil fuels areabandoned at T, but this limits the supply of energy services and hence final output
The cost of energy services has to rise dramatically to cover the full long-run cost ofalternative energy supply infrastructure and incentivize the investment required
Spending on energy and investments, and constrained output, reduce consumptionIEEJ：May 2016 © IEEJ2016

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Real price of energy
0.45

0.4

0.35

0.3

0.25

0.2

0.15

0.1
0

20

40

60

years

80

100

120

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Output growth rate
0.12

0.1

0.08

0.06

0.04

0.02

0

-0.02

-0.04
0

20

40

60

years

80

100

120

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Consumption/output ratio
0.7

0.68

0.66

0.64

0.62

0.6

0.58

0.56

0.54

0.52
0

20

40

60

years

80

100

120

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RICE UNIVERSITYTOPIC 5
The future role of natural gas

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A “golden age of gas”?

Barring a breakthrough in alternative energy technology, fossil fuels are likely todominate energy production for many more decadesHowever, many expect natural gas to grow faster than coal or oilNatural gas has much lower emissions than other fossil fuels – especially coalControlling “conventional” pollutants from coal is already raising costs

CCS and gasification as strategies to keep coal competitive?

The resource base for natural gas is huge – especially if one includes hydrates
Even if renewables subsidies continue, wind and solar generation tend to require
more natural gas as backup
Time of day pricing to smooth the load curve is a possible alternative approachIEEJ：May 2016 © IEEJ2016

RICE UNIVERSITYNatural gas in transportation?








For transportation, gasoline and diesel have higher energy density than CNG
and are easier to handle than LNG
Nevertheless, LNG may be used more widely in truck fleets, rail, and especiallyshipping, in part because of the relative environmental benefits

Natural gas is already indirectly used in transportation via oil sands and ethanol
production, and in the form of electricity
Electric cars also have some advantages over internal combustion enginesAdvantages in braking and idlingGenerating plants are more energy efficient that internal combustion enginesBut batteries currently have low energy density

Vehicle choice versus driving choices in multi-vehicle households

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RICE UNIVERSITYTOPIC 6
LNG market developments

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106 m3 liquid LNG

Increasing spot and short-term LNG trades
600

30%

500

25%

400

20%

300

15%

200

10%

100

5%

0

0%
2000

2001

2002

2003

2004

2005

LNG volume from liquefaction plants

Source: GIIGNL

2006

2007 2008

2009

2010

2011 2012

Spot and Short-term Trades/Total LNG

2013

2014

2015

Re-exports/Total LNG

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Increasing numbers of LNG traders
110100
Regasification terminals

90

Liquefaction plants

80
70
60
50
40
30
20
10
2000

2001

Source: GIIGNL

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

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Spot trading is related to the number of importers
30%

Spot sales/Total LNG shipped

25%

20%

15%

10%

5%

0%
30

35

40

45

50

55

60

65

70

75

80

85

90

Regasification terminals
Source: GIIGNLSpotFrac = 0.187 ln(Regas) - 0.590 ; R2 = 0.9370(0.0130)(0.0532)

95

100

105

110

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Average LNG shipping distance
Volume share weighted distance in nautical miles

9000

Total
Spot, <4 yrs

8000

Contract >4 yrs
Re-export

7000

6000

5000

4000

3000

2000
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Sources: Author calculations based on GIIGNL and VesselDistance.com

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Recent evolution of spot natural gas prices

Source: Platts

Source: US Energy Information Administration (EIA)
Jan-2016

Jan-2015

Jan-2014

Jan-2013

Jan-2012

Jan-2011

Jan-2010

Jan-2009

Jan-2008

Jan-2007

Jan-2006

Jan-2005

Jan-2004

Jan-2003

Jan-2002

Jan-2001

Jan-2000

Jan-1999

Jan-1998

Jan-1997

Jan-1996

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RICE UNIVERSITYUS LNG Imports/Marketed production
7%

6%

5%

4%

3%

2%

1%

0%

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Japanese LNG imports: Long-term contract and other200
180

millions m3 liquid per year

160
140
120
100
80
60
40
20
0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Source: GIIGNL

contract, > 4yrs

spot, < 4yrs

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Other recent developments

LNG swaps and other spot trades increasingly exploit arbitrage opportunities



Many regasification terminals are adding storage capacity to support arbitrage



Expiration of long-term contracts for some early liquefaction developments hascreated spare capacity and without a need to finance large investmentsMany recent contracts have greater volume flexibility, destination flexibility, andless than 100% off-take commitments by buyers
After the EU restructuring directive of 1998 (promoting competition in EU gas
markets), the Commission found destination clauses anti-competitive in 2001
More of their output is being sold short-term and spot

This stimulated re-export of cargoes and increased destination flexibility

Growth of “branded LNG” sourced from many sellers and sold to many buyers

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Effects of US developments on LNG tradeThe first few US terminals are proposing exports under a tolling arrangement
Typical feed gas price 115% of Henry Hub and liquefaction fee $3–3.50/mmbtu

Several buyers will add the LNG to their global portfolio

Some proposed facilities are smaller and more modular than traditional trainsFor example, Elba Island (which also has output assigned to Shell’s global portfolio)
LNG Ltd Lake Charles terminal using a more energy efficient less capital intensive
process

Future co-location of regasification and liquefaction facilities in the US withpipeline connections to a deep market will facilitate short-term arbitrage

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Summary comments on recent developments

More elastic natural gas supply and demand curves will reduce price volatility
Intermediaries providing hub services and having access to storage will allow
more effective price arbitrage, further reducing price variability
The gap between spot prices available to importers and exporters also will
decline as market liquidity rises

Spot market trades from parties to contracts should continue to increaseGreater use of spot and short-term trading may favor lower capital cost projects







Growth in spot trading may reduce volumes under contract and raise spot
market participation, further raising spot market liquidity
Long-term contracts will also become more flexible to allow parties to better
exploit the optionality of spot and short-term trades
There are compelling reasons for retaining oil prices as the main indexing
variable for long-term contracts, but limited use of gas price indexes from deep
natural gas markets might provide some risk diversification benefits

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RICE UNIVERSITYTOPIC 7The value of long-term LNG contracts
in an uncertain environmentIEEJ：May 2016 © IEEJ2016

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Explanations for long-term contracts

We focus on two main explanations for the desirability of long-term contracts:
1. The hold-up problem
2. Securing a lower cost of finance by reducing cash flow variabilityCommercial parties emphasize the risk sharing benefits of contracts, but theacademic literature has focused on the hold-up problem

The academic literature has also focused on the efficiency benefits of take-or-pay
clauses in long-term contracts

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The hold-up problem
This can occur when trading partners make large up-front investments
dedicated to the trade partnershipOnce investments have been made, the counter-party has an incentive to bargain
for prices that cover operating costs but do not yield a competitive return on thecapitalThis can also apply to re-negotiating an indexation formula

The problem can become more acute if some information is known only to one
party, so the rents associated with the relationship are not public knowledge
Contracts often allow more quantity adjustments than price adjustments
Price adjustments are zero-sum, while quantity adjustments leave the other party withalternative avenues for making up lost profitsIEEJ：May 2016 © IEEJ2016

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Rent in the contracting relationshipBest spot prices for buyer pMContract price p
Best spot prices for seller pXParties in a long-term contract tend to be better
matched to each other than to outside parties
The next best price for the buyer pM and the next
best price available to the seller pX will varyrandomly
While the two contracting parties generally are
better off trading with each other that may notalways be true
The contract price will tend to be toward the top of
the pX distribution and the bottom of the pM
distribution

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RICE UNIVERSITYTake or pay clauses

Contract price p
Best spot price for buyer pMBest spot price for seller pXIn the situation illustrated, the importer would prefer tobuy spot rather than honour the contract
But it would be efficient to buy from the exporter since
they would both be better off trading at a price between pX
and pM than both using the spot market
A take-or-pay clause requires the importer to make theexporter “whole”, that is pay pay p – pX to the exporter, if
the contracted volume is not taken
Then the buyer would choose to not take delivery only
when pM < pX in which case this is efficient
But the take or pay clause also leads to a transfer from thebuyer to the seller in situations like the one illustrated

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Long-term LNG contracts and project financing
Long term contract is “bankable” because it makes cash flows less volatileThis in turn allows increased leverage, and reduces the cost of project financeThe total amount of debt is limited by a “value at risk” type constraint:

We assume the net benefits of debt are approximated by corporate tax benefits alone

After-tax cash flows to importing and exporting parties are random
The constraint requires an upper bound on the probability that the after-tax cash flow
will not be sufficient to service the debt in any given year

Key findings:
Contracts can allow trade where it would not otherwise be supportable

General increases in spot prices are indexed 85–90%

Contracts are more valuable when there is “rent” in the relationshipParties may limit long term contract volumes to allow more flexibility to exploit
profitable spot market trades
Increased spot price variability generally raises the benefits of long-term contracts

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RICE UNIVERSITYTOPIC 8Indexing in long-term LNG contracts

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Indexing in long-term contractsEnergy relative prices tend to be much more stationary than the prices ofindividual energy commodities











For supply, resources that can be used to produce natural gas in particular can also be
used to produce oil and relative output shifts in response to relative prices

Many studies have shown that oil prices tend to be the most exogenous energy
price in markets where both prices are free to fluctuate independently
Natural gas prices are the most volatile fossil fuel price (next slide)
US natural gas prices have looked more attractive recently because the foreignexchange value of the $US has affected the oil/gas price ratio

For demand, energy content is the dominant determinant of value, although energy
density, ease of handling, environmental effects and other attributes are relevant

After US LNG is traded, US gas prices may be a less attractive index to Asian buyers

Other spot natural gas markets need to become sufficiently deep and liquid to
reduce risks to investors in these large capital intensive projects
Indexing to natural gas hub prices may exchange geographical basis differentials
for commodity basis differentials

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Relative volatilities of Henry Hub and Brent
Densities of standard deviations
Brent

30

JKM
Henry HubDensity

20

10

0
0

.05

.1

.15

.2

Rolling 28-day standard deviations of log prices

Source: Author calculations based on data from the US Energy Information Administration (EIA).25

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Influence of exchange rate on Brent/HH priceLong-run relationship requires relative heat rates and the foreign exchange
value of the $US to be included to be stableIEEJ：May 2016 © IEEJ2016

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Within sample fit of dynamic modelAdjustment to long-run error is approximately 6% per monthUnexpected inventory changes have about 2x the effect on prices as expected ones

HDD and CDD deviations and major hurricanes have expected effects on Δln(pNG)

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Relationship of JKM to other fuel prices

Data sources: Platts and EIAIEEJ：May 2016 © IEEJ2016

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Impulse response functions: Model D
LNG→LNG

1.6

RFO→LNG

0.10

1.4

coal→LNG

0.25

0.05

0.5

0.20

1.2

0.4

0.00

1.0
0.8

Brent→LNG

0.6

0.15

0.3

0.10

0.2

-0.05

0.6

-0.10

0.1

0.4

0.05

-0.15

0.2

-0.20

0.0
0

7

14

21

0.16

0

28

LNG→RFO

7

14

21

28

RFO→RFO

1.2

0.12

0.0

0.00

-0.1
0

7

14

21

28

coal→RFO

0.20
0.15

21

28

LNG→coal

0.22

-0.05
0

7

14

21

28

RFO→coal

0.14

7

14

21

28

coal→coal

0

7

14

28

21

28

Brent→coal

0.12

1.4
0.08

1.2

0.10

0.14

0.0
0

1.6

0.12

0.18

21

0.1

0.0
14

0.2

0.00

0.2

7

28

0.3

0.4

-0.08

0

21

0.4
0.05

-0.16

28

0.5

0.6

-0.12

21

0.6

0.10

-0.04

14
Brent→RFO

0.8

0.8

0.00

7

0.7

1.0

0.08
0.04

0

1.0

0.08
0.10

0.04

0.8
0.06

0.06
0.02
-0.02

0.4

0.02

0.2

0.00
0

7

14

21

28

LNG→Brent

0.15

7

0.05

0.5

0.00

0.4

14

21

28

-0.08
0

7

RFO→Brent

0.7
0.6

-0.04

0.0
0

0.10

0.00

0.6

0.04

14

21

28

coal→Brent

0.25

0

1.2

0.15

1.0

0.10

0.8

0.3

-0.10

0.2

0.05

0.6

-0.15

0.1

0.00

0.4

-0.20

0.0

-0.05

0.2

-0.25

-0.1

-0.10

7

14

21

28

0

7

14

21

28

14
Brent→Brent

1.4

0.20

-0.05

0

7

0.0
0

7

14

21

28

0

7

14

IEEJ：May 2016 © IEEJ2016

RICE UNIVERSITY

Concluding remarksEnergy is of fundamental importance for economic growth
The energy industry has experienced tremendous technological change and thishas kept fossil fuels as the lowest cost energy source for a long time

The transition to alternative energy sources is costly and will take time











Forcing it with subsidies and mandates is imposing substantial welfare costs
We should distinguish subsidizing research into new technologies versus
subsidies/mandates for the deployment of new technologies that are not yet
competitive

Natural gas is a favored fuel in the short and intermediate run
LNG is growing relative to pipeline gas supplies, but the LNG market is also
undergoing rapid change as it makes natural gas more of a globally traded good
The capital intensity of LNG projects leaves a role for long-term contracts but
spot and short-term trading, and flexibility in contracts, are all increasing
While there are good reasons for indexing to oil prices, other indexes are
possible and have some desirable features
Contact :report@tky.ieej.or.jp