LNG: A Trade Wars story

With the rhetoric on both sides of the Pacific regarding a potential US-China trade war continuing to mount, energy is not exempt from the list of US goods that the authorities in Beijing are targeting with tariffs. In this article we look at what this could mean for US gas exports, whether Europe offers a viable alternative destination and how further deterioration in relations between Washington and Moscow could affect pipeline flows from Russia to the EU.

“Aggressive negotiations”

While oil and propane deliveries to China from the US were subject to a 25% tariff from the start of July 2018, LNG was not included, reflecting the importance of the fuel to the Chinese government’s plans to decarbonise heat and power generation under its “Blue Skies” policy. However, with the trade dispute between the two nations ratcheting up, the Chinese Ministry of Finance announced at the start of August that it was considering imposing a similar 25% tariff on American LNG imports.

Given the growth in LNG demand caused by “Blue Skies”, as well as a surge in the nation’s LNG requirements earlier in the year due to a colder than expected winter, there had been an apparent reticence on the part of the authorities in Beijing to introduce LNG import tariffs. This position now looks to have changed, although the Ministry did not give a date for the introduction of the new levies, rather that, “the implementation and date of (Chinese) tariffs will be decided by US actions.”

With Chinese LNG demand seen as potentially underpinning the expansion of the American LNG export sector, the introduction of tariffs would hamper this growth – as well as opening the door for exporters from nations including Qatar and Australia that could look to meet the resultant Chinese supply gap. It would also see US LNG cargoes looking for alternative markets to send their cargoes, such as Europe.

“A lot of special modifications”

China’s transition from coal to gas meant that its demand for American natural gas was expected to grow considerably, with the country having already overtaken South Korea as the world’s second-largest importer of LNG behind Japan. At the same time, the US was forecast to emerge as the primary source of new LNG supply in the remainder of the current decade as more LNG facilities came on line.

Furthermore, the announcement in February 2018 of a 25-year supply deal between Texas-based Cheniere Energy and the Chinese National Petroleum Corporation (CNPC) was seen as the first of many such contracts and a means by which to support the growth of US exports; this also having been cited by Secretary of Commerce Wilbur Ross as a means by which the US-Chinese trade deficit could be reduced.

Figures for 2017 show that US LNG deliveries to China rose from zero in 2016 to 407,000 tonnes in 2017[1]. However, with Chinese LNG imports in the year standing at around 38mn tonnes[2], this represented a small percentage of the total compared to Qatari and Australian imports.

China’s position in the global LNG market is also different to that of Japan and South Korea – something that has implications for cargo pricing and availability. LNG supply to the Asia-Pacific region has historically been underpinned by long-term, oil-indexed supply contracts that guarantee cargo deliveries.

However, China’s indigenous gas reserves and pipeline links with other markets means that it typically uses LNG as a means of topping up other sources of supply, and as a result it is more reliant on spot cargo deliveries of the fuel. The prospect of a short-term jump in demand for spot cargoes from China could therefore lead to increased LNG price volatility, while the growing removal of destination clauses from LNG contracts will give suppliers of the fuel more flexibility in where they send their deliveries.

Here, the possibility of a 25% tariff on US LNG imports would risk pricing American cargoes out of the Chinese market – and although long-term contracts may be partially insulated from the effects of such levies, US spot LNG cargoes would be particularly hit.

“Take a short cut”

At the same time, figures released by the Panama Canal Authority (PCA) indicate that the route could well see the transit of 30mn tonnes of US LNG by the end of 2020, a fivefold increase on the volumes seen in 2017. Shipping via the canal reduces transport time as well as fuel costs, and could be an important catalyst in US-Asian LNG deliveries.

Having seen its long-awaited expansion inaugurated in 2016, a move that enabled much larger vessels to use the canal, the PCA is already eyeing further expansion to meet the ever-growing demand from vessels to use the link. US LNG producers are expected to be among the beneficiaries of the most recent expansion, and could see further opportunities through any future work.

Figures from the International Energy Agency (IEA) in its Gas 2018 report[3] show the US will displace Australia as the second largest LNG exporter in the world by 2023 with annual deliveries of 101bcm (~74.2mn tonnes[4]), while Qatar will retain top spot with exports of 105 bcm (~77.2mn tonnes).

The US’s ability to tap into the Chinese market is therefore, to a large degree, dependent upon access to the canal. This is by no means certain, given widespread reports of delays being experienced by LNG tankers in using the canal, including a current allocation of one slot per day for LNG cargoes along the route[5].

Indeed, the demand for more flexible LNG cargoes may not be compatible with the current operating practices of the PCA, with the group’s chief executive Jorge Quijano stating, “We can focus on giving them (LNG tankers) a second slot when they start to behave with a more contract-like pattern with their suppliers and buyers.”

“There is another”

China is not the only potential destination for US LNG exports – particularly if Beijing introduces its proposed levies. There is a geographical advantage to American producers providing cargoes to the European market given the questions over the ability to use the Panama Canal.

Increasing supplies to Europe would see the US competing for contracts directly with Russia, which has recently resolved a long-running anti-trust dispute with the EU through the creation of new free trade agreements for gas.

The dispute centred on anti-competitive behaviour, such as excessive prices and prevention of reselling gas delivered into eastern Europe. Under the new arrangements, Russia’s state-backed Gazprom will have to price more gas linked to the European hubs (TTF, Peg-Nord etc.) rather than its traditional oil indexation method (see Figure 1), while on-selling restrictions on gas will have to be lifted, the goal being to create a more competitive environment.

The deal further cements Gazprom’s position as the largest supplier of gas to Europe. In 2017 it provided around a third (34%) of EU gas demand. Russian supplies to Europe are expected to be reinforced by the construction of Nord Stream 2, a second undersea pipeline linking Russia to Germany. This would double the capacity of this link to 110bcm per year, thereby reducing the strategic importance of the southern pipelines, including those that cross Ukraine, an area infamous for being at the mercy of Russian supplies and political pressures.

All of this is good news for security of gas supplies in western and northern Europe, where the Nord Stream 2 project has received strong political backing from the five main European companies involved: Engie (France), OMV (Austria), Shell (GB-Netherlands), Uniper and Wintershall (both Germany). It will however come as a great disappointment in the US, which has been lobbying hard on the benefits to European security of supply from US LNG cargoes.

Sourcing gas from the US is also the preferred option for some European states, namely Poland, which continues to be wary of Russia. US gas also faces a cost disadvantage in Europe. At its source, US gas is cheap, with its benchmark price, Henry Hub, trading at a considerable discount to the global market. As LNG however, its ability to compete in the European market is limited.

The EU’s existing LNG terminals are already underutilised, while plans to develop new assets in Croatia, Greece and Cyprus – despite financial support from the European Commission – continue to experience delays. While US LNG deliveries could take advantage of the current spare capacity, pipeline supplies from both Russia and Norway remain more readily available and relatively attractive on price terms once the costs of the fuel’s production cycle (liquefaction, transportation, regasification) and delivery from the US are considered. At the same time, the Asia-Pacific market is more attractive to US LNG exporters on price grounds, given the premium that it currently commands over its European counterpart.

“Never tell me the odds”

The US has established legislation paving the way for sanctions on Russia, which extends to those companies working with Russia – the Countering America’s Adversaries through Sanctions Act 2017[6]. The act includes a clause to, “prioritize the export of United States energy resources in order to create American jobs, help United States allies and partners, and strengthen United States foreign policy.”

Furthermore, there is a geopolitical question in the presence of renewed American sanctions against Russia, in addition to challenging perceived Russian dominance of the European gas market. Indeed, the US Congress’ National Defense Authorization Act for Fiscal Year 2018[7] points out the importance of energy security in America’s relations with Europe, stating that more needs to be done to “promote the growth of liquefied natural gas trade and expansion of the gas transport infrastructure in Europe”.

This, it adds, is due to American concerns that Russia uses its energy deliveries to Europe “as a weapon to coerce, intimidate, and influence those countries”. On that front, Russian President Vladimir Putin described Nord Stream 2 as a “purely economic” asset, while Kremlin spokesman Dmitry Peskov added has said that the project should not be politicised.

How this situation ultimately develops may be determined by the markets. Gas demand in the EU has posted three years of consecutive growth to 2017 (see Figure 2) and has been sustained through 2018 so far by a combination of factors, including coal plant closures, nuclear plant outages in France and low hydro-power stocks across the continent. All of these have resulted in increasing gas demand for power generation.

There are diverging opinions about whether the increases in demand will continue. The IEA has forecast that demand would fall back whereas Bernstein predicted steadily increasing requirements through to 2030. One thing generally agreed upon is that indigenous European production levels will continue to fall and at an accelerated pace with the need to wind down output from the Groningen field in the Netherlands.

On the supply front, the US may be put in a difficult position if tariffs effectively lock its cargoes out of the Chinese LNG market at a time when the nation’s demand for the fuel is growing. China could turn to Qatar, Australia and other markets for LNG supplies – pushing American cargoes towards Europe. At the same time, European companies have to walk the tightrope of possible expanded American sanctions against Russia and the need to secure affordable gas supplies.

All of these factors put the UK in something of a difficult position. The government is supportive of sanctions on Russia and former Foreign Secretary Boris Johnson suggested possible unilateral actions after leaving the EU. However, its gas market is becoming increasingly reliant on imports and it requires a well-supplied European market to maintain competitive pricing.

If the improvements to overall continental demand continue, coupled with falling local production this may pave the way for both US and Russian gas to be part of the supply mix which would benefit both security of supply and the competitive integrity of the European market.

[1] Source: Thomson Reuters Eikon
[2] Chinese General Administration of Customs (http://english.customs.gov.cn/)
[3] https://www.iea.org/gas2018/
[4] Conversion rate of 1 mn tonnes of LNG = 1.36 bn cubic metres
[5] https://www.bloomberg.com/news/articles/2017-12-08/u-s-shale-has-a-panama-canal-problem-that-s-got-no-easy-fix
[6] https://www.congress.gov/bill/115th-congress/house-bill/3364/text
[7] https://www.congress.gov/bill/115th-congress/house-bill/2810/text

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