Interesting times for gas in China

By Nicholas Fulford and Ryan Pereira 20 February 2017
Sinopec's LNG terminal in Beihai, Guangxi. (Sinopec) Sinopec's LNG terminal in Beihai, Guangxi. (Sinopec)

China appears to be heading for something of a watershed when it comes to gas. And what happens in China will be pivotal for the global gas sector as the country will move the needle on world gas demand.

Gas is seen as a beacon of growth amid a general slowdown in the Chinese economy, boosted both by government support for clean energy and the global oversupply of LNG.

This short piece from Gaffney, Cline & Associates looks at what is happening in the Chinese gas market in terms of the emerging trends, the challenges and the opportunities.

‘Trinity for change’ is gathering pace in China

We have looked at unbundling as a way of creating a liquid market with prices set by supply and demand fundamentals.  We coined the term ‘trinity for change’ to describe the three ingredients that act together as a catalyst for gas market reform.

Trinity for change

There are three features that have catalysed change in all the previous examples of gas market reform – whether in the United States, Canada, the UK or Continental Europe – and are now doing so in many parts of Asia:

  • Multiple competing supply options, often resulting in lower wholesale prices.  
  • Mounting pressure from end-users who want access to competing supplies to lower their costs.
  • Governments seeking to create a more competitive economy and drive growth through a more efficient energy value chain and lower energy costs.

How does China stack up against the Trinity for Change? 

The global oversupply of LNG means China is well-positioned to take advantage of low-cost gas in the short-to-medium term; we have already seen contract renegotiations among existing longer-term buyers and new entrants keen to secure lower-cost supplies.

Gas is having to compete with lower-cost oil, coal, LPG and renewables when compared with regulated citygate prices. Battle lines are being drawn between the ‘old guard’ – typically state-owned entities that control much of the natural gas supply chain – and new entrants, which are increasingly turning to independent solutions with their own infrastructure to access gas.  Other state-owned or state-controlled entities – some with more entrepreneurial cultures – are having to decide which camp they want to be in. There are also emerging opportunities for gas as a transport fuel and in local gas-to-power markets.

Within China, the central government’s ability to shape policy is perhaps less dominant than some might think. Among the provincial governments and the powerful energy  groups, there appears to be some pushback against centrally dictated policies on gas, especially third-party access to LNG terminals and major pipelines. Similarly, with plans for a liquid gas hub in China, supported by an active trade in futures through an exchange, other market possibilities are being discussed.

Complexities create tensions

With the complex backdrop described above, government regulation of city gas prices is increasingly challenging. There is growing tension between pressure to cut prices to drive demand and improve air quality on the one hand, and the need for China’s main gas producers – under pressure from low cost-LNG – to create a more sustainable investment platform for gas on the other.  

Overall, government action on citygate prices and continued investment in infrastructure appear to be creating an environment where the gas price is increasingly influenced by market forces, with infrastructure open to third-party access . However, it appears unlikely this development will mature quickly or without some disruption along the way.

There are few quick wins for gas-related investment in China. Long-term commitment will be needed before gas starts to provide a return, and this may deter some of the less well-capitalised players.

The challenges in the Chinese gas market

As competing LNG suppliers and importers square up against one another, there is an increasing chance there could be some ‘take-or-pay’ issues in China similar to those seen in Europe. Contracted supplies could become more expensive in an increasingly over-supplied market, while spot LNG could fall in price. Within a few months, long-term oil-linked contract gas could be significantly more costly than spot. Given current oil prices and Asian spot gas prices during most of 2016, a typical cargo of LNG delivered under a long-term, oil-indexed contract could be as much as $10 million more expensive than the same LNG sold on the spot market – although the rise in spot prices at the end of 2016/early 2017 has mitigated this effect temporarily. Such a two tier market is not sustainable, and the pressures to align long term and spot prices will only get bigger. This will be especially true as market fundamentals for 2017 suggest more LNG supply, which is pushing down spot prices again to sub $6/MMbtu. With oil stabilising at somewhere over $50/bbl, corresponding to around a $7/MMBtu gas price for oil indexed contracts, we are likely to see some dissatisfied buyers.

Potential pricing model evolution over next decade

In general, the co-existence of three completely separate pricing models in Asian markets (spot, Henry Hub tolling based and oil-linked) has only been sustained by luck. During the course of the past 4-5 years we have seen these three pricing structures draw more or less level to within a couple of dollars . With these prices now diverging (ironically, with US gas as potentially the most expensive and spot gas being cheaper), the whole of Asia is heading for a turbulent period when it comes to gas pricing, where either long-term oil-based or tolling agreements in the US could lead to stranded costs.  

There are also signs emerging of contract renegotiations in China, with some of the major players allegedly discussing both price and volume, but potentially not with sufficient leeway to fully address the issues. There appears to be an increasing number of gas supply agreements where Chinese buyers have expressed dissatisfaction over their contract terms and are taking action. If Europe is to be our guide, where gas indexation displaced oil as the dominant force in gas contracts over a relatively short time, the speed of evolution in China could be even quicker. Once price reopeners, renegotiations and arbitrations have worked through the system, the portion of gas priced off some kind of gas on gas index could end up becoming the norm.

Opportunity is still huge for the right investments, but can catch out the unwary investor

Gas is attractive in an otherwise bleak economic outlook. Consequently, there is a plethora of well-funded ‘second tier’ companies keenly looking for opportunities and ready to deploy capital in the energy sector. They have growing knowledge of and interest in gas. 

North America still represents a popular investment ground for China. However, with Henry Hub prices firming to the mid $3/MMBtu mark, the current lack of competitiveness of US Gulf Coast LNG exports is not lost on the bigger companies. Western Canada may increasingly be seen as a longer-term option as a result of FID delays, but the low cost of Canadian gas and the more process-driven regulatory system still attracts attention, particularly given the evolving policy situation in the US. The Woodfibre LNG project, which reached FID in November 2016 on the back of Chinese gas-for-power demand, is a good sign this region remains a contender.

Chinese gas market participants need to be suitably savvy to navigate a successful investment path that avoids inefficient and poorly integrated growth. Such problems could be caused by the following factors:

  • The significant challenges of implementing policies on third-party access, which have so far been largely frustrated by incumbents.
  • The changing environment for the formulation of long-term gas contracts.
  • An uncertain regulatory environment. 
  • Geopolitical tension created by over-contracted supplies of LNG and Russian/Central Asian pipeline gas.
  • A two-tier gas market that favours those without long-term supplies and a rapid expansion in provincial regasification and transmission infrastructure, especially power-related.
  • A rapidly evolving environmental policy, driven largely by air quality issues.

In conclusion, China has established an increasingly competitive mechanism for setting regional gas prices and started to put in place arrangements for third-party access to LNG regasification infrastructure. These steps look likely to form the foundation for establishing market-based prices that will respond to wholesale supply and demand.  

There is also the potential for take-or-pay contracts to come under pressure as supply runs the risk of exceeding demand, as has happened in the UK and Europe. Amid several uncertain evolving factors, the only certain thing is that the coming months will be a busy time for anyone involved in the Chinese gas market. And because of the increasing connections between Chinese developments and global markets, these factors are something no one in the gas business can afford to ignore.

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Gaffney, Cline & Associates (GCA) provides both broad-based and detailed technical, commercial and strategic advice to clients across the upstream, midstream and downstream sectors of the oil and gas industry, using a project team approach: https://www.gaffney-cline.com.

Nicholas Fulford is global head of gas and LNG. Nicholas has worked in natural gas for over 30 years and was heavily involved in the legislative and regulatory changes that transformed the gas and power markets in the UK in the 1990s. Email Nicholas at nick.fulford@gaffney-cline.com.

Ryan Pereira is principal commercial manager for global gas and LNG. Ryan has over 13 years of experience in the energy sector, from industry and advisory roles with majors and operators to working with joint venture parties and national oil and gas companies. Email Ryan at ryan.pereira@gaffney-cline.com.

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