Expensive Energy

Gas prices in Europe aren’t going to decline anytime soon.

The natural-gas business has been transformed over the past few years by the growth of U.S. gas reserves, mostly located in shale deposits. Assessing the broader geopolitical implications of this boom in "unconventional" gas supplies, however, is tricky. Since natural gas is not a global market, change impacts countries in very different ways. The boom in U.S. gas supplies will likely lead to lower prices here for an extended period, and it will also help prolong a global gas glut. But the tightness in the global market will return, even though the Unites States will remain disconnected from that market. What is more, the center of enthusiasm-replicating the U.S. gas revolution in Europe-will take time to happen, meaning that the Continent shouldn't expect unconventional gas to make up a large portion of its energy supply before 2020.

Natural gas is not a global market-it is a regional and even a local market. Gas does not have a global price that one can see on the front page of the Wall Street Journal. Not only do prices change from country to country, they also often move in different directions. This is the result of three distinct realities, all of which are important to keep in mind when considering the changing geopolitics of natural gas.

The first reality is infrastructure. Gas is transported either in pipelines or in the form of liquefied natural gas (LNG) from specially designed export facilities to specially designed import facilities. The precious resource can move only along existing infrastructure, which is often limited. Contractual obligations also have to be taken into account. Because of the high investment needed to transport gas, it is usually produced only after a sales contract has been secured. This limits risk, but it also means that there is little gas which is produced without a pre-dedicated market. Pricing, too, is important. In much of the Organisation for Economic Co-operation and Development (OECD), but not the United States or the United Kingdom, gas is priced relative to oil, a legacy of the effort to replace crude with gas in the 1970s and 1980s. So in much of the world, the price faced by end-users depends on what happens to oil markets rather than gas markets alone.

Given this fragmentation, we need to think of regional rather than global implications. For one, the outlook for U.S. gas prices is bearish, which is good for consumers but bad for producers. The United States already has lower prices than many of its peers. Henry Hub, the pricing point for natural gas at the New York Mercantile Exchange, was $3.92 per million British thermal units (MMBtu) in 2009, 55 percent lower than the price of gas in Japan. Abundant supply comes amidst weak demand, which peaked in 2000. The U.S. Department of Energy forecasts gas demand to grow at just 0.2 percent per year out to 2035; the International Energy Agency expects U.S. demand in 2030 to be at the same level as 2007. As such, the U.S. gas lobby is trying to create new demand either through favoring gas relative to coal in power generation or through the increased use of gas for transportation.

The upside of this anemic demand is that North America (including Canada) can remain broadly self sufficient when it comes to gas production. This removes an important source of demand from the global market. In the early 2000s, the consensus was that U.S. gas production would decline and that imports would be needed to meet demand. Companies accordingly invested heavily in LNG facilities, increasing the world's LNG export capacity-which is set to grow by 50 percent between 2007 and 2013, in part based on investments targeting the U.S. market. But demand has fallen. The United States does not need to import much gas, while the rest of the world has seen demand weaken as the result of the economic crisis. We're in the midst of a gas glut.

Even so, this hasn't led to much change in the energy markets. In Asia, gas prices are linked to oil. Since oil prices have remained high, gas prices have too. In Europe, there is a gap between the prices linked to oil (as in most of the Continental states), which are high, and those prices linked to liquid hubs (as in the UK and parts of NW Europe), which are low. Buyers cannot easily substitute one for the other, in part due to a dysfunctional market whose liberalization has been half-hearted. That the two prices can differ by as much as 50 percent is proof enough that arbitrage is insufficient. That is why Gazprom made limited concessions to its buyers by linking only about 10-15 percent of its price to liquid hubs-and that provision is scheduled to last only to 2012. While this has been hailed as a victory in Europe, it is hardly so. The move towards a hybrid pricing system (hub and oil-linked) has been underway for several years anyway, so the changes reinforce an existing dynamic rather than forming a breakthrough. And there is no guarantee that a hub-based price is "better"-hub prices have often traded much above oil-linked prices.

The bigger question is whether the gas surplus will be long lasting-either because without the United States it will be impossible to sop the excess gas from the market or because the exportation of the technology to develop unconventional gas will create derivative revolutions elsewhere. On both counts, there is reason to be cautious.

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