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Robert Johnston
Eurasia Group

The development of multiple export strategies for liquefied natural gas exports from the West Coast of Canada to global markets is backed by strong political support from Canadian political leaders, including both the Premiers of Alberta and British Columbia. LNG exports face less political controversy than proposed oil sands export projects to the Pacific Ocean from Alberta, which have already been subject to a non-binding vote barring oil tanker traffic to the port of Kitimat, in the Canadian Parliament on 7 December 2010.

In addition to the tanker issue, there is a clearer sense with respect to natural gas exports that exports of gas from the shale gas plays of northern BC must find a new market due to the absence of markets in Eastern Canada and the US, as those regions are increasingly saturated by competing shale gas plays in the lower 48.  By contrast, oil sands still have significant growth potential in the US Gulf Coast refining market, making the case for a short-term outlet to Asia somewhat less pressing.

Should the flagship Kitimat LNG project move forward on schedule to begin exporting gas in 2015, it will be the first Canadian contribution to what is a rapidly growing global gas market. LNG markets have grown in volume, with recent capacity expansions dominated by the 77 mmtpa dual Qatargas and RasGas projects in Qatar. The final of the megaproject’s 14 LNG trains came online in 2010. Over the next few years, liquefaction supply growth will shift to Australia, with the Pluto, Queensland LNG, Gorgon, and Wheatstone megaprojects ramping up. The Kitimat LNG terminal under development by Apache Energy, EOG Resources, and Encana could export up to 10 mmtpa (1.3bcf/day) in two phases. According to a report prepared by Poten & Partners in support of the Kitimat LNG application in front the National Energy Board forecast that the Asian LNG market would have a gap of 47mmtpa by 2020, leaving ample room for Canadian gas exports. The report also highlights the high costs of the rival Australian and Papua New Guinea projects and suggests that the Kitimat LNG project should be competitive for Asian buyers.

With US Markets Saturated, BC Gas Looks to China

For North American gas markets, the Horn River and Montney plays have been at times somewhat of an afterthought. Most attention on the shale gas front is focused on the US plays in the Marcellus (Pennsylvania), Barnett (Texas), and Haynesville (Louisiana), as well as liquids-rich gas plays such as Eagle Ford (Texas). The BC shale gas plays produced just 500mmscf/day in 2009, but even in a low price scenario are projected by the NEB to produce 2bcf/day by 2012. Encana recently predicted BC gas production could grow to 7bcf/day by the end of the decade.

To get to that kind of growth scenario, Western Canadian gas must find new markets. If the US market is saturated and faces slow growth, then Asia looms as the obvious market because of its size and rapid growth. China in particular is critical because growth there is expected to jump from 100bcm/year in 2010 to 260bcm/year by 2015, according to the most recent projections in China’s 12^th Five Year Economic Plan. While the growth of gas demand in China is in part driven by strong economic growth and a desire to slow the growth of coal for environmental reasons, it is also important to note that Chinese economic planners and political leaders will only encourage wider use of natural gas if the supply outlook is secure.

This is the opportunity for Kitimat LNG and other future Canadian gas export plays from the West Coast. China is looking to diversify its supply of imports, as the country became an importer of pipeline gas for the first time in 2009. China has a multitude of pipeline and LNG import options and will also look to leverage its own potential unconventional gas resources. Canadian energy companies, including both exploration and production firms as well as oil services firms will participate in the opening of China’s unconventional gas sector.

In addition to a diversified supply mix both domestically and internationally, gas security in China (and elsewhere) is also predicated on fungible supply and flexible markets. In markets controlled by fixed flows of gas through long distance pipelines, flexibility is difficult, particularly when pipelines are controlled by a single operator. The recent growth of LNG is creating the beginnings of more flexible markets, even if long-distance pipelines and LNG trains are still dominated by fixed contracts with destination clauses.

Global Crises Alter Supply & Demand Outlook

The proof of the emerging flexible gas market is evident in the aftermath of the February 2011 earthquake in Japan. Major participants demonstrate the growing flexibility and resiliency of the global market by using cargo swaps and other strategies to meet Japan’s needs. The events of March 2011 appear to pose the first serious test for the "global" gas market, as it faces simultaneous problems on three continents. Meanwhile, the North American gas markets remain mostly unaffected by tighter market conditions elsewhere.

The collective impact of events in Libya, Japan, and Germany appears to be an approximately 25–30 billion cubic meter (bcm) change in market expectation for global gas supply and demand compared to pre-crisis levels. Libya’s Greenstream pipeline, which supplies gas to Italy, is offline due to civil conflict, causing a 10 bcm shortfall in EU gas supplies. Japan will need to replace 12,730 MW of generating capacity from nuclear power plants that are shut down due to the earthquake. This is equivalent to 9.4 bcm worth of natural gas demand. Germany’s decision to shut down seven of its oldest nuclear plants for three months will impact 7,419 MW of power supply, equivalent to 5.65 bcm of natural gas demand.

To be clear, there will not be a one-for-one relationship between the amount of lost nuclear supply and new gas demand. Coal- and oil-fired power plants as well as demand management programs will also help address the shortfall. Similarly, in Germany, coal will also compete with gas to replace idled nuclear capacity. The larger issue for Germany and the EU is the expected diversion of spot LNG cargoes from Europe to Asia. In 2010, EU countries imported around 27.5 bcm of spot market LNG, along with 61 bcm of fixed-contract LNG. As LNG exports to the US become increasingly negligible, EU-bound LNG cargoes are the most likely candidates for diversion to meet Japanese needs.

Shell, one of the largest LNG producers and traders, was an early mover in diverting some of its gas to Japan. With LNG supply from Russia, Nigeria, Brunei, and Qatar, Shell has the flexibility to shift cargoes. Similarly on the consumer side, the Korean state gas company KOGAS also announced that it would deliver some of its contracted cargoes to Japan in exchange for swaps in the longer term. Earlier, in response to the Greenstream disruption in Libya, both Russia and Qatar indicated they could increase exports to account for lost supply in the EU. Collectively, these responses indicate that the global gas market is becoming more flexible. The growth of LNG and contracts that are more flexible than the traditional fixed-destination, take-or-pay pipeline contracts, particularly in Europe, is allowing the market to adapt to current circumstances. In 2009, total global trade in LNG was 242 bcm, so the current dislocations totaling 25-30 bcm, represent just under 10% of the overall market.

The ability of the global gas market is limited however by contract structures, shipping constraints, and a limited pool of flexible LNG supply. So while the current crises seem within the scope of the global gas market to manage without major disruptions or price spikes, additional supply outages or demand spikes could create much more significant problems. Still, the fact that (so far as of this writing on 17 April 2011) the supply disruptions from Libya and demand shocks from Japan and Germany have not created a massive price spike is good news for Kitimat LNG. The evident flexibility in the LNG market and the ability to quickly meet new demand will make Chinese leaders more comfortable from an energy security perspective, while making the potential market for Canadian gas even bigger.

US Exploring LNG Export Prospects

A final question to consider is whether proposed LNG export plays in the US will also be able to benefit as effectively as Kitimat LNG and similar Canadian plays from the emerging flexible global gas market. Cheniere Energy announced on 3 June 2010 that the company will seek to construct up to 2 billion cubic feet (bcf) per day of LNG export capacity at its Sabine Pass import/regasification terminal in Louisiana. The proposed capacity would represent roughly 3% of current US gas production. It is now conventional wisdom that the growth of US shale gas resources is a game-changer for global gas markets. However, all but the most bullish advocates of shale gas’s potential until now, maintained that shale production will not add enough to North American supply to allow for exports. The Sabine Pass project will put such assumptions to the test as it moves forward through planning and regulatory approval over the next few years.

The Cheniere strategy, likely to be followed by rival LNG export developers Freeport Energy, is to offer gas to European buyers at US Henry Hub pricing, which currently is at a significant discount to European prices. This pricing strategy could also be attractive to Asian markets as the Panama Canal is widened over the next decade, opening up a new supply route for LNG tankers. However, the additional shipping costs to Asia would limit the upside for shippers. Still, recent investments by CNOOC into the Eagle Ford shale play perhaps set the stage for LNG links, although this would only likely be in the very long-term.

In order to overcome opposition in Washington, Cheniere and Freeport Energy are highlighting the flexible nature of their projects, which will allow shippers to pay for capacity for both export and import. Flexibility would allow for US exports outside the peak winter season, even if the US continues to import spot LNG during that time.

When compared to the Kitimat LNG proposal, the politics around exporting US gas may be more problematic. Gas-intensive industrial consumers, power plant operators, and advocates of increased use of natural gas–powered vehicles will likely oppose the LNG projects on the grounds that diverting supply to international markets will push North American prices higher. Cheniere and Freeport will have to position the project as a seasonal outlet for US gas during periods of peak storage and/or weak demand. Cheniere in particular is seeking investment from trading firms that could effectively run arbitrage around these types of market fluctuations.

Robert Johnston, PhD is the director of Eurasia Group's Global Energy & Natural Resources practice.