Introduction Peak oil? Destination clauses and the nuclear dilemma: Japan New opportunities, new markets: Singapore Increased supply: Algeria Gas to power: Africa North Slope and rail opportunities: Alaska Global LNG uncertainty Brexit: the likely impact Comment

Introduction

Profitability in the liquefied natural gas (LNG) market continues to be squeezed as prices remain low in a market awash with capacity. Despite predictions in September 2016 that the increase in Brent to US$55 per barrel by the beginning of 2017 would likely contribute to a higher contracted LNG price, the current slump in the price of oil, together with increasing costs in the sector, has dampened such predictions. Costs have risen as human and resource availability has failed to keep pace with the rate of development. As a result of market conditions, a number of companies posted losses in the third quarter of 2016.

LNG spot prices in Asia increased from US$4.241 per million British thermal units (Btu) in May to US$6.60 per million Btu as winter approached – a shadow of the US$20 per million Btu being realised in 2012 to 2013. The price increase was driven by demand from South Korea, which saw four nuclear units put offline following earthquakes in mid-September, depriving it of 22 gigawatts of network capacity. India also proved to be an active market in September, as LNG became an attractive alternative to competing fuel supplies due to depressed prices and ready market availability.

The momentum of the A$200 billion LNG construction boom in Australia – coinciding with increased supply from Qatar and North America – continues to subdue prices across the market. At the same time, the industry has seen higher than forecast project costs and cost overruns. Other projects (eg, the US$40 billion Woodside Browse project, a partnership including Royal Dutch Shell, British Petroleum (BP) and a joint venture between Mitsubishi and Mitsui) have been halted indefinitely amid concerns of feasibility. Unsurprisingly, no new greenfield sites in Australia are scheduled to be approved in the coming years.(1)

With increasing pressure on large-scale LNG plants to prove returns to investors, the market is increasingly backing smaller-scale LNG initiatives. The technology enabling LNG providers to offer a variety of 'plug and play' products is now proven, due to early adoption, and offers commercial opportunities with decreased commissioning times in bunkering, distribution by lorry and rail, and small-scale distribution and redeployment. The technology allows for scalable supplies that are better suited to respond to short-term fluctuations in demand, including demand originating from areas of the market that were previously unsuited to LNG as a fuel source. The interior of Alaska and the islands of Indonesia are two examples that this update discusses in detail.

In addition, tighter regulation on emissions in the European Union – both atmospheric and marine (where bunker fuel must have a sulphur content of 0.5% or lower from January 1 2020) – continues to encourage growth in small-scale LNG projects across the continent, from reloading services (eg, Grain LNG, United Kingdom) to bunkering initiatives (eg, Port of Rotterdam Harbour Basin and Zeebrugge) to multi-modal LNG reload terminals and truck loading (eg, Enagas, Spain). Opportunities for small-scale LNG in transport are also being realised, with the first LNG-fuelled bus in India being launched at Petronet's Kochi LNG import terminal. This project ? involving Petronet LNG, India Oil Corporation and Tata Motors Ltd ? demonstrates the market interest in LNG alternatives.

Engie, Mitsubishi Corporation and NYK Line have also launched Gas4Sea, a bunkering initiative that combines leading industry experience in LNG supply with shipping expertise to offer a ship-to-ship refuelling platform. The purpose-built bunkering vessel is the first of its kind, offering 5,000 cubic metres of LNG capacity, which was scheduled to become operational in the fourth quarter of 2016.

Where large-scale LNG investment is occurring, the market has seen an increasing preference for floating terminals over land-based options. Floating terminals offer lower associated long-term risk, with scalable capacities through the addition of extra floating storage units. This also realises efficiencies in existing LNG infrastructure by recovering additional value from older LNG carriers, which can be readily adapted for storage purposes. Advancements in LNG connector technology have facilitated a number of flexible mooring options that can withstand rougher sea conditions with easier, intelligent connection points. This greatly increases the ease of access to LNG by removing the need for established docking facilities, reducing costs and improving safety across the industry.

Developments in the LNG market reflect the Einsteinian theory that: "In the middle of difficulty lies opportunity." A number of key industry and broader geopolitical headlines that emphasise this current dynamic are outlined below.

Peak oil?

In early November 2016 the former chief financial officer of Shell, Simon Henry, predicted that "oil demand will peak before supply and that peak may be between five and 15 years from hence".(2) Oil demand in Europe has decreased by 17% over the past decade, largely as a result of a widespread move towards renewables and clean energy. Demand in China has also flattened over recent months, due to a slowdown in industry. Henry's prediction highlights the increasing role that LNG could play in meeting energy demand worldwide. With dwindling support for coal and oil, gas is the cleanest alternative to fuel the baseload generation required to support networks increasingly powered by renewables, without the associated risks or costs of nuclear.

Destination clauses and the nuclear dilemma: Japan

The Fair Trade Commission of Japan recently launched an investigation into whether re-sale restrictions in so-called 'destination clauses' in LNG contracts (contractual provisions limiting a buyer's right to sell contracted cargo to a third party) violate competition laws. Japan is the world's largest import market for LNG, having imported over 80 million tonnes in 2015. If such clauses are found to violate fair trade laws, more than US$600 billion-worth of long-term trading contracts may be renegotiated. A report conducted for Japan's Ministry of Economy, Trade and Industry revealed that approximately 80% of Japanese and South Korean long-term LNG import contracts could be subject to such renegotiations.(3) This is likely to strengthen the position of Japanese LNG buyers by providing the leverage to amend existing contracts for flexibility. If found to be anti-competitive in Japan, contracts across the Asia-Pacific region are expected to be renegotiated, just as happened in Europe following the decision of the European Commission in October 2004.

As a result of a return to coal and the restarting of two nuclear generators, Japan's LNG imports for 2016 were expected to decrease by 3% overall by the end of the year, with a further decrease of 3% forecast for 2017. However, it remains the largest net LNG importer in the world. In addition, the large-scale restart of nuclear is far from certain. The announcement by newly elected governor of Niigata, Ryuichi Yoneyama, that the Kashiwazaki-Kariwa nuclear plant will not be reopened demonstrates the pressure on Tokyo Electric Power Co (TEPCO) to meet power demand with alternatives to nuclear. Forty of the 42 reactors in Japan remain offline amid safety concerns. LNG has been TEPCO's preferred replacement since the Kashiwazaki-Kariwa reactors closed – with 65% of the company's electricity production attributable to LNG, representing 27% of the country's overall LNG imports.(4)

New opportunities, new markets: Singapore

Shell and Pavilion Gas were awarded licences by the Singapore Energy Market Authority (EMA) to import LNG to Singapore, with the next tranche of imports expected to commence from 2017. Pavilion Energy had already announced plans to work with ExxonMobil to develop LNG bunkering and other downstream solutions in Singapore. Pavilion's chief executive officer, Seah Moon, has highlighted the role that developments in small-scale LNG could have on demand in Southeast Asia, as the EMA continues to adopt a strategy to create a regional LNG fuelling and reloading hub on the island. The interplay between small-scale and large-scale LNG will be a key source of growth for the sector.

The Singapore authorities claim that, by virtue of its geography, Singapore provides a natural location from which larger LNG carriers could break bulk and reload on smaller regional barges for 'milk-run' LNG deliveries. For example, Indonesia has a population of 250 million across 17,000 islands. While demand across the population may be small and fragmented, the collective volume represents a significant alternative market for LNG growth in the region. Pavilion has signed a memorandum of understanding with state-owned Pertamina in Indonesia to explore joint marketing, trading and procurement opportunities. Meanwhile, BP has obtained final investment approval to expand operations at its Tangguh LNG project, which will see a 50% increase in production to 11.4 million tonnes. Perusahaan Listrik Negara, the Indonesian government-owned electricity provider, will receive 75% of the annual LNG production from the new train.(5)

Increased supply: Algeria

In addition to new projects coming on stream, existing supply is returning to the market. Algeria has restarted its Skilda LNG plant following two months of planned maintenance. The country is the second largest natural gas supplier to Europe (after Russia), producing 6.5 trillion cubic feet gross in its last production year – a 4% increase on the previous year. State-owned Sonatrach exported 12.1 million tonnes of LNG to Europe in 2014, of which 25% went to France and 2.74 million tonnes to Spain. The company was expected to have exported 36 million tonnes of gas to Europe by the close of 2016 – a 15% increase on 2015 levels. In addition, three new projects are to come on stream by June 2017: the Touat gas venture, the Timimoun project and the Raggane gas wells.

Gas to power: Africa

The Department of Energy (DoE) in South Africa has issued an information memorandum relating to the independent power producer programme to procure two LNG-to-power projects, totalling 3,000 megawatts of capacity at a cost of US$3.7 billion. The DoE selected the Ngqura port in the Eastern-Cape province and Richards Bay in the KwaZulu-Natal province for the first phase of the procurement programme.(6) A separate request for qualification will be released for each project, with preferred bidders selected to submit request for proposals. The integrated LNG-to-power projects will incorporate floating storage regasification units in the port limits, and transmission pipelines and generation facilities outside the ports. Both generation units will receive revenues under a power purchase agreement with Eskom, the South African public utility provider.

The significant interface and finance risks associated with LNG-to-power projects have increasingly been overshadowed by the large financial incentives for providing a cleaner alternative to emission-intensive coal plants in the absence of World Bank subsidies. South Africa has particular appeal to companies with existing gas interests on the west coast of Africa. Other countries in the West African region have also shown growing interest in LNG imports for the purposes of power generation, with the first gas imports expected in Ghana by the end of the first quarter of 2017.

North Slope and rail opportunities: Alaska

BP has joined ConocoPhillips to give assurances to the Alaskan LNG project amid doubts that the state-led project would become operational. In late 2015 the Alaskan government paid US$65 million for TransCanada Corporation's 25% stake in the Alaska LNG project, which would transport gas from the North Slope fields to a facility on Cook Inlet for shipment to the Asian market. However, increasing global supplies of LNG and depressed prices have dissuaded private-project partners from investing further. In August 2016 a report from Wood Mackenzie found that the Alaska LNG project was "one of the least competitive" proposed plants worldwide, prompting ExxonMobil to withhold investment from the next stage of the project.(7) The Alaskan governor Bill Walker took to South Korea and Singapore to meet key LNG buyers with an aim of securing a contracted buyer for the 20 million tonnes per year of LNG that are forecast from the site. Despite the negative feasibility analysis in the Wood McKenzie report, Walker insists that the Alaska LNG project would bring billions of dollars of revenue to the state, even with oil prices as low as US$45 per barrel. However, should prices return to the US$27 lows of January 2016, it is difficult to see how investors may be willing to participate further.

Meanwhile, Alaska Railroad Corporation has been awarded the first US rail licence to transport LNG by rail. A month-long operational performance trial period took place between September and October on a route between Anchorage and Fairbanks. The proposal is that LNG transported in International Standards Organisation (ISO) containers by rail could help meet Alaska's growing energy needs in the interior, where few pipelines are available. The proposal is to transport the fuel at night on existing infrastructure to avoid interaction with passenger railcars. ISO containers are of a standard dimension, ensuring compatibility with loading and unloading venues. This avoids the high cost of new bespoke infrastructure and minimises the concerns of travellers who perceive LNG as dangerous cargo.

Global LNG uncertainty

A period of uncertainty faces the global LNG market. If recently awarded US export licences are suspended in order to satisfy domestic demand, the price of LNG on the global market is expected to rise in the short term as supply decreases. However, the medium and long-term implications following the recent US election on the trade of LNG are unclear. Increased investment in the oil and gas sector, sustained by tax incentives and softened policies on carbon emissions, could help sustain significant growth in the market, with increased export potential.

Brexit: likely impact

Following the outcome of the United Kingdom's referendum on continued membership of the European Union, concerns have been raised about the effect that Brexit might have on LNG volumes and UK prices.

In practice, the United Kingdom already has mitigation against security of supply risks built into the system. The import infrastructure allows multiple sources of supply via its three gas interconnectors and three LNG import terminals. As the infrastructure is already largely in place, operations and gas flows are expected to continue as normal, irrespective of Brexit.

For Brexit to have an effect on UK prices, it would need to lead to consequences such as export tariffs imposed on EU gas flowing to the United Kingdom. LNG import capacity is not fully utilised, but this is more of a supply-and-demand issue unlikely to be connected to Brexit. LNG accounted for only 13% of UK gas supply in 2015, but this could increase given the spare capacity and with a fourth import terminal under construction (offshore Barrow-in-Furness). A joint project between Flogas and Stolt-Nielsen has also been announced at the eastern Scottish Port of Rosyth, with a scheduled operation date for 2019. Small-scale Stolt-Nielsen carriers are expected to deliver LNG for bulk storage at the port, before regional truck distribution by Flogas – demonstrating the increasing potential of small-scale LNG in the United Kingdom. However, whether the United Kingdom will be an attractive destination for spare LNG volumes is most likely to be driven by the price of gas in the UK market. Questions could also be raised about the guarantee of gas supplies through key interconnectors (eg, the UK-Belgium interconnector system) in the event that continental members wish to store surplus supplies on the mainland during European shortages.

Regardless, the impact of Brexit will not be clear until Article 50 is triggered and, even then, may not be fully known until the United Kingdom's future trade relationship with Europe is established and implemented.

Comment

The depressed price of oil (which remains a key factor in securing finance), paired with oversupply, has seen the price of LNG fall. Industry overruns and the costs associated with LNG research and development continue to squeeze profit margins in the sector. However, opportunities remain. The growing sustainable relationship between large-scale and small-scale LNG, together with increasingly tougher regulations on emissions, continues to promote LNG as the hydrocarbon of choice. Competitive prices and ease of availability look set to cement global interest for years.

For further information on this topic please contact Richard Howley or Penny Cygan-Jones at Norton Rose Fulbright LLP by telephone (+44 20 7283 6000) or email (richard.howley@nortonrosefulbright.com or penny.cygan-jones@nortonrosefulbright.com). The Norton Rose Fulbright website can be accessed at www.nortonrosefulbright.com.

An earlier version of this article was first published in LNG Industry.

Endnotes

(1) J Smyth, "Cost overruns near $50bn as Australia's LNG boom falters", Financial Times (October 31 2016).

(2) N Butler, "Will oil peak within 5 years", Financial Times (November 3 2016).

(3) S Stapczynski, T Inajima and D Murtaugh, "More Than $600 Billion Is at Stake as Japan Probes LNG Deals", Bloomberg (July 20 2016).

(4) S Stapczynski, T Inajima and E Urabe, "Japan Said to Review If LNG Contracts Barring Resale Violate Law", Bloomberg (July 14 2016); A M Ferraro, "Gas & LNG in Review: October 16-21, 2016", Gastech News (October 21 2016).

(5) "BP announces final investment decision to expand Indonesia's Tangguh LNG facility", BP (July 1 2016).

(6) "South Africa releases PIM for LNG to IPP Procurement Programme", IPP Journal (October 17 2016).

(7) "US Alaska North Slope other discoveries", Wood Mackenzie (August 2016).

Jack Longden assisted in the preparation of this update.

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