Gas: Struggling to realise its potential

11 September 2009

Middle East gas producers must tackle the region’s reliance on associated gas and the legacy of subsidising domestic consumers if they are the make the most of their reserves

Despite being home to more than a third of the world’s proven gas reserves, the Middle East accounts for just 12 per cent of global gas production – a fraction of its potential.

The production of gas will become increasingly important in the region in the coming years, both to meet domestic demand, and to raise revenues through the sale of liquefied natural gas (LNG) on the world markets.

Qatar, for example, plans to significantly expand its natural gas production, targeting production of 8.7 trillion cubic feet (tcf) by 2012, nearly six times its 2005 output levels.

But while the Middle East has been striving to realise its gas potential by investing in liquefaction facilities, global demand for gas has been volatile in the past 18 months.

Weakening demand

In the first half of 2008, the economic outlook for gas producers was strong. A tight supply and demand balance and rising energy prices provided the incentive for producers to invest in greater production capacity.

But since the global recession and financial crisis hit the Middle East in the second half of 2008, the global market for natural gas has been characterised by weak demand and plummeting prices.

US Henry Hub gas prices – a global pricing benchmark for gas futures contracts – fell spectacularly to $2.24 a million British thermal units (BTU) in early September, having traded at highs of $14 a million BTU in the summer of 2008.

Gas demand among member countries of the Organisation for Economic Co-operation & Development (OECD), which includes most of the world’s largest energy consuming countries, fell by 4 per cent in the first quarter of 2009 and is expected to decline further throughout the year – the first annual drop for half a century according to the Paris-based International Energy Agency (IEA).

Key Fact

When Saudi Arabia’s Karan gas field comes on stream in 2012, it will produce 1.8 billion cubic feet a day

Source: MEED

In Japan, for example, demand for gas has fallen substantially, down 6-10 per cent during the first quarter of 2009. There are also signs that supply is outstripping demand in the US. The Energy Department reported that US gas stocks had risen to almost 2.9 tcf in July, the highest level since 1994. The department forecasts that in the US, industrial gas consumption will drop by 8.2 per cent this year. Total US gas demand will slide by 2.3 per cent to 62.1 billion cubic feet a day.

“Despite some recent signs of economic stability, the severe contraction during the first half of the year contributed to an estimated 3.8 per cent decline in daily average natural gas consumption compared with consumption during the first half of 2008,” said the Energy Department’s Short-Term Energy Outlook for the US published in early August.

World gas supply is growing, however, with more than 60 billion cubic metres of liquefaction capacity coming on line across the globe by the end of the year. Where the demand for this new gas will come from is now the question gas producers are facing. This uncertainty is manifesting itself in pricing on the global gas markets. Natural gas futures have proved to be one of the worst performing commodities on the New York Mercantile Exchange, losing almost 40 per cent of their value over the course of 2009. Crude oil futures by comparison have rallied, recording 40 per cent gains.

However, despite prices having fallen in 2009, the US’ Energy Information Administration (EIA) expects prices to improve next year. It predicts the Henry Hub spot price will increase from an average $3.92 a million cubic feet in 2009 to $5.48 a million cubic feet in 2010, due to a decline in drilling activity and projected growth in consumption.

Despite the turbulent markets, gas production is proving relatively resilient in the Middle East. According to Houston-based oil and gas consultants Baker Hughes, the total number of oil and gas rigs operating in the Middle East in July this year was 249, down 18 per cent from 280 in July 2008.

“Saudi Arabia’s Empty Quarter search has been an epic disappointment and the country is struggling to cope”

Samuel Ciszuk, analyst, IHS Global Insight

The number of gas rigs operating in the Middle East was down to 69 in July 2009, down just 13 per cent from the 79 rigs operating in July 2008. In contrast, the number of oil and gas rigs in operation globally was down by 40 per cent to 2,080 from 3,436.

There have however been notable delays to gas production projects both in the Middle East and elsewhere as a combination of restricted financing, falling oil and gas demand and generally poor market conditions has prompted the industry to scale back spending. With the global economic slowdown have come falling construction and materials costs and this has further delayed schemes as clients have sought to renegotiate contracts.

For example, Qatar Petroleum (QP) and the US’ ExxonMobil Corporation delayed the development of their $5bn Barzan gas field venture by up to a year from March 2009 to benefit from falling costs across the region.

In May, Fatih Birol, chief economist at the IEA, predicted a significant decline in investment in the global energy sector on the back of lower demand, tight credit markets and falling cash flows. The IEA forecasts investment in 2009 will fall by about 21 per cent, or $100bn, compared with 2008.

In its medium term outlook, the IEA warns that, while liquefaction capacity will see an unprecedented growth of 50 per cent between 2009 and 2013, there will be a dearth of new capacity in the period after 2013 unless new projects are approved this year and in 2010.

Gas demand has the potential to rebound quickly but increasing supplies generally takes far longer. Building a major gas liquefaction plant such as the Yemen LNG project, which is being led by France’s Total, can take up to four years.

Supply shortage

While the Gulf states are investing in liquefaction plants for export purposes, with the exception of Abu Dhabi and Qatar most countries in the Gulf are also facing a severe domestic gas supply crunch.

Saudi Arabia may have the largest production share for oil in the GCC, for example, but it is lagging in the gas sector. New discoveries have been rare. Saudi Arabia’s search for gas in the Rub al-Khali (Empty Quarter) has been unfruitful and hopes of new commercial finds are fading. “Saudi Arabia’s Empty Quarter search has been an epic disappointment and the country is struggling to cope with gas shortages,” says Samuel Ciszuk, Middle East and Africa analyst at US-based IHS Global Insight.

In the Gulf, the petrochemicals sector is a major domestic user of gas, and reduced petrochemicals production due to weak consumer demand has provided some respite for gas producers in the region. Nonetheless, there are still reports in the Saudi press of gas shortages in some industrial areas.

“This is particularly acute in the Hejaz region, which is seeing power outages of up to five hours a day, in what is the region’s peak demand season,” says Ciszuk.

Analysts do not expect any large quantities of additional gas to come on stream in Saudi Arabia until about 2012, when the Karan field is due to begin operating, producing 1.8 billion cubic feet a day.

Most of the kingdom’s gas comes from associated fields, where oil and gas are found together. This provided sufficient supplies during the rapid expansion of oil production in 2007 and 2008. However, as oil production rates have been cut back – in September 2008, the Organisation of Petroleum Exporting Countries (Opec) agreed to cut production by 4.2 million barrels a day – so have supplies of the associated gas. In March, Saudi Oil Minister Ali al-Naimi reported that compliance with the lower Opec production levels among oil producers was at 80 per cent.

“For governments, this is not just an economic issue but a question of political legitimacy”

Jonathan Stern, Oxford Institute for Energy Studies

Oil production levels will need to rise next year, however, if the predicted increase in domestic gas demand is to be met by Gulf producers. But both government and analysts’ predictions suggest this rise is unlikely. “We will see very slow and perhaps no growth in [international gas] demand in 2010,” says Jonathan Stern, director of gas research at UK-based Oxford Institute for Energy Studies.

“No one is rushing to make new investments in gas production in the next few years – perhaps in 2013 and later,” he adds. At the moment, there is nothing coming on stream except what is already under construction.”

While the financial crisis has dampened gas producers’ appetite to invest in greater production capacity globally, in the Middle East the incentive to invest is further complicated by domestic demand factors, in particular low pricing. The region suffers from a legacy of governments subsidising the price consumers pay for their gas.

“In the Middle East and North Africa, they do not want to increase prices to anywhere near what would be considered market levels,” says Stern. “Gas sales to much of the domestic market do not cover the cost of distribution and delivery, let alone production.”

Domestic users typically pay below $1 a million BTU, less than half current spot prices of $2.24 a million BTU.

This low pricing has exacerbated the difficulties for gas producers. With most of the gas in the Middle East coming from associated fields, reduced crude oil production in a global recession was always likely to bring about shortages of gas and critics claim the onus placed on oil must now be redressed.

“These are now well and truly gas-based economies. We need to end the view of gas as a by-product of oil production that used to be flared,” says Stern, who argues there are few options open to the region’s governments.

Reaching a more sustainable price for gas will involve a mammoth effort to re-educate the local population and to change the way both governments, the industry and end-users think of gas. “For the governments, this is not just an economic issue but a question of political legitimacy,” says Stern.

All countries in the region are struggling with a similar dilemma, of how to boost domestic production at a time of lower global energy prices, with international oil companies consequently wary of making large new investments. The need to provide more supplies to domestic industries will also remain difficult to address while export deals are potentially so much more lucrative.

Unless the imbalance in domestic and export prices is resolved, the Middle East will continue to struggle to make the most of its potential in the gas sector.

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