The problem of low gas prices in the Gulf

03 November 2009

As industrialisation in the region creates increasing demand for gas, Gulf governments will have to address the issue of subsidies

While the Middle East as a whole is gas-rich, its reserves are not spread evenly throughout the region. Iran has the largest endowment, estimated to be 948 trillion cubic feet. Qatar is home to the world’s largest non-associated gas field, the North field, with more than 900 trillion cubic feet of recoverable reserves and total proven reserves of 910 trillion cubic feet.

Saudi Arabiaand the UAE have significant reserves, with 267 and 214 trillion cubic feet respectively. By comparison, Bahrain has just 3.25 trillion cubic feet of proven reserves.

Key facts

  • 93 billion cm/y - Saudi Aramco’s target for non-associated gas production by 2015
  • $2.8bn - Iran’s annual spend on gas imports

cm/y=cubic metres a year.

Source: MEED

But some of the states with the largest gas endowments are nonetheless net importers of gas and struggle to meet demand from both domestic consumers and industry.

Iran, for example, despite having the world’s second-largest natural gas reserves after Russia, is a net gas importer, spending about $2.8bn a year on imports.

Feedstock shortages

More than 75 per cent of the region’s gas reserves are associated with oil fields, meaning the gas is only extracted when oil is pumped from the fields. Gas has historically been viewed as a by-product of oil, which is considered a more valuable commodity, and less desirable in its own right.

Many Gulf states have traditionally used their gas to reinject into maturing oil fields to maintain pressure and production, or have simply burnt off the gas released while extracting oil, a process known as flaring, because they do not have the necessary technology to capture or store it.

As long as the Gulf remains reliant on oil revenues for the majority of its income, states will continue to reinject their gas reserves into maturing oil fields, despite domestic shortages of gas for industrial and household use.

Saudi Arabia, for example, relies on oil for 90 per cent of its export earnings, which contribute 45 per cent of the kingdom’s gross domestic product (GDP). When Opec members agreed to cut oil production by 4.2 million barrels a day between September 2008 and January 2009, in a bid to stabilise oil prices at $70-80 a barrel, they effectively slashed gas output at associated oil fields, exacerbating the region’s gas supply shortages.

In March, after enormous efforts over the past five years to increase crude oil production capacity to 12 million barrels a day (b/d), state-owned oil company Saudi Aramco restricted production to 8 million b/d in a bid to stabilise the global economy.

The result has been a shortage of gas feedstock for the kingdom’s downstream industries, such as petrochemicals. In response to the shortage, power plants across the region are using imported fuel oil as feedstock, rather than gas.

But the gas shortage problem is not just a short-term symptom of lower oil production.There is a fundamental flaw at the heart of the region’s gas sector in the pricing of the product, which is proving a hurdle to development. “The energy sector in the region is fundamentally broken,” says Justin Dargin, a research fellow at the Dubai Initiative at the US’ Harvard University. “The region’s national oil companies [NOCs] either subsidise the cost of gas, or sell it significantly below the potential international export prices.”

“The region’s oil companies either subsidise gas directly, or sell it below export prices”

Justin Dargin, research fellow, Harvard University

Having such low gas prices, he adds, can also lead to wasteful consumption patterns. Domestic gas prices for industry, power and water companies in the Gulf are set at an average of $1 a million BTUs. Production costs, however, can be four times higher as much of the gas is sour – with a sulphur content of about 25-30 per cent – making it more expensive to process.

Raising prices to near market levels would ease the cost burden oil companies bear in processing sour gas, but a mutually agreeable price between producers and consumers has proven elusive.

One example of where pricing is undermining efforts to address gas shortages is the ongoing dispute between Iran and the UAE over gas exports. In 2001, the UAE’s Crescent Petroleum signed a 25-year agreement to import about 600 million cubic feet a day (cf/d) of gas from Iran’s Salman field.

The project was scheduled to deliver gas by the second half of 2006, but has suffered a series of delays, primarily as a result of disagreements over price.

Under the contract, the gas price was linked to the oil price in 2001 but, as oil prices have risen significantly since then, Tehran has called for a revision of the price formula.

While National Iranian Oil Company (NIOC) says it is still prepared to supply gas to Crescent, the UAE firm has begun legal action.

On 15 July, Crescent said it was taking its gas supply contract to the International Chamber of Commerce to start arbitration proceedings because its customers in the UAE, such as the Federal Electricity & Water Authority (Fewa) and Sharjah Electricity & Water Authority (Sewa), had “lost patience” after a three-and-a-half-year delay in receiving gas from Iran. The case is now in arbitration.

The reluctance of Gulf governments to tackle the politically thorny pricing problem, which would mean removing subsidies and charging residential and industrial users market prices, means there are few incentives for gas exploration to boost supplies in the Middle East.

“Key economic incentives need to be established to address this issue, which will otherwise negatively affect future growth prospects,” says Philipp Lotter, senior vice-president at ratings agency Moody’s Investors Service’s corporate finance group in Dubai.

Aramco plans to raise non-associated gas processing capacity to 93 billion cubic metres a year (cm/y) by 2015, from the current 64 billion cm/y, to meet rising demand from industry. But with disappointing results from four years of exploration in the Rub al-Khali (Empty Quarter), Riyadh may struggle to reach this target, which would hamper its attempts to diversify its economy.

The kingdom was the first country in the region to promote the development of a petrochemicals industry, with the establishment of Saudi Basic Industries Corporation (Sabic) in 1976. The aim was to provide diversification to its economy, moving away from crude oil production to value-added products.

Ethane was the feedstock of choice for one simple reason: its massive cost advantage. Aramco supplies the feedstock to petrochemicals producers at a fixed rate of $0.75 a million BTUs, compared with a current market price of about $3.50 a million BTUs for most US producers. Riyadh, however, has been struggling to find gas allocations to fuel its new downstream energy industries.

Exploration incentives

It is not just the petrochemicals industry that is worried about gas availability. A growing fear among the region’s metal producers is the limited availability of competitively priced gas feedstock, says one producer.

The Saudi Industrial Development Fund says it has several proposals to build a series of direct-reduced iron plants across the kingdom, but the fund is currently unable to approve them. There are no new gas allocations to fuel them from Riyadh, which some observers say favours petrochemicals companies over other manufacturing industries in terms of gas allocations.

Saudi International Petrochemical Company was the last company to receive an ethane allocation from the Oil & Mineral Resources Ministry, in 2006. “Due to their sensitive nature, quite how the region’s authorities prioritise their gas allocations is a well-guarded secret,” says Samuel Ciszuk, Middle East and Africa analyst at London-based IHS Global Insight. “There is an impression that electricity generation is very high up on the agenda.”

According to research by King Fahd Uni-versity of Petroleum & Minerals, demand for power in Saudi Arabia is expected to increase fourfold between now and 2032, reaching 140GW. Saudi Electricity Company (SEC) said in August that it intends to invest about $28bn in the next three years to increase power generation by 13GW and upgrade the transmission network.

“Riyadh does not want disruptive power cuts to industry,” says Ciszuk. “Saudi Arabia is not as badly affected as Kuwait, with rolling blackouts. Kuwait has had a massive deficit in capacity over the past five to six years, mainly due to political impasse.”

“Economic incentives need to be established to address this issue, which will otherwise affect growth”

Philipp Lotter, senior vice-president, Moody’s

In September, SEC announced its intention to issue 33 tenders for new or expanded power plants between 2010 and 2023. This will add 21.1GW to its current capacity of 30.7GW.

As the largest liquefied natural gas (LNG) producer in the world, Qatar has come to the rescue of some of its gas-hungry neighbours. Its Dolphin Energy pipeline began operating in 2008, delivering gas from the North field to the UAE and Oman.

The pipeline has reduced gas shortages in both countries, although the UAE’s northern emirates still face regular power cuts. However, the Dolphin project will be insufficient to meet the UAE and Oman’s gas demand in the long term.

In recognition of this, Abu Dhabi National Oil Company is currently analysing contractor bids for its $10bn Shah Gas project to process 1 billion cubic metres a day of sour gas.

But the Shah development’s technical complexities, and the associated cost of processing sour gas, which has a high sulphur content, may have dampened contractors’ interest in the scheme in part because of the low gas prices charged to Gulf consumers.

Social contract

Increasing domestic gas prices, which could in turn create incentives to increase gas exploration and launch production projects in the region, is key.

“It is possible that an effective way to remove this price distortion would be the progressive implementation of a GCC gas market that operates under a competitive mechanism, which will need the parallel implementation of market-driven, inflation-adjusted electricity tariffs,” says Lotter.

The theory may be sound, but the Gulf governments’ political will to remove subsidies is lacking. “I do not see any indications that would point to removal of subsidies,” says Ciszuk. “The political cost of stopping subsidies is still considered too high.”

“In Saudi Arabia, subsidies are ingrained in the psyche,” says Dargin. “Cheap electricity is considered part of the social contract.”

The global economic slowdown has provided some respite for the region.

“Lower demand for feedstock from petrochemicals has saved Riyadh to an extent in Saudi Arabia,” says Ciszuk.

This respite will not continue beyond the financial downturn, however, so the under-lying supply and demand imbalance remains unresolved. Until the expectation of cheap domestic gas is removed – and more associated gas captured with oil production – the Gulf region and the wider Middle East will continue to suffer from shortages, despite its vast gas endowment.

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