The Shale Invasion: Will U.S. LNG Cross the Pond? New terminals ramp up exports.

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1 ? The Shale Invasion: Will U.S. LNG Cross the Pond? New terminals ramp up exports. Morningstar Commodities Research 6 December 2016 Sandy Fielden Director, Oil and Products Research sandy.fielden@morningstar.com Data Sources for this Publication gu.s. Energy Information Administration g Platts For more information about these data sources Click Here U.S. LNG Shipments Improve Market Transparency Back in 2012, surging production of natural gas from shale overwhelmed domestic demand and caused gas prices to crash and midstream operators to seek new markets. Higher prices for natural gas in Asia and Europe encouraged the development of liquefied natural gas, or LNG, export terminals on the Gulf and East coasts. U.S. midstream operators are building out export capacity from five LNG terminals along the East and Gulf coasts over the next two years to the end of LNG exports began from the first terminal at Sabine Pass in February 2016 and reached an average of 1.5 billion cubic feet a day, or bcf/d, in November. Most of the offtake from these terminals is under long-term take-or-pay contracts. The Gulf Coast terminal's gas will be priced based on the U.S. Henry Hub, Louisiana, benchmark, and the cargo destination will not be restricted. These terms contrast with traditional LNG deals based on oil price indexes with restricted destination clauses. We expect U.S. contract terms to set the base price in LNG spot markets and improve market transparency. The extent of this influence will depend on U.S. supplies remaining competitive in international markets. This note describing the U.S. terminal build-out and its impact on the European market this winter is based on a presentation at the joint Platts/Morningstar London Gas Forum on Nov. 29, Surging Supply and Wide Price Spreads U.S. LNG exports began to flow this year from the Cheniere terminal at Sabine Pass, Louisiana, that has operated two liquefaction plants, or trains, starting in February and August, respectively. In November 2016, according to S&P Global Platts data, the U.S. for the first time became a net exporter of natural gas with shipments of LNG from Sabine Pass combined with pipeline gas exports to Mexico and Canada, exceeding imports. The U.S. is ramping up gas exports and building LNG export terminals in response to increased domestic production from shale. According to the Energy Information Administration, U.S. dry gas production increased by 50% from 51 bcf/d in January 2005 to 75 bcf/d in April Much of that growth comes from the Pennsylvania, Ohio, and West Virginia Marcellus and Utica shale formations that now produce nearly one third of U.S. gas. In the face of such a rapid increase in supplies, it was hard for new demand to keep up because new gas-fired power plants and industrial uses require costly and time-consuming infrastructure build-out. Gas prices crashed to less than $2/million British thermal units, or mmbtu, during 2012 when supplies threatened to overwhelm available storage capacity. At this point, midstream operators such as Cheniere perceived an opportunity to export surplus natural gas from liquefaction terminals on the East and Gulf coasts to take advantage of wide annual average arbitrage spreads between U.S., Asian, and

2 MTPA Page 2 of 6 European gas prices. During 2012, the U.S. benchmark Henry Hub gas price averaged $2.82/mmBtu, the Asian equivalent Platts Japan Korea Marker, or JKM, averaged $15.08/mmBtu, and European marker the U.K. National Balancing Point, or NBP, averaged $9.37/mmBtu. These wide price spreads and a perception that demand for LNG in Asia would continue to increase, have to date led 45 companies to apply for LNG export permits from the U.S. Department of Energy. Terminal Build-Out The first five terminals are under construction and will boast 14 liquefaction trains capable of producing 64 million tons per year, or mtpa, of LNG for export by the end of 2019 equivalent to about 9 bcf/d (Exhibit 1). The first terminal, Cheniere s Sabine Pass, is already operating with two 4.5 mtpa trains consuming an average 1.5 bcf/d of gas during November, when a record 10 cargoes of LNG were exported. A third Sabine LNG train is expected on line in June 2017 with a fourth by the end of the year and a fifth in The second new LNG terminal expected on line by the end of 2017 is the Dominion project at Cove Point, Maryland, with a single 5.25 mtpa train. The third terminal, expected on line during 2018, is Cameron LNG, owned by a consortium including Sempra, Engie, Mitsui, and Japan LNG. The Cameron, Louisiana, terminal will have three 4.5 mtpa trains. The fourth terminal, also expected on line in 2018, is Cheniere s second project, located at Corpus Christi, Texas, consisting of two 4.5 mtpa trains. The fifth terminal is owned by Freeport LNG, located on the Texas Gulf Coast and will have three 4.4 mtpa trains, the first expected on line in September 2018 and the second and third in Exhibit 1 U.S. LNG Terminal Build-Out 70 Sabine Pass Cove Point Cameron LNG Corpus Christi Freeport Source: Morningstar

3 Page 3 of 6 Open Destination The success of these LNG terminals is largely predicated on U.S. LNG prices being competitive in international markets and adequate supplies of gas being available to ship. Most the new terminals have already signed up a critical mass of shippers under long-term sales purchase agreements, or SPAs. Unlike most previous SPAs for LNG exports, the U.S. agreements have no destination clause specifying where cargoes are to be delivered. The lack of destination clauses means that every cargo can theoretically be delivered wherever the best price is available, making the LNG market truly international. Previous SPAs for LNG terminals outside the U.S. were typically priced relative to oil and had destination restrictions to prevent resale. Our analysis that follows compares U.S. prices with international benchmarks in this new SPA environment and then homes in on competition in the European marketplace this year. Competitive Marketplace Since U.S. LNG export terminal projects were initiated, the world marketplace has become far more competitive as a result of an abundance of supply. Prices for LNG in Asia as measured by the JKM benchmark have fallen from a post-fukushima high of $20.2/mmBtu in February 2014 to an all-time low of $4.0/mmBtu in April of this year in response to lower demand and a supply surplus aggravated by significant new capacity coming on line in Australia. In Europe, the NBP benchmark gas price has fallen from a high of just over $12/mmBtu in December 2013 to a low of $3.66/mmBtu in August Although JKM and NBP prices have recovered this winter, their averages from January to Dec. 2, 2016, are $9.63/mmBtu and $4.72/mmBtu lower, respectively, than they were in 2012, leaving U.S. LNG shippers with lower returns than anticipated when the terminal projects were proposed. As we shall see, with lower prices and competition from other suppliers, few U.S. LNG cargoes have yet been delivered to Asia the market that offered the most promising returns in Low European Prices The situation in Europe is no better, because the delivered price of U.S. LNG has been uncompetitive for most of Exhibit 2 shows prices in U.K. pence/therm at the Dutch TTF, Belgian Zeebrugge, and U.K NBP pricing hubs as well as delivered prices for U.S. gas to Europe. The delivered price is calculated with the price formula used in Shell s SPA for Cheniere s first LNG train at Sabine Pass. That formula multiplies Henry Hub monthly settlement prices by 115% and then adds a fixed $2.25/mmBtu throughput fee for the LNG liquefaction plant. The delivered price also includes a freight rate to Europe that averaged about $0.45/mmBtu this year. Once the 115% upcharge, throughput fees, and freight are added to Henry Hub prices, the delivered price was higher than the local competition for all but a brief two-week period in November 2016 when the green line in the chart crossed below NBP and Zeebrugge opening a small window for U.S. LNG cargoes to ship to Europe. Unfortunately, that window followed a one-month maintenance outage at the Sabine plant in October that prevented shippers from taking advantage. Platts analysis of European gas flows indicates that European buyers preferred to purchase increased volumes of competitively priced Russian gas delivered by pipeline this year rather than importing U.S. LNG..

4 UK pence/therm Page 4 of 6 Exhibit 2 European Gas Prices and Delivered Henry Hub TTF Zeebrugge NBP HH Winter DES Europe Source: Morningstar, Platts Shippers Favor South America In fact, rather than the eager European or Asian buyers that terminal operators expected, most of the 38 LNG cargoes delivered from Sabine Pass since February 2016 have been shipped to South America. According to Platts C-flow data, nine LNG cargoes went to Chile, five to Mexico, and four each to Brazil and Argentina (Exhibit 3). Although LNG freight from the U.S. Gulf to South America is roughly equivalent to rates between the U.S. and Europe (about $0.50/mmBtu), U.S. LNG shippers faced less gas-on-gas price competition in South American markets.

5 Number of Cargoes Page 5 of 6 Exhibit 3 Destination of U.S. LNG Cargoes in Source: Morningstar, Platts Freight costs to Chile on the western coast of South America as well as other Pacific destinations were reduced by the expansion of the Panama Canal in June That expansion permits passage for the largest LNG vessels and reduced rates and transit times. Since the canal was expanded, two LNG cargoes have been shipped to China, but there has been no steady flow to Asia except for four cargoes to India, where LNG demand has been robust this year. So far, only four cargoes have shipped to Europe even as prices were uncompetitive, and these were probably test cargoes to buyers wanting to check the quality of U.S. gas. Even though most U.S. LNG cargoes have not headed to traditional markets in Asia or Europe, these shipments have had an important impact on world prices. Because of the lack of destination clauses in SPAs, shippers can send their LNG wherever the price is right. U.S. LNG therefore sets the international clearing price for spot cargoes and places downward pressure on competitors using prices linked to oil or other market indexes. K

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