LNG: Towards a global natural gas market. The Mexican experience

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1 LNG: Towards a global natural gas market. The Mexican experience Mr. Gerardo Bazan G., PEMEX CEO Advisor, +(52) , gbazan@dg.pemex.com The views and opinions presented in this paper do not represent the official position of the company that the author represents and can be referred only to him, who is sole responsible for them. Introduction Since its origins, more than 40 years ago, the Liquefied Natural Gas (LNG) industry has been created to satisfy natural gas demand in specific parts of the world. Not long ago there were only few LNG producing and importing countries 1. However, as the industry has matured, there had been a number of structural changes, such as cost reductions in development and transport, the entrance of new players into the distribution markets and a greater flexibility into the trading and acquisition contracts. These changes are contributing to transform an industry, erstwhile in existence in only a few countries, into a global energy system, in which many countries rely for their development and growth. Nowadays the LNG industry is facing a series of important uncertainties. According to some experts 2, prices and conditions of natural gas regional markets will be more and more influenced by the market conditions and inter-regional trading, as the commercialization of LNG grows which generates interaction between regional markets- and also due to new LNG commercialization schemes. The basic principles of LNG are simple. Natural gas is produced in different parts of the world (especially in countries with access to large natural gas reserves and usually with low demand for natural gas). The gas is cooled below 160 C, until it changes into liquid stage, it is placed in large thermally-insulated tankers and then shipped into the market. Once on its final destination, the temperature of the liquid natural gas is raised so it can return to its original gaseous phase and then it is fed into traditional distribution systems. This principle could seem simple but until vey recently, the complexity of these processes and the high costs associated with them made LNG accessible to just a few. Moreover, the complexity of the commercial contracts that cover the risks of the investors created another barrier for the entrance of new players. In fact, it used to be a common practice of this industry to establish long term contracts, rigid enough to render the distribution 1 According to the International Energy Agency, in 2000, there were 12 exporters and 11 importers, whilst by 2010, these numbers will duplicate. 2 Toward a global gas market, The Aspen Institute. Natural Gas Market Review, IEA.

2 channels as virtual pipelines between the liquefaction centres and the regasification terminals, despite the fact that they might be thousands of miles apart across the ocean. In this paper I will briefly explain how the LNG market has been developing in the most important natural gas trading regions of the world, including some of the challenges that the LNG industry will be facing in the near future, considering the main structural changes that the industry has had, especially during the last ten years. Furthermore, I will explain the Mexican experience with LNG, the important role that this resource will have in the near future and the main challenges and uncertainties that the country will face in the whole natural gas industry. LNG Market In most parts of the world, natural gas demand has grown significantly over the last 15 years. Since 1990 the world natural gas consumption has increased 50%, from 73,142 billion cubic feet (bcf) to 103,641 bcf in In terms of trading, global natural gas trading has increased from 18,886 bcf in 1990 to 30,640 bcf in 2006, 62% increase, while world LNG trading has grown from 2,612 bcf in 1990 to 7,590 bcf in 2006, 190% increase. Thus, in % of global natural gas consumption came from intra and inter-regional trading (via pipeline and LNG), from which 25% was in the form of LNG 3. Share of trade and LNG in world natural gas consumption World gas consumption (bcf) 38,830 73,142 89, ,641 World natural gas trade (bcf) 2,118 18,886 22,733 30,640 World LNG trade (bcf) 141 2,612 4,942 7,590 Share of trade in consumption (%) Share of LNG in consumption (%) Share of LNG in trade (%) Source: IEA data. Nowadays, there are three major natural gas consumption regions in the world: North America, Asia and Europe. Traditionally, North America depends heavily on natural gas trading, especially through pipelines from Canada. In 2007, more than 83% of the US natural gas trading was made by pipelines, while 17% was made by LNG 4. However, due to the strong market demand and growth, the US is 3 International Energy Agency. 4 International Energy Agency.

3 preparing an aggressive expansion of its pipeline network as well as for its LNG import capacity, either from the Atlantic Ocean, as well as from the Pacific Ocean. Asia is also a region strongly dependent on natural gas trading, especially in the form of LNG. LNG represents 88% of the total natural gas trading in this region. Similarly to the US, Asian LNG demand is also growing rapidly. According to the International Energy Agency (IEA), the regasification capacity of this region is expected to grow 18% from 2007 to Therefore, the number of buyers and traders of LNG in the Pacific Ocean will substantially increase. Europe, on its side, depends heavily on natural gas imports through pipelines from Eastern and Northern Europe and North Africa. In 2007, 88% of OECD Europe imports came through pipelines, while 12% were LNG imports made to countries such as France, Spain, Italy and the United Kingdom. However, Europe is seeking to expand its LNG import capacity in order to diversify its resources. By 2010, Europe expects to grow its regasification capacity by almost 60%. Major LNG trading < 2001 Source: IEA data.

4 Major LNG trading > 2008 Source: IEA data. According to the IEA, in OECD regions the dependence from LNG will grow from 11% in 2004 to more than 20% by Under this premise, by 2015, LNG will provide almost one fourth of the natural gas demand in OCDE countries. In the specific case of the US, by 2015, imports of LNG will provide 9% of its total natural gas needs, far from the 2% in In Europe, the dependence on LNG will grow from 7% in 2004 to more than 20% in In Asia Pacific, the dependence on LNG will grow from 74% in 2004 to 77% in Thus, global LNG dependence will double in the next ten years. Nevertheless, most of the projections and perspectives for LNG assume that the supply and transport of this product will not be a problem. However, many of the potential supplies of natural gas are likely to be constrained by economic, technical and political issues. To assume that this industry will grow and develop unscathed could be a mistake. Important delays could bring serious consequences to economies that are relying on uncertainties under totally new market conditions. Structural changes of the industry During the last ten or fifteen years, there had been a number of factors that have been shaping the future of both the LNG and the natural gas industry. Some of the most important changes are: new technology, new players and increased trading flexibility. According to the Gas Technology Institute, during the last ten years the costs of natural gas liquefaction has decreased 50%. Nevertheless, due to the strong demand for supplies and contractors, the construction costs have escalated dramatically over the last three years; though these

5 costs might not be permanent. Similarly, as the technology advances and the size and capacity of LNG tanquers increases, the costs of ship building of LNG tanquers have decreased 35% during the last ten years 5. Regarding the entrance of new players into the distribution markets, Qatar has recently become the largest LNG exporter in the world 6, taking over traditional suppliers such as Indonesia and Malaysia. According to the IEA, by 2010, Qatar will have 30% of the world LNG supply share. Moreover, very recently, countries such as Guinea Equatorial and Norway just started to export LNG and in years to come, Russia, Venezuela, Iran, Yemen and Peru will join this club. However, it is important to bear in mind that many of these new players have specific national policies and geopolitical issues to solve before new supplies hit the market. But the factor that will probably become more influent in the LNG market and that could affect the global natural gas market is the trading flexibility and new supply contracts. With a growing supply and demand, LNG trading is starting to depict important changes in the way they operate. Traditionally, the LNG industry had been dominated by fixed long term contracts. However, nowadays spot and short-term contracts represent 20% of the new trade contracts 7, compared to less than 2% in the late 1990s. 8 These spot and short-term contracts, in some cases, have contributed to arbitrage in some regional markets. During 2007 several existing regasification facilities in Europe were little used because cargoes had been delivered to more lucrative markets. Furthermore, in 2007, Japan nuclear industry faced serious problems which lead to Japanese utilities to pay high amounts for spot LNG cargoes from all over the world. Challenges With the rapid growth of the LNG industry, under new premises and conditions, it seems very possible that in the mid term the natural gas industry will be influenced by the LNG market. Probably natural gas will never be completely traded freely as oil does, but the trading flexibility, the growing participation of LNG in the energy portfolios and the dilution of borders will contribute to create, at some level, a global natural gas market. However, in the near future, the LNG industry will face four main challenges: access to large natural gas reserves, high costs of raw materials (including steel), availability of contractors to develop large engineering projects under adverse conditions and highly qualified technical professionals. The Mexican Case In Mexico, LNG made its commercial debut in 2006 with the regasification terminal of the Stateowned electricity company, Comisión Federal de Electricidad. This terminal is located in Altamira, by the Gulf of Mexico and processes natural gas from Nigeria, Qatar, Egypt and Trinidad and Tobago. 5 Okimi 6 Natural Gas Information 2008, IEA. 7 Natural Gas Market Review 2008, IEA. 8 World Energy Outlook 2004.

6 During 2007, regasification in this terminal reached 340 million cubic feet per day (mmcfd), which represented 29% of the natural gas imports of the country 9. Recently, on September 2008, the second LNG regasification terminal in Mexico, located in Baja California, by the Pacific Ocean, began operations, while a third terminal, located in Manzanillo, is currently under construction and will start operations in During the following years, it is estimated that a number of additional terminals will be built in the country, especially along the west coast. Therefore, LNG will play a crucial role in the Mexican energy portfolio. Mexico LNG regasification terminals Ensenada Altamira Actual LNG regasification projects Manzanillo Possible LNG regasification projects Since 1997, Mexico is a net natural gas importer. Even though domestic production has grown significantly in recent years, the domestic supply of natural gas has not been able to cope with the high demand. In the upcoming future, Mexico will keep depending on natural gas imports in order to balance its domestic demand. In 2007, natural gas demand in Mexico reached 7,100 mmcfd. According to the Mexican Ministry of Energy (SENER), by the year 2016 the natural gas demand will exceed 9,200 mmcfd 10. In 2007 natural gas production reached 6,300 mmcfd, therefore, almost 800 mmcfd of the natural gas 9 Mexican Ministry of Energy. 10 Petróleos Mexicanos.

7 consumption came from imports. SENER estimates that, under an optimistic scenario, by 2016 the domestic natural gas production will reach 7,600 mmcfd. The difference between supply and demand will have to be balanced by imports, which might exceed 1,600 mmcfd and from which three quarters of these imports will come in the from of LNG. As in many other countries, a large amount of natural gas in Mexico goes to the power sector. In 2006, 43% of the total public power generation was based on natural gas, which contrasts with a contribution of 12% held ten years earlier. According to SENER, under an optimistic scenario, by 2016, 64% of the fossil fuels consumption for power generation will come from natural gas, from which only 50% will come from domestic production and the rest from imports, via pipelines and LNG. By 2016 LNG will represent one third of the total natural gas consumption for power generation. Mexican public power generation, by fuel 250 TWh Average annual growth rate (%) Vapor and Wind Uranum Hidro Coal Diesel Natural Gas Fuel Oil Source: SENER data.

8 Mexican fossil fuels consumption for power generation ,407 Terajoules / day ,427 Terajoules / day Coal 20% Diesel 1% Fuel Oil 32% Coal 20% Fuel Oil 17% LNG 6% Natural gas (imported) 16% Natural gas (domestic) 25% LNG 21% Natural gas (imported) 10% Natural gas (domestic) 32% Source: SENER data. However, as Mexico becomes another player in the LNG arena, a number of questions emerge in terms of flexibility and energy security, especially for a country with a large amount of hydrocarbons and submerged in a highly competitive LNG market. Mexico s energy portfolio is relying heavily on natural gas, especially in the power sector, while it has been shown that the country is not self-sufficient in this matter. Furthermore, this reliance is based on two delicate and crucial factors: On the one hand, the portfolio that supports the domestic production of natural gas strongly depends on the success of a large number of exploration and production projects across the country. According to the State-owned oil company, PEMEX, in % of the natural gas production will come from new discoveries and incorporations 11, with the risks and uncertainties that this situation implies. On the other hand, with the higher participation of imported natural gas in the energy portfolios around the world, new variables incorporate to the regional markets: interdependency of the regional markets, higher price volatility and growing LNG demand. Specifically for Mexico, in case that the domestic production does not reach the forecasted levels, the exceeding demand will have to be covered trough imports, and considering that pipeline imports from the US are limited by the distribution networks, these imports would have to be covered by additional LNG supplies. Thus, Mexico might become more vulnerable to external market conditions. 11

9 Mexican natural gas production.- actual reserves and future incorporations Million cubic feet / day 8,000 7,000 6,000 5,000 Future discoveries 4,000 3,000 2,000 1,000 Actual reserves Source: Another important issue worth mentioning is the open participation of the State-owned power company in the natural gas market. By law, PEMEX is the company entitled to provide natural gas in Mexican territory. However, due to a series of reforms made in early 1990 s, private companies are allowed to import, store and transport natural gas for its own use, leaving domestic sales to PEMEX. And this is exactly what Comisión Federal de Electricidad is doing. The issue arises when, according to public documents 12, some regasification terminals will sell surpluses of natural gas to private industries (probably following specific association schemes). Therefore, in terms of first-hand sales, PEMEX will compete directly with another state-owned company. In this sense, it becomes necessary to update the legal and regulation schemes of natural gas, as LNG becomes widely available and PEMEX is, still, the only company entitled to perform first-hand sales of natural gas within Mexican territory. More than 10 years ago Mexico had the option to diversify its energy portfolio by investing in proved technology and domestic energy resources, but the government decided to bet on natural gas. However, the demand has over passed the supply. Nowadays, the current Mexican government is considering diversifying its energy portfolio, by investing heavily in renewable projects. However, there is much to do in order to cope with the growing demand of natural gas, without comprising the country s development and national security. During the following years, the natural gas market will face important challenges. It is highly probable that natural gas prices will rise and turn more volatile, whilst more countries might become dependent within regional markets. To assume that this industry will grow and develop unscathed could be a mistake. 12 Prospectiva de Gas Natural , SENER.

10 Mexico has joined the global LNG market. In the near future the demand for LNG will grow rapidly and the regions that once were considered distant and strange could have an important impact in Mexican local natural gas markets, especially in terms of demand and pricing. It becomes necessary to incorporate the new market conditions and variables of the global markets into the evaluations and forecasts of local markets. Moreover, current energy regulations will have to adapt to the new market variables in order to create the appropriate conditions for investments, certainty and market development.

11 References CFE (2008). Informe Anual SENER (2008). Prospectivas del Mercado de Gas Natural. SENER (2008). Prospectivas del Sector Eléctrico, IEA (2008). Natural Gas Information (2008 Edition). IEA (2007). Natural Gas Market Review, IEA (2008). Natural Gas Market Review, PEMEX (2008). Anuario Estadístico BP (2008). Statistical Review of World Energy, EIA (2008). International Energy Outlook, Hiroki O. (2006). Comparative Economy of LNG and Pipelines in Gas Transmission. World Gas Conference, 2006 Silvie Carnot, Olivier Appert, Ralf Dickel, et all (2006). The Challenges of Future Cost Reduction for New Supply Options (pipeline, LNG, GTL). World Gas Conference, PEMEX (2008). Perspectivas de la exploración y producción de hidrocarburos en México. April Lakahal Samira (2006). The Economics of Transportation Pipelines vs LNG vs GTL. World Gas Conference, Aspen Institute. Toward a Global Gas Market.