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Ai Group letter to PM and Opposition Leader on Energy Action / gas swaps

This letter outlining a number of actions/solutions to the energy crisis including gas swaps was sent last week to the PM and Opposition Leader and relevant Ministers and Shadow Ministers. 

(LETTER FROM INNES WILLOX, CHIEF EXECUTIVE, AUSTRALIAN INDUSTRY GROUP)

SOLUTIONS TO THE GAS CRISIS

Ai Group and our members strongly welcome the interest from both sides of politics in addressing the severe concerns that have built up around the gas market. There are important actions that can help secure adequate supply in the longer term. However, there has been a paucity of suggestions that can help in the near term. We wish to outline two options which we think may be viable and are worth developing further: voluntary ‘gas swap’ arrangements to put gas currently earmarked for export into the domestic market; and a national interest assessment process for gas exports to underpin swaps and guard against a recurrence of the current crisis.

Background

Eastern Australian gas demand for domestic use by households, power generators and industry has been around 600-700 petajoules (PJ) per annum in recent years. The new Liquefied Natural Gas industry in Queensland has massively increased demand, requiring around 1,400 PJ per annum. Major new coal seam gas (CSG) resources developed specifically to feed the LNG projects have disappointed, with production evidently falling short of forecasts; as a result domestic supply has failed to rise on the coattails of export development, and export projects have even dipped into the local market to contract supply that would otherwise have been available. Supply is expected to fall short of demand, and the market is extremely tight.

There are different views on how big the shortfall is. Some gas suppliers appear to still deny the market is physically short at all. The recent Australian Energy Market Operator Gas Statement of Opportunities finds a gap of 10-54 PJ per annum from 2019-2024 (unless demand from gas fired electricity generation declines equivalently, which would lead to electricity shortages at critical times), or a cumulative gap of 156 PJ to 2024. We are aware of significantly more pessimistic assessments by gas market observers. EnergyQuest believes the market is a cumulative 172 PJ short by 2020 and 205 PJ short by 2025. Credit Suisse believes the gap is bigger, sooner.

However short the market is, the price impacts are clearly enormous. Most gas is sold through confidential contracts, and in the past these have often been set for long periods. That makes it hard to observe prices or describe a typical experience; many customers will face prices reflecting older agreements (with their retailers, or between their retailers and upstream suppliers) for some time yet. However, the leading edge of price change is being seen by medium-sized manufacturing businesses coming out of contract. Many were recently paying around $6 per gigajoule (GJ), an increase on the historic average but manageable. Over the past year they have seen many retailers cease offering contracts at all, evidently lacking gas to contract. The offers they have been able to obtain reached $9/GJ in mid 2016, $12 short term in late 2016, and as high as $16-$22/GJ for a one year contract in February 2017. Prices as ‘low’ as $12.50/GJ can only be obtained by locking in for at least three years. There is every indication that prices are continuing to rise.

While gas-using businesses vary widely in their energy intensity, and some businesses in non-traded sectors may be able to pass on cost increases to consumers, these price increases will place trade exposed businesses, particularly manufacturing, under extreme pressure. In 2014 Ai Group and a coalition of gas user organisations commissioned Deloitte Access Economics to model the impacts of rising gas prices1. The main comparison was between:

  • a counterfactual case where no Eastern Australian LNG industry developed, and gas prices only rose to reflect production cost increases; and
  • a case where gas prices rose to export parity, based on then-current estimates from the Government’s Eastern Australian Domestic Gas Market Study.

This modelling found that gas prices rising to a $9-10/GJ range, $4-5 above the counterfactual, would lead to the loss of around $118 billion (in 2014 Net Present Value terms) of cumulative output from manufacturing over 2014-21. There were also impacts of mining ($34b), transport ($11b) and agriculture ($4b). Overall GDP impacts of the LNG scenario were still positive given the large boosts to the gas and construction sectors involved.

However, this modelling almost certainly underestimates the impacts of the reality we now confront. Gas prices are rising significantly above the levels modelled, and they do not reflect export parity but a mismatch between local supply and demand. With spot gas prices in Japan, Europe and the United States at low levels, Australian gas users do not merely face the loss of a previous competitive advantage in gas, but the imposition of a gas price disadvantage. Meanwhile, lower international oil and gas prices have badly dented the market value of the gas exporters, and the associated revenues and GDP benefits appear to be lower than hoped for. And high gas prices are greatly worsening price and supply security problems in the National Electricity Market.

Policy options

Solutions to our gas challenges must rebalance supply and demand. The options include:

  1. Increasing gas production. This is the obvious solution and gas-using industry strongly supports it. Options include expansions to offshore production near Victoria; the Narrabri CSG project; the Northern Gas Pipeline (NGP) and associated potential for expansion to carry prospective Northern Territory shale gas; expanded drilling in South Australia; and, somewhat further off, potentially significant but very uncertain conventional and unconventional onshore gas resources in Victoria.

    However, there are two problems with these production options. Firstly, they will all take years to deliver significant new volumes of gas to market. The NGP offers the nearest prospect, though litigation is causing some delay; Narrabri may be five years away; and Victoria is even further off.

    Secondly, unconventional gas production is the subject of strong and sincere concern in parts of the community. While we are confident that the genuine risks of production, particularly around water, are manageable with good engineering and firm regulation, it remains to be seen if the community will be persuaded. This will take time to achieve.

    Thus, while new production is essential and sustained effort will be needed to achieve it, nearer term solutions are also required. A mosaic of several sources of new production is likely to be needed given the size of the gap and the potential for political, commercial or geological limits on the scope of these production options.

  1. LNG imports. While the concept of an Eastern Australian LNG import terminal has previously seemed absurd, it is being seriously investigated by AGL – and rightly so given the severity of the supply gap. Any imported gas is likely to be expensive, with speculation putting the price anywhere from $10-$14/GJ. Even so, more available and contractable gas would be helpful, increasing supply competition and serving as a ceiling on domestic prices. However, an import terminal seems to be at least five years away, based on AGL’s published timetable.
  1. Demand reduction. There may be significant potential to reduce domestic gas demand without losing associated economic activity. While some industrial gas demand is for chemical feedstock, and not easily substitutable, much is for heat or power. There are industrial energy efficiency or fuel switching opportunities to reduce this. Residential and commercial gas use is even more likely to be reducible without loss of amenity, though upgrading major household appliances is not done often or lightly. Gas fired electricity generation is critical in the near term for the stability of the grid, but in the medium and longer term other sources of energy and flexibility are viable and likely cheaper.

    Gas efficiency measures will also make energy users less vulnerable to movements in gas prices, and should be developed or strengthened as a priority. However, even with established technologies savings will take time to scale up and are unlikely to resolve the most immediate market tightness.

  1. Market reform. A strong agenda for a more competitive wholesale market and gas transport sector is already under development after extensive work by the COAG Energy Council, the Australian Energy Markets Commission, and the Australian Competition and Consumer Commission. These reforms are positive and will be important to ensure that competition puts downward pressure on the price of any gas we produce. However, these measures will take time to finalise and implement, and are unlikely to greatly change the fundamentals of supply and demand that are currently shaping price.

With these supply side, demand side and market reform measures some time away from delivering, there are only three obvious options to rebalance the market in the near term:

  1. Demand destruction, as prices rise as high as necessary to deter sufficient consumption. Given the vital near term role of gas-fired electricity and the likely slow response of households it seems likely that the bulk of this demand destruction would come from industry, particularly small and medium sized manufacturers without long term gas contracts. While this is the option that will happen by default without further action, it would be very costly and destructive. Ai Group’s priority is to avoid this outcome.
  1. Government intervention to divert gas from export. There are many possible forms an intervention could take, but one of the most important variables is whether an intervention operates only prospectively on future contracts and resource development, or whether it has the potential to impact significant volumes of gas already developed or contracted for. For example, while Queensland is experimenting with a small-scale and prospective domestic reservation, any positive impact from this or similar measures will not be felt for years. To address immediate shortages a reservation, export ban, or other intervention would need to be able to operate retrospectively. But depending on how this was done it could raise serious sovereign risk, trade law and compensation issues. Ai Group would like to see such problems avoided. In particular, we have never supported reservation policies, which could be very inflexible and inefficient – or entirely ineffectual, depending on how they are implemented. However, the application of a national interest test to export arrangements could play an important supporting and safeguard role for voluntary solutions, as outlined further below.
  1. Voluntary commercial arrangements, potentially facilitated by government in some form, to swap gas from the export channel to the domestic market. This appears physically possible but complex to arrange. In the absence of better information or alternatives it is Ai Group’s preferred path and is described further below.

The swap

The shortage in the domestic market could be between 10 PJ and 54 PJ per year if AEMO is right, or somewhat higher if other observers are correct. But the export channel is expected to send 1300-1400 PJ overseas each year. A modest contraction in this volume could easily cover domestic shortfalls for the several years required for other supply- and demand-side options to deliver.

Meanwhile, there are large volumes of gas available on international spot LNG markets. In 2015 nearly 4,000 PJ of gas was traded as LNG outside of long term contracts, and supply has increased since. Spot prices for LNG landed in Japan have been well below historic levels recently. With oil prices rising from recent lows, spot LNG has recovered from below AUD$6/GJ in May 2016 to around AUD$12/GJ in February. Those remain well below the prices originally anticipated for gas landed in Japan under long term contract. Some of the spot gas actually comes from Australia, particularly from WA projects.

With spot LNG plentiful and relatively affordable, it should be possible to put together a ‘swap’ arrangement in which some of the commitments made by Australian exporters to overseas customers are instead met with gas from outside Eastern Australia, freeing up local gas to be sold into the domestic market. This could involve:

a)     Australian LNG producers with wider international portfolios making internal arrangements to deliver gas from their assets outside Eastern Australia;

b)     Australian LNG producers arranging to purchase LNG from third parties to deliver to their customers;

c)     Overseas customers making arrangements with Australian LNG producers to either forego delivery of a portion of their entitlement, or on-sell some of their entitlement within Australia without requiring physical delivery;

Domestic customers could be involved as contracting parties to provide certainty of demand for any volumes released.

Since prices appear to be modest in spot markets and high within Australia, it should be possible for this arrangement to leave nobody worse off and the domestic market considerably better off than the status quo. While the details of the LNG export contracts are confidential and Ai Group is not experienced in international gas trading, the following illustrative example may be worth considering:

  • 10 PJ of gas is contracted for delivery in Japan, landed at $14/GJ, while domestic Australian retail customers are facing contract offers of $12-$22-GJ.
  • 10 PJ of gas is purchased on the spot market to fulfil the contract, at a cost to the exporter of $12/GJ and to the importer at the contracted price of $14/GJ (or perhaps $13/GJ if the customer’s consent to a change of contractual clauses is required to facilitate the arrangement)
  • 10 PJ of gas is sold by the exporter into the domestic market at an oil-linked export parity price (we believe this is about $9.50/GJ at current oil prices)

If these assumptions are close to correct the arrangement would be positive sum and all parties could benefit, though different distributions of benefit are possible and would be a matter for negotiation.

Possible hurdles

It may be asked why, if a swap makes so much sense, it is not already happening. We are told that two of the LNG consortia are already net contributors to the domestic market, and have made some significant swaps. We also understand that international gas traders are taking an increasing interest in the situation. However there are several possible barriers which may explain why the problem is not already solved.

  1. Less favourable economics

    It may be that the real relative costs of a sufficiently large swap are less favourable than we suppose. Moderately unfavourable costs could potentially be bridged by private parties accepting a loss, or the public sector providing a subsidy, if they judged avoiding a domestic supply crisis to be in their larger interest. If costs were very unfavourable it is unlikely anyone would pursue a swap.

    Better information about relative costs is required.

  1. Contractual barriers

    While the LNG export contracts are confidential, it is widely supposed that they contain terms that may need to be changed, waived or worked around for a swap to proceed. In particular, at least some of the contracts are said to contain location clauses that either oblige the seller to provide supply from a particular source, or forbid buyers from on-selling the gas, or both. If this is correct, resolving this would be possible but sensitive. APPEA have suggested to us that their overseas customers would need to initiate any swap, though it is not obvious why overseas customers would be sufficiently motivated to solve Australian supply problems.

    Better information about relevant contractual terms and possible workarounds is required.

  1. Sensitivity to contractual changes

    The biggest barrier is likely to be that the existing LNG export contracts are central to the value of these projects, and in the case of Santos to the financial stability of the companies concerned. The contracts were settled at a very different time when conditions were more favourable to sellers and oil and gas prices, and gas demand, were expected to be higher. Sellers may be extremely worried that any variation in their contracts may give buyers an out, or lead to wider renegotiation. The potential for benefit through redirecting small volumes of gas at the margins would be outweighed (for the exporter) by the risk of lower returns on the large volumes committed for export.

    Better information about the positions and preferences of exporters and their overseas customers is required.

  1. Unintended consequences

    If a swap were executed by one or more exporters and freed more gas in the Australian market, it is possible that another exporter might simply acquire some or all of that gas to meet its own export commitments or spot opportunities, leaving the local market still short. The apparent travails of Santos and its GLNG partners in meeting even their base level of commitment mean this is a real threat. Indeed, we are told by producers that some gas has already been sold to help the domestic market, then onsold to GLNG.

    This risk might be reduced either by involving domestic customers directly in arrangements, or by commitments by all exporters not to snap up freed gas – potentially enforced by the national interest test described further below.

  1. Australian on-costs

    If a swap were executed it is possible that additional on-shore costs in Australia (particularly for transport through pipelines) could substantially increase the cost to domestic customers of any gas freed. Any contractable gas, even at a high price, would be helpful at this point.

    However, transport costs could be reduced through a second level of purely domestic gas swaps. Large national entities, such as the major energy retailers, may be well placed to swap between Queensland CSG, Cooper conventional and Victorian offshore supplies to minimise transportation costs.

  1. Lack of information and transparency

    It is clear that the most immediate barrier to a swap is the lack of readily available information. Government may be able to play a critical role as a neutral and trusted player able to acquire and collate the necessary information, much of which is highly commercially sensitive.

A National Interest Test

Ai Group has long supported a national interest test on gas exports to underpin supply security. Such a test can play an important role in ensuring that future LNG-related developments do not threaten domestic supply; it would have been better if difficult questions had been asked about the adequacy of the gas production associated with the new LNG terminals before final investment decisions were made. The existence of such assessment will help reassure the community that new production is worth supporting. But national interest assessment – or even the threat of it – could be very useful to address the current supply crisis we face.

Essentially a national interest test provides that relevant export developments will proceed unless the Government or a delegate body determines that they are not in the national interest. Such a policy can be more flexible, efficient and effective than a domestic reservation policy. Reservation of a given resource or proportion of all resources for domestic use raises the likelihood that the proportion will differ from what an ideal market would deliver, either:

  • guaranteeing too much domestic supply, in which case resources may not go to their highest value use and gas users may be subsidised by suppliers and taxpayers; or
  • guaranteeing too little domestic supply, in which case the policy will have no effect.

A national interest test can be applied case-by-case to determine whether there is a threat to domestic supply adequacy and, if so, specify approval conditions that would avert the threat.

National interest assessment is a feature of other major energy producing nations, including the United States and Canada. Guidance and clarity around the application of a test would be needed to ensure it does not create uncertainty damaging to investment. The key features to settle include:

  1. The scope of activities covered. We have previously suggested a test applied only to new or expanded export infrastructure. However, it is now clear that a test will need wider application: there are unlikely to be any further LNG expansions in Eastern Australia, and the urgency of the current crisis requires broader flexibility to respond. In addition, it would be legally simpler to apply the test to the act of export (which can be dealt with under the existing Export Control Act 1982) rather than the construction of facilities, where existing Commonwealth oversight largely relates to environmental and foreign ownership matters. Therefore we suggest that a national interest test be applicable to all contracts and arrangements for gas export – existing and future – potentially with a minimum threshold for volume or duration.
  1. The nature of the national interest. It is important to clearly define what the test is about, so that decision makers know what to do and the gas industry knows what to expect. We suggest that the best and clearest focus for a test is on the adequacy and security of gas supply to meet expected domestic demand. One formulation that is conceptually simple and has been advanced by the gas industry itself is whether the export arrangement is also a net contributor of gas to the relevant domestic market. Further work would be needed to establish clear and watertight regulations that leave no scope for structuring or avoidance.
  1. The legal basis of a test and the responsible decision maker. Under section 7 of the Export Control Act 1982 the responsible Minister can issue regulations to prohibit the export of prescribed goods unless specified conditions or restrictions are complied with. This provides wide latitude for the design of an appropriate regime to safeguard Australia’s national interest in a secure and adequate supply of natural gas. The simplest approach would be to make the Minister, acting on the advice of their Department, the arbiter of whether an arrangement should be prohibited.

The design and use of a national interest test would also need to take account of our international trade obligations, including multilateral agreements and relevant bilateral agreements like the Korea-Australia Free Trade Agreement and its energy and investor-state dispute resolution provisions.

Overall, we believe that the Australian Government should consider a national interest test favourably. Its clear and proper purpose in assuring adequacy of domestic supply, and the low scope for side effects on economic flexibility and investment, make it superior to alternatives like reservation. And the existence of a test would make it much more likely that voluntary commercial arrangements to manage the current tight market will be established and effective.

Next steps

The Government has challenged the gas industry to ensure adequate supply, and left them to make the necessary arrangements. This is an excellent start, but for the reasons considered above it may not be enough. The Government should immediately move to gather information from producers, exporters, retailers, domestic customers, international customers and market analysts to better understand whether and how a swap is feasible.

If this assessment is favourable, the Government should increase pressure on parties to reach suitable agreements, and consider if necessary playing a more facilitative role. This could involve acting as a repository of sensitive information; clarifying that any necessary arrangements do not violate competition law; or other steps.

The Government should also move immediately to establish a national interest test which can both add to the pressure to negotiate swaps, and guard against any repeat of the current crisis as Australia’s gas market and exports evolve.

 

INNES WILLOX
Chief Executive
Australian Industry Group

 

1. Deloitte Access Economic, Gas Market Transformations (July 2014)