Oil and gas prices are critical to the future development of the industry both in the North Sea and worldwide.
Basic economics tells us that prices are determined by supply and demand. If demand for a commodity exceeds the supply then prices will rise; and the opposite will happen if demand drops.
However, the current situation in the oil&gas industry is much more complicated. Some of that can be attributed to differences between short and long-term prices, but not all.
Crude oil was trading at around $85 per barrel at the time of writing, which was an 18-month high, but gas prices in the UK and US were at record lows. Why the massive difference?
It is widely believed that oil&gas prices are closely linked, but that does not appear to be the case today. When commodities are substitutes then there should be a close price relationship. Oil&gas are substitutes for some uses, notably electricity generation and heating, but not for others, notably transport. Nevertheless, historically, many gas prices have been linked to oil prices, but with a significant discount – for example, 25% of the fuel-oil price.
The gas side of the industry often requires much greater capital investment than does oil, such as for the construction of pipelines and liquefied natural gas (LNG) terminals.
Consequently, gas producers normally want the security of long-term supply contracts, and those have often been linked to oil prices. Such arrangements worked well until the massive rise in oil prices in 2008, when crude shot to $147 per barrel, then plummeted to the low $30s in the US. Since then, oil&gas prices have diverged. Many gas supply contracts are long-term, of course, so they may not have been affected, but the spot or short-term prices show a very different picture.
I believe that we can expect a period of relative stability in world oil prices in the range $70-80. Some commentators, notably from Goldman Sachs, have predicted that prices will rocket to $200, but there is little justification for that view. There will inevitably be short-term fluctuations, but the demand and supply fundamentals support the price range indicated above.
Demand for oil&gas fell substantially as a result of the credit crunch and associated, largely western, recession. That implies falling prices, but there seems to have been a floor at around $70.
Oil producers responded to the recession by cutting production, not just Opec but IOCs like BP, Shell and ExxonMobil. It is relatively easy to adjust oil production levels, and there is also substantial storage capacity in the industry, both onshore and offshore in tankers, which can be used to even out short-term fluctuations.
Opec, at its last meeting, stated that the $70-80 price range is acceptable to its members, and other organisations, such as the International Energy Agency (IEA) and the World Bank, have expressed similar views. Prices in that range must have a negative effect on world economic output, but the UK economy, for example, seems to have adapted to that level.
The recession in the UK and elsewhere was not caused by high oil prices, but by other factors. The countries suffering the most from oil prices at around $80 are the poor nations without their own oil production. Saudi Arabia, Norway and other oil producers are doing very well at the present time.
In contrast, current gas prices conform more to the basic economic principles of supply and demand. The latter has also been depressed by the recession but, at the same time, there has been a surprising increase in supply.
One of the reasons for that is the big rise in output from shale-gas reservoirs in the US. Consequently, the US demand for imports, both by pipeline and LNG, has fallen dramatically, as have gas prices.
LNG producers have been forced to switch cargoes to other markets in Europe and Asia, and there have been corresponding declines in gas prices there. In the UK and elsewhere in Europe, there has been a massive increase in the number of LNG import terminals over the last few years, partly to reduce the dependence on gas from Gazprom and the Russian Federation.
There has also been substantial growth in LNG production capacity, notably in the Middle East, but also elsewhere, such as in Norway. Many more facilities are proposed. Qatar dominates the LNG industry and I believe is willing to accept – possibly even encourage – a period of low gas prices in order to stop as many of the proposed facilities – both liquefaction and regasification – going ahead. I do not know how long that period will last, but it could be for two to three years. Thus, I expect considerable volatility in gas prices in the short run and continuing divergence away from oil prices. It may take two to three years for worldwide gas demand and production capacity to achieve better equilibrium.
Gas consumers in the UK should welcome these trends, but there are clearly big differences between wholesale and retail prices. Some of the gas suppliers are also producers and are presumably keeping retail prices as high as possible to compensate for their reduction in upstream income.
And some people tell me that the UK gas market is the most liberated in the world?
Tony Mackay is MD of economists Mackay Consultants
