Gassed

Economists are experts at knowing tomorrow why the things they predicted yesterday didn’t happen today.

In 2011, the IEA hypothesised about a golden age of gas. “The future for natural gas is bright” they wrote in their 2011 special report, pointing to a “strong post-crises recovery”, “mounting concerns over energy security and global climate change, and renewed debate surrounding the future role of nuclear power”.

Just five years on, the IEA’s outlook had run out of… err umm gas. Their gas story became one of “subdued economic growth”, “lessening demand growth for all fossil fuels, including gas”, and “decline in the energy intensity of the world economy”. Suddenly gas was finding it difficult to “compete in a world of very cheap coal, falling costs and continued policy support of renewables”.

The IEA was not alone in their sanguinity. The department’s 2013 March Resource and Energy Quarterly (REQ) — which forecast LNG production, exports and prices out to now checkable 2018 — proposed a similar outlook. Here’s a bunch of numbers:

· Australian LNG exports were expected to grow by 30 per cent a year, reaching to 88 million tonnes (mts) five years later. The outcome was almost a third less than this, export volumes growing at 21 per cent per year, and reaching a total closer to 63 mts.

· Oil prices were expected to stay high, which would keep up the long term contract price for LNG. This would underpin $52.8 billion in exports. High oil prices however, did not eventuate, and combined with the less than expected production volumes, LNG export earnings this year will be about $29.9 billion.

Forecasts are either wrong or lucky. That’s not a criticism of the methodologies used to derive the forecasts above, nor their implicit optimism. Things change, new information emerges, unknowns become knowns, and forecasts are updated accordingly. The REQ, like the IEA, was making use of the best information available at the time.

Moreover, unpacking where and why these forecast misfired, reveals some fascinating learnings about how markets work, and of the strategic interactions between players.

Surprise number 1 was Japan. Japan was then, and is now, the largest importer of LNG in the world, completely reliant on imports to meet its domestic consumption requirements. Their dependence on gas imports increased in the wake of the 2011 earthquake and tsunami, where the country’s 54 nuclear reactors were taken offline for safety inspections. They were expected to increase their imports year on year by an average rate of 8 per cent per annum, hitting 122 mt by 2018.

Over reliance on an imported energy source doesn’t bode well for energy security. The Japanese Government’s response was to look for alternatives be they coal, renewables (which roughly doubled over this period), energy efficiency or and nuclear restarts. The net effect was a decrease in gas demand. Japan’s total LNG imports peaked in 2014, at not quite 90 mt. They’ve since plateaued at around 86 mt.

Surprise number 2 was the dramatic drop in oil prices. Oil prices (which under pin LNG prices) were expected to increase steadily, rising from US$107 a barrel in 2013 to US$113 a barrel in 2018. What eventuated however, was a six month price fall from mid-2014, to a low of US$47 a barrel in January 2015.

Why did this happen? A few reasons, the main one being the “game changing” innovation and technology developments that unlocked the US’ shale gas revolution, establishing the US as the world’s largest oil producer. US oil production increased by 8 per cent in 2014 year alone.

OPEC had previously countered imbalances like this by restricting supply. However, given the rise of the US, such a strategy would have been detrimental to their interests, and so the Saudis and their Gulf allies opted to retain market share instead. Prices stayed low as a result.

And finally, surprise 3 was that it took longer for Australian production capacity to come online than was originally anticipated (88 mts expected for 2018 versus 68 mts realised).

It’s important to have perspective on the enormity of these projects. In real terms, the amount invested in Australia’s LNG production could have built 30 Snowy Hydros, or three 3 Gorges Dams. We’d have about $20 billion in change from the Marshall Plan. However, well-intentioned and efficiently managed these projects were, delays in projects of that size are not to be unexpected. Risks materialise, the unanticipated happens, weather disrupts.

Furthermore, Australia was not the only ones investing in LNG. The surge in global demand saw additional capacity being built in the US, SE Asia and elsewhere. Its our job as economists to understand how the forces of supply and demand interact, and these interactions net out in terms of price. For the most part that was understood.

But what was seemingly undervalued was the effect that competition would have on the market. Supply and demand fragmentation would ultimately result in a shift in the nature of contract volumes, values and duration. This has affected project economics here in Australia, and combined with the other factors mentioned, has resulted in rising underutilisation for Australian LNG export projects.

The key learning from the above is to remember that the world is not static. Technology improves, policies change and buyers and sellers react accordingly. High prices in particular, are tremendous at launching the search for alternatives — be they technological or policy.

Post script: This is serves the basis for a talk I’m about to give at the Australian Domestic Gas Outlook Conference. Let me know if I’ve strayed too far off the reservation.