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Will a gas market develop in the Caribbean? Part one

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LNG Industry,

By Yasmine Zhu, a Senior Analyst with McKinsey Energy Insights, where she conducts market analysis for its North American upstream and midstream sectors. Topics she covers include shale productivity, natural gas regional market dynamics, US LNG, and midstream capital investment.

Caribbean countries have traditionally used oil products to generate electricity, leading to high power costs and pollutant emissions. Now, thanks to the growing number of LNG suppliers and advances in small scale technology, opportunities are arising for oil-to-gas conversions, which could lead to the development of a regional gas market in the Caribbean. But several challenges still remain, including ensuring a sufficiently high utilisation rate of the LNG infrastructure, accounting for long-term market uncertainties, and raising the high level of front-end investment required for power plant conversions to gas.

With limited hydrocarbon resources of their own, most Caribbean countries rely on imported oil products to generate electricity and meet other energy needs. 85% of primary energy usage is sourced from imported petroleum products1. Because oil products are expensive, producing electricity from these sources has pushed up the cost of power, which can depress economic development. However, the alternative of switching to natural gas has historically not been a popular choice, because the needs in the Caribbean were generally deemed too small to support the economics of LNG delivery.

Now, LNG market conditions have changed. International liquefaction capacity has grown. The US is emerging as a significant LNG exporter. Technological advancements are bringing down costs in small scale LNG shipping and regasification. While these developments are promising, high debt and other financial pressures mean most Caribbean governments have little money for oil-to-gas conversion projects. Additionally, fuel oil and diesel prices have plunged by 50% since 2014, reducing the cost advantage of LNG over oil.

In this article, we take a look at how LNG can compete with fuel oil in a lower-for-longer oil market and what new opportunities this might present for gas suppliers and users in the region, as well as assessing what transformations might already be underway.

LNG is competitive now, but will it last?

As shown in Exhibit 1, in the near to medium term through 2024 – 25, fundamentals are likely to favour LNG buyers globally due to oversupply resulting from a rush to build LNG capacity in the first half of this decade, combined with sluggish demand growth. In the Caribbean, buyers may gain further advantage from their proximity to the US, where the shale gas revolution has seen a dramatic rise in low-cost supply, including feed gas for LNG export. These expected oversupply conditions have also impacted US LNG export contracting. Only about 60% of US LNG export capacity is tied to long-term end-user contracts in 2021, making the US a potential swing supplier to areas such as the Caribbean. Indeed, suppliers are already positioning themselves. In Panama, for example, AES announced a partnership with Engie at the Costa Norte LNG project to market LNG sourced mainly from the US2. But are LNG costs likely to remain at this level?

Beyond 2024 – 25, however, the LNG market could tighten if sufficient new liquefaction capacity is not built beforehand, and the advantage may switch to LNG suppliers. We could also see oil prices rise by the early 2020s, as lack of upstream investment accelerates non-OPEC legacy declines and new projects FID approved after 2014 is not enough to fill the supply gap. This is likely to be true if North America shale oil growth keeps a lid on prices for the next few years – in line with our base case ‘Lower for Longer’ scenario.

To assess which fuel would be least expensive, we examined a scenario in which the Caribbean sources gas from the US Gulf Coast and compared the delivered cost to that of fuel oil and diesel. Exhibit 2 shows the US LNG delivered cost to the Caribbean through a standard large-scale onshore terminal, including the Henry Hub gas price, liquefaction, transportation, and regasification costs3.

Over the past six months, the estimated delivered LNG cost has stayed at roughly the same level as delivered fuel oil prices and at a sharp discount to diesel. However, there is far less commodity risk with LNG, as the raw material cost (based on Henry Hub) is a far smaller proportion of the delivered cost, compared to the crude oil element of the delivered fuel oil cost. A sensitivity analysis on the right of Exhibit 2 shows that, while nearly 90 – 95% of delivered fuel oil or diesel costs are linked to crude prices, the US LNG delivered cost to the Caribbean has only 40% of its cost tied to Henry Hub. While fuel oil prices may fluctuate anywhere between US$5 – 11/MMBtu, in line with crude prices, LNG contracts are much less volatile in response to moves in Henry Hub pricing, staying at a level of US$7 – 8/MMBtu for large-scale delivery. Diesel has the highest costs in all three price scenarios and has a commodity risk similar to fuel oil.

However, longer term the economics could be different. As mentioned before, if too few new LNG plants are commissioned to come onstream after 2025, then rising demand may significantly overtake available supply, and there would be upward pressure on delivered LNG prices, including in the Caribbean. Instead of a Henry Hub-linked cost-based pricing system, the value of US LNG could be influenced by oil-linked Asian netback pricing as cargoes are drawn across the Pacific. That means a relatively higher gas price, more exposure to commodity risk, and less advantage compared to oil products for Caribbean gas buyers.

For power generators in the Caribbean to convert to gas, it is crucial to develop a strategy that secures a low-cost Henry Hub-linked LNG supply source (beyond 2024 – 25). This could be achieved through LNG contract negotiation or the development of seaborne compressed natural gas (CNG). Although not commercially ready yet, CNG is a promising technology that ties pricing to the regional Henry Hub-based market. Because it is most cost-effective within distances below 2000 miles, the CNG price will be much less affected by a tightened global gas market.

1. Excluding T&T and Haiti, Caribbean Energy Sector Macro-Related Challenges, IMF, Sep 3, 2015
3. Additional transportation costs from the LNG regas terminal to the fuel consumption facility have not been considered

Read part two here.

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