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SPE 24238An Emerging Economic View of World Natural GasDemand and SupplyW.H. Dorsett*, Chevron Corp., and G.B. Ackerman, Decision Focus Inc.*SPE Member

Copyright 1992. Society of Petroleum Engineers, Inc.This paper was prepared for presentation at the SPE Oil & Gas Economics. Finance and Management Conference held in London, England. 28-29 April 1992This paper was selected for presentation by an SPE Program Committee following review of informat ion contained in an abstract submit ted by the author@). Contents of the paper,as presented, have not been reviewed by the Society of Petroleum Engineers and are subject to correction by the author@). The mater ial, as presented, does not necessari ly reflectany position of the Society of Petroleum Engineers, its officers, or members. Papers presented at SPE meetings are subject to publication review by Editor ial Committees of the Societyof Petroleum Engineers. Permission o copy is restric ted o an abstract of not more han 300 words. lllustrationsmay not be copied. The abstract should contain conspicuous acknowledgmentof where and by whom the paper is presented. Wri te Librarian. SPE, P.O. Box 833836, Richardson, TX 75083-3836 U.S.A. Te lex, 730989 SPEDAL.

ABSTRACTN a tu r a l ga s i s s w i f t l y moving f rom al o c a l l y t r a d e d co-dity i n r e g i o n a lm ar ke ts t o a q l o b a l l y t r a d e dcommodity. his d e s c r i b e s anum e r ic a l m odel o f i n t e r n a t i o na l ga st r a d e w hich e v a l u a t e s t h e e f f e c t s o fi n t e r - and i n t r a - r e g i o n a l g a s t r a d e ondemand, sup ply and p r i c e.P r e li m i na r y ev i de n ce i n d i c a t e s n a t u r a lg as p r i c e s a r e 15 t o 3 0 % low er i n r e a lterms w he n in t e r - r e g iona l t rade o c c u r sa nd l o c a l consum pt ion o f n a t u r a l ga si nc re as es r e l a t i v e t o f u e l o i l i n t h el o c a l m ar ke t.N a t u ra l g a s d e v e lo p e r s o r m ar k e te r s t h a te x p l i c i t l y c o ns id e r t h e i n t er - re g i on a lim pa c ts o f ga s t r a d e w i l l h a v e a g r e a t e rl i k e l i h o o d of u n de rs t an d in g t h e r i s k s i nm a r g i n a l p r o j e c t s a n d a re more l i k e l y t oembrace economic p r o j e c t s and eschew non-economic pro jec t s .VALUE OF INTERNATIONAL GAS TRADE TOGLOB& COMMUNITY

"For both economic and environmental reasons,natural gas is becoming the fuel of choice in many- - -

References and charts at end of paper.

rnurkets. ... The forms of con tracts employeci, theease of access of new entrants to the gas business,the pricing formulas and the use that bothsuppliers and consumers can make of gastransmisswn and distribution systems will allaffect the terms under which old and new gascomes to the marketplace . All these facbrs willhave a major impact on whether gas use picks upan4 if so, a t what pace" 'Many co u n tr ie s wi th undevelopedi n di g en o u s n a t u r a l g a s r e s o u rc e sare a nx ious t o de ve lop new m a rke t sf o r t h e i r g a s. T hese c o u n t r i e sr e co g ni ze t h a t d e l a y s i n d e ve lo pi ngt h e s e r e s o ur ce s r e s u l t i n a l a r g ef i n a n c i a l c o s t , s lo wi ng t h e i r owndevelopment as a n a t i o n . F or t h i sreaso n , many a r e now o f f e r in gf i n a n c i a l i n c e n t i v e s , s uc h a s t a xh o l i d a y s , g r a n t s , l o a n g u a r a n t e e s,r e d u c e d r o y a l t y a n d a c c e l e r a t e dc o s t r ec o ve ry t o p r i v a t e an d p u b l i cc om pan ie s t h a t w i l l deve lop andm ar ke t t h e i r i n d i ge n o u s g a sr e s o u r c e s .W hi le n a t u r a l g a s i m p o r t i n gc o u n t r i e s w ould p r e f e r t o d e ve l opt h e i r own r e s o u r c e s a nd a vo id c a s ho u tf lo w t o e x p o r t i n g c o u n t r i e s ,t h e y m us t a p p r e c i a t e t h a t r ed u ce d

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SPE 2 4 2 3 8 W.H.DORSETTc o s t s o f i m po r te d g a s a f f o r d s a no p po rt u ni t y t o i n v e s t t h e s a vi n gs i nd e v e l o p i n g o t h e r r e s o u r c e s .I n a d di t i o n t o c o s t s a vi ng s i n t h e t o t a le ne rg y b i l l , i n t e r - r e g i o n a l t r a d e whichc a p i t a l i z e s on l ow er n a t u r a l g as c o s t so u t s i d e t h e i r b ou nd ar ie s, h e l p s c o u n t r i e sd e ve l op more d i v e r s i t y a nd s e c u r i t y o fs up pl y. With n a t u r a l g a s r e p l a c i n g f u e lo i l f o r t h e non-core m ar ke t, t h e r e sh o ul dbe le ss d ep en de nc e on t h e v o l a t i l e wo rl do i l m ar ket .E n v i r o n m e n t a l l e g i s l a t i o n i s e s c a l a t i n gi n many p a r t s o f t h e wor ld , wi th somec o u n t r i es r e q u i r i n g u s e of n a t u r a l g as a sa r e pl ac em en t f o r f u e l o i l a nd n u c le a re ne rg y i n t h e e l e c t r i c g e n e ra t io n m a rke t .Th i s c o u ld be m i s i n t e r p r e t e d a s m eaningt h e s e c o u n t r i e s w ould b e w i l l i n g t o p ayh i g h e r p r i c e s f o r u s e of i n d ig e n ou s g a so n ly .In a wor ld o f i n c r e a s in g t e c h n o lo gy a ndl ow er c o s t s o f d e v e lo p i ng g a s r e s o u r c e s ,consum ing c o u n t r i e s n ee d t o e v a l u a t e t h eeconomic b e n e f i t o r c o s t o f i n t e r -r e g i o n a l g a s t r a d e a s c om pared w i t hdeve lop ing ind igenous res our ces . To doo t h e r w i s e c o u l d l e a d t o p o o r e co no mici n v es t m e nt s a nd h i g h e r c o s t o f e n e rg y f o ra l l c on su me rs .THE ROLE OF COMPETITIONAlmost a l l g e og r ap h ic r e g i o n s o f t h ewo rld ha ve s ome n a tu r a l g a s . Of t e n t h eg as i s a s s oc i a te d w i th c r ud e o i l o rl i q u i d p r o d u ct s a n d t h e r e f o r e , i scons ide r ed a by-p roduc t f o r whichp l an n er s s t r u g g l e t o f i n d l i k e l y ma rk et s.The e x t e n t t o w hich a r e g i o n ' s i n d ig e n ou sgas supp ly i s c o m p e t i t i v e w i t h i m p o rt s i st h e focus o f t h i s paper . How much lo c a l l yp ro du ce d g a s c a n a l o c a l m ark e teconomical ly absorb? What are t h e p r i c er e sp o ns e s a t t h e w el l he a d a nd b ur n e r t i pwhen i n t e r - r e g i o n a l s u p p l i e s a r ein t ro d u c e d ?T r a d i t i o n a l l y , t h e e n er g y i n d u s t r yt h o ug h t o f n a t u r a l g a s a s a b a l k a n iz e dcommodity -- t h a t i s , a p r o d u c t n o tw id el y t r a d e d a c r o s s c o u n t r y o r r e g i o n a lb o rd e r s . Y e t , i n t h e l a s t two decades ,i n t e r - re g i o n a l g a s t r a d e -- wi th in No r th

A m e r i c a ( f ro m Can ad a t o t h e l owe r4 8 S t a t e s o f t h e U.S,A.); t o N or thAmerica from A f r i c a and Norway; t oWeste rn Europe f rom Af r i ca , Ea s te rnEurope , and t h e former So v i e tUnion ; and t o Japan f romAu s t r a l i a , t h e U.S., I n d o n e s i a ,M a la y si a , a n d s e v e r a l o t h e rc o u n t r i e s -- a re e v i d e n c e t h a tn a t u r a l g a s m a r k e t s a re becomingmore g lobal .An economic v iew of g l ob a l marke tsr e q u i r e s u n d er s t an d i ng t h e i mp ac tso f i n c r e a s e d c o m p e t i t i o n o n t h es u p pl y o f n a t u r a l g a s ; a nde s p e c i a l l y t h e i mp ac ts o f i n t e r -r e g i o n a l n a t u r a l g a s t r a d e on ar e g i o n ' s d o me s ti c n a t u r a l ga sdemand and p rod uc t io n . The f i r s tp a r t o f t h i s d i s c us s i o n f o cu s es ont h e m ar ket e f f e c t s of g r e a t e rc o m p e t i t i o n w i t h i n a g i v e n r e g i o n ,a nd t h e s ec on d o n t h e e f f e c t s o fi n c re a s ed n a t u r a l g a s i m p o rt s i n t oa r e g i o n .There are f e w g l o b a l r e g i o n s ,e xc ep t i n t h e U. S. , w h e r e n a t u r a lg a s i s s u b j e c t t o c o m p e t i t i o n amongg a s s u p p l i e s e m a n a tin g fromd i f f e r e n t s u b re g i on s . I nd ee d,e ve n i f n a t u r a l g a s i m p or t s fr omCanada and Alger ia w e r e s h u t o f f , as t ro n g c o m p e t i t i v e e nv i ro n me n twould remain i n t h e U.S., wherei m p o rt s a c c o u nt f o r less t h a n 2 TCF( 5 6 G m3) of a 1 9 TCF ( 5 3 8 G m3)market .It s h ou l d b e a xi o m a ti c t h a t f o r" fr ee -m a rk et " c o m p et i t io n t o e x i s tw i t h i n an y r e g i o n , t h e r e are t h r e en e c e s s a r y c o n d i t i o n s :-gas-on-gas com pet i t ion a t end-usemarke ts ;- t r a n s p o r t a t i o n sy st em s t h a t o f f e ro pe n a c c e s s t o s e l l e r s , t h i r d -p a r t y s h i p p e r s , a nd b u y er s ;* u n r e g u l a te d w e l l he a d p r i c i n g a ndp r o d u c t i o n o p p o r t u n i t i e sa v a i l ab l e t o a l l p a r t i e s .

The f i r s t c on d i ti o n i s o f t e n

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4 EMERGING ECONOMIC VIEW OF WORLD NATURAL GAS SPE 24238confused with gas-on-oil competition, orgas-on-coal competition. When naturalgas is only competing against anotherfuel, then prices tend to maintain paritywith that fuel.This cross-fuel substitution provides aceiling price, which the price of naturalgas rarely exceeds. Open competitionoccurs when natural gas competes not onlywith oil and coal, but also with othersources of natural gas from differentregions which have different productionand transportation costs (the combinationof production, transportation, anddistribution costs is referred to hereinas the net-forwardmarginal cost).Intra-regional trade among gas producersis necessary to obtain a competitivemarket. The degree of competition amonggas producers is a function of the accesswhich the intra-regional pipeline systemaffords producers.Hence, the existence of natural gascompetition, and the benefits thereof donot depend solely upon the existence ofinter-regional trade. Competition withina region depends upon the rules governingthe process of moving natural gas fromunderground reserves to the burner tip.In the mature competitive markets of theU.S., natural gas imports were previouslyconsidered marginal supply sources usedonly during peak demand periods. But,during the 1980s the import picturechanged dramatically such that relativelyinexpensive imports from Canada became aninfra-marginal source or a part of thebase load demand. Domestic producers inthe lower 48 states of the U.S. have beenforced to compete with the prices andterms offered for these Canadiansupplies.Over 75 TCF (2,123 G m3) of relativelyinexpensive proved reserves are in theProvince of Alberta, which will becomeavailable to the U.S. market as morenatural gas pipeline capacity is added.The potential competitive impact isimmense. For either marginal producers( high-cost producers) or marginalpipeline projects, the economic impactcould be devastating.

Many North American natural gasprojects to add production orpipeline capacity could be injeopardy of financial failure ifnatural gas imports continue toexert downward pressure on prices.The economic viability of someprojects depends upon natural gasprices reaching parity with fueloil, escalating each year at 1 percent (real) or more. The samedegree of uncertainty could occurin Western Europe where several newmega projects have been announced.And, the same scenario can beconstructed among LNG productionfacilities supplying natural gas toJapan, Korea, and Taiwan.The consumer benefits of aggressivecompetition -- whether from intra-regional or inter-regional trade --include lower end-use prices andmore natural gas products among whichconsumers may choose. This may notbe good news for the gas producers,since their economics might havebeen based on less competitivemarkets. This is not always thec a s e b e c a u s e p r o du c e r s'profitability does not alwaysincrease or decrease at the samerate as end-use prices.Requirements for Analvzinq Inter-Reuional Gas TradeInputs to the model of intra-regional and inter-regionalcompetition in natural gas tradeinclude:-exploration and development costsupply curves for major reservebas ins;=transportation tariffs formovement of natural gas viapipeline and LNG production,shipment, and re-gasification;-natural gas demand for core users(i.e., no fuel switchingcapability) and non-core users ( fuelswitching capability available).

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SPE 24238 W.H.DORSETTTo study the interactive aspects of theserequirements, an economic computer modelwas developed in 1990. The objective wasto develop a simulation tool which woulduse supply, transportation, and demanddata from a comprehensive data base, andallow regional demand and supply forcesto interact then estimate the prices andvolumes of natural gas within and betweenregions.

The authors recognize that simulationtools cannot model complex politicalinteractions and realities precisely.But, careful use of simulation tools suchas this model can reveal relationshipswhich deserve examination andexplanation.MODEL DESCRIPTIOIPThe model was designed to simulate theeconomics of the world markets and toequilibrate the demand and supply for gasat each location and point in time. Thedemand for natural gas varies with theprice of natural gas and with the priceof competing energy sources.Natural gas producers are assumed to tryto maximize the wealth of the resourceowners, who determine the quantity of gasto sell from each resource. ( Table I isa listing of the Global and Local regionsand output reports which are available.)Supply cost curves for over 200 naturalgas basins around the world wereestimated using publicly available data.A proto-typical supply cost curve for anyresource is in Figure I.The two-dimensional mapping of costs in1991 dollars per MCF (35.3 k m3) againstcumulative production sets the supplycurve with which the model begins toiteratively solve the equilibriumbalance. As a result of using thisparadigm, cheap resources get sold first.Exhaustible resource prices tend toincrease over time (absent technologicalchange). Resource prices are usuallyhigher than actual production costs dueto economic rent and value basedassessments. These higher prices resultin rates of return on investments which

induce resource owners to depletereserves sooner.Demand curves in the model aresegmented as shown in Figure 11.Competition between natural gas andoil results in a chair shapeddemand curve. The seat of thechair is at parity price of naturalgas and competitive fuel oil. Ifthe net-forward marginal cost of naturalgas drops below the price of thecompetitive fuel, the non-core orfuel switchable portion of thedemand curve begins switching tonatural gas.Conversely, natural gas priceshigher than competing fuel oilprices means that only the coresegment of the market utilizesnatural gas, and the fuel-switchable market eschews naturalgas in favor of competing lowercost fuel oils.In the model, the non-core marketis represented in two distinctparts: Utility Electric Generation(UEG), and all other non-coredemand. A constant ratio of UEGmaximum natural gas demand relativeto all non-core maximum demand wasassumed for each region.Finally, the model representationsof distribution and transportationcosts were simplified. Sufficientdata was assembled to estimate thefixed dollar markup and fixedpercentage fuel efficiency to bringnatural gas from the aggregatewells in each region, to therespective burner tips.LNG costs, and long-haul naturalgas pipeline tariffs were moredifficult to estimate. However, atariff structure was assembled byconducting a series of trial-and-error experiments using sensitivityruns of the model to examinevolumetric flows between regionsunder different tariff assumptions.

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6 EMERGING ECONOMIC VIEW OF WORLD NATURAL GAS SPE 24238CASE STUDY EXAMPLE:IMPACT OF INTE R-RgG ION AL TRADE ON WESTERNEUROPETwo states of world gas trade wereconstructed for the purpose of conductingthe case study. The purpose of creatingthese two states of the world is toidentify and isolate the supply, demandand price effects of inter-regionalversus intra-regional trade.In the inter-regional trade case, freecompetition is assumed in natural gasmarkets within the region. This allowsimports into and exports from the region.All producers are globally competing forthe highest return on investments, andall consumers are buying the lowest-costsupplies, regardless of where thesupplies originate.In the indigenous supply case, it is assumedthat Western European supplies are theonly sources to satisfy Western Europeannatural gas demand. That is, all naturalgas imports from any other region arechoked off using an extremely high tariffrate. In both cases Western Europeannatural-gas exports are not economic.All other assumptions in the model areidentical between the two cases. Oncethe conditions are set, the modeliterates to find a supply/demandequilibrium. Natural gas pricesfluctuate, and both core and non-coredemands (UEG and all other non-coredemand) are allowed t o respond accordingto assumed short-term and long-term priceelasticities encoded in the model.Standard reports are produced for eachstate-of-the-world case, and are comparedand graphed using a spreadsheet program.Figure 111, entitled Western EuropeanNatural Gas Wellhead Prices, compares thetwo cases. Whereas the beginning andearly year price spreads between the twocases is very small, by the year 2000 theprice difference is 38C per MCF (35.3 km3) in 1991 U.S. dollars. A price changeof this magnitude is worthy of notice. Inaddition, the price differentialincreases with time.An increase in price might be expected,but the magnitude of the difference is

more important than the priceincrease itself. Certainly,constraining Western Europeans toconsume only natural gas fromwithin the Western Europeanconnnunities induces higher naturalgas prices. But now, we are ableto examine the downward pressurenatural gas imports can have onprices that producers map obtainunder an open-trade state-of-the-wor ld .Many natural gas producers regardinter-regional competition asaffecting only the end-use price ofnatural gas, but not the averagewellhead price.The indigenous supply case suggests thatsome marginal producers in WesternEurope may not be able to competewhen open trade is allowed. Theseproducers should be keenly aware ofwellhead prices not only in WesternEurope, but also global prices thatrepresent potential competitors,now and in the future.There is a surprise, however, whenWestern European productionprofiles are compared under the twocases. Figure IV shows the five-year snapshots of natural gasproduction for the two cases.Between the years 1990 and 2000,Western Europe enjoys a higherproduction profile -- a maximumproduction of about 9 Tcf (2,549 Gm3) in 1995 -- when there is inter-regional trade and a lower profilewhen trade is restrained.After the year 2000, however, theprofiles switch. Open traderesults in Western Europe producingless than if no natural gas tradewere allowed.Figure V offers an explanation ofthis outcome. Comparing non-corenatural gas prices (average end-use) to non-core oil prices(exogenously assumed and the samein both cases) shows the following:-With inter-regional trade, the

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SPE 24238 W . . ORSETTend-use prices of natural gas and oil areroughly at parity, yet before the year2000 natural gas is slightly cheaper thannon-core oil. After the year 2000, non-core oil is relatively cheaper thannatural gas.*Without inter-regional trade,natural gas end-use prices arehigher relative to non-core oil.A reason for this is, in the indigenoussupply case, the non-core markets moveexclusively to oil because high naturalgas prices reduce non-core demand inindustry and electric generation markets.But, in the with inter-regional trade case, thenon-core markets are almost equallydivided between natural gas and competingfuel oils.Figure VI provides the demand andproduction profiles for Western Europeunder the with inter-regional trade case. Thisdemonstrates that supply tracks demandwith regularity. Due to the relativegas/oil prices in the with inter-regional radecase (see Figure V) , Western Europeannatural gas demand increases in the firstdecade because gas is less expensive.Then it decreases significantly in thesecond decade due to lower priced fueloil, and begins a slow ascent in thelater years as total energy demandincreases.Natural gas production follows the samepattern, suggesting that incrementalsupplies for Western Europe are embeddedin part of the indigenous WesternEuropean supply, whereas natural gasimports are entirely base load. Duringthis time, imports remain at a relativelystable amount between 3 and 4 TCF (85 to113 G m3) per year.Figure VII provides additional insight byplotting the indigenous supply case supplyprofile between the Figure VI demand andsupply profiles. Since supply equals coredemand in the indigenous supply case, it seemsthat European production after the year2000 with inter-regional trade is less than thecore demand for natural gas1

CONCLUSIONS1. ) The economic viability of aproject cannot alone be judgedsimply on intra-regional supply anddemand balances for natural gas.2.) Increased inter-regional gasflows will closely follow theglobal energy economy thatpresently exists for crude oil andrefined products.3. ) The degree to which natural gasmarkets are competitive depends onthe rules by which producers,shippers, and end-users are allowedaccess to different gas supplies,and intra-state transportation.4.) Inter-regional gas tradeapplies competitive pressure onnatural gas markets but, inter-regional trade is not sufficient byitself to change a monopolistic ormonopsonistic natural gas marketinto one which is more fullycompetitive.5. ) As inter-regional gas tradeopens up gas markets in a region,there may be more natural gassupply sources than were previouslyconsidered.6.) The higher cost domesticproducers are likely candidates tobe eliminated from the competitivequeue.7.) Relatively high-cost producerscould quickly change from base loadproduction to swing producer.8.) The idea that inter-regionalnatural gas imports only serve tomeet incremental growth in naturalgas demand, or swing demand shouldbe re-considered.

TCF = 1 x 10'' cubic feetG m3 = 1 x 10' cubic metersMCF = 1,000 cubic feetk m3 = 1,000 cubic meters1 cubic foot = 35.315 cubic meters

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8 EMERGING ECONOMIC VIEW OF WORLD NATURAL GAS SPE 24238ACKNOWLEDGEMENTThe authors wish to thank R. D. Samuelsonfor his assistance in running the modelexamples,. Also thanks to the managementof Chevron Corporation and Decision FocusInc. for permission to publish this work.REFERENCES1. International Energy Agency, NaturalGas Prospects and Policies, Organizationfor Co-operation and Development, Paris,France, pp.9-10.

TABLE IWORLD GAS MODEL REPORTS

I. GLOBAL and LOCAL REGIONS:A. North America,14 Local Regions;B. Latin America,

6 Local Regions;C. Western Europe,5 Local Regions;D. USSR + East Europe,6 Local Regions;E. Africa,4 Local Regions;F. Middle East,6 Local Regions;G. Mainland Asia,7 Local Regions;

H. Pacific Rim,7 Local Regions;I. World Total.11. AVAILABLE FOR EACH REGION:A. Local Production;B. Prices;C. Imports;D. Exports;E. End Use Demand, Prices,Core, Non-Core,UEG;F. Liquified Natural Gas,Source, Price, Trade;G . N o n - C o r e O i l / G a s ,Consumption and Prices.

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Cost $

Cumulat iveProduction

FIGURE I TYPICAL RESOURCE SUPPLY VS COST CURVE

Natural Gas. . . . . . . . . . . . .. . . . . . . . . . . . . CompositeDemand Curve

. . . . . . . . . . . . . . .. . . . . . . . . . . . . . .. . . . . . . . . . . . . .. . . . . . . . . . . . . . .

FIGURE 11 NATURAL GAS DEWUUD CURVE VS PRICE

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1990 1995 2000 2005 2010 2015 2020 2025 2035Year

FIGURE I11 WESTERU EUROPE NATURAL GAS WELLHEAD P R I C E S

1990 1995 2000 2005 2010 2015 2020 2025 2035Year

FIGURE XV WESTERU EUROPE UATURRI. GAS PRODUCTIOU

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17 - - Western Europe Non-core Oil

.....................................................................

..................................

. . . . . . . . . . . . . . . . . . . . . . . . . . . .

1990 1995 2000 2005 2010 2015 2020 2025 2035Year

FIGURE V WESTERN EUROPE OIL AN D NATURRL GAS PRICES

Supply w/ Inter-regionalTra Year1990

FIGURE VI WESTERN EUROPE NATURAL GAS DEMAND AND PRODUCTION

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'CFIYear

Indigenous,ply wl Intel

FI URE VI I WESTERN EUROPE NATURAL GAS DEMAND AND PRODUCTION -INDIGENOUS SUPPLY AND INTER-REGIONAL SUPPLY