An Overview of the LNG Industry

The first 50 years of LNG history were about technology and capital. The next 50 years will be about the markets and their institutions.

Since the discovery of the North Field under the waters of the Persian Gulf in 1971, Qatar has emerged as the central player in the global business of liquefied natural gas (LNG). They have the third-largest world natural gas reserves, currently estimated at 900 trillion cubic feet (TCF). The LNG industry owns its existence to the early works in cryogenics developed by Michael Faraday in the 1820s, followed by Carl von Linde and his work on refrigeration in the 1870s. But it was not until 1939 that the first pilot plant to produce LNG was built, thanks to the perseverance of businessman and scientist Thomas Cabot. A few years later, the East Ohio Company built the first LNG storage facility, to meet the energy needs of factories in the U.S. during World War II. The first LNG shipment took place in 1957, when British Gas imported the first cargo from Louisiana, as they started reducing the burning of coal and replacing it with cleaner fuels i.e. natural gas, as a priority to combat crippling air pollution over London. The beginning of international trade occurred shortly after when Shell made the first shipment from Algeria to London in 1964. Further development in Europe stalled in the mid-1960s due to discoveries of cheaper and more accessible gas reserves in the Netherlands, the British North Sea, Norway, and Russia. However, the postwar economic boom in Asia boosted LNG developments in Taiwan, South Korea, and more importantly Japan, as they all became major importers. Since natural gas replaced not only coal but oil in power generation, the LNG price became indexed to oil prices. 

In the meantime, the natural gas industry in the U.S. developed in a different way. Natural gas had become an important energy resource but was largely localized, requiring large corridors of long-distance pipelines connecting the gas fields with the main population and industrial centers all across the country. When a shortage hit in the mid-1970s, companies scrambled to find new supplies and LNG looked like a good and timely answer; several contracts were written to import LNG from Algeria, and many re-gasifying terminals were built both in the East and West Coast. It turned out this shortage was the result of an inflexible market regulation which brought prices down to the point of curbing supply. The natural gas policy act of 1978 started to decontrol prices, but it also banned the use of natural gas for power generation since it was considered too valuable and had to be reserved for higher uses. As a result, supplies increased but prices remained low, creating such an oversupply that the LNG industry turned into a bust. The market changed again in the 1990s when the prohibition on using natural gas for power generation was lifted, the economy was booming, and electricity demand was growing. Drilling for new sources of gas increased but incremental volumes were insufficient. The market tightened as a result of rising demand and flat supply, and the answer once again seemed to be LNG, which was now less costly through cost reduction innovations and increased scale. By the end of the decade, LNG started flowing again to the U.S. from offshore reserves recently found in Trinidad.

Meanwhile, in Qatar, the merger of Exxon with Mobil in 1999 made great LNG expansions possible. A new political regime had started in 1995 and the new emir was determined to transform his country into a global energy giant through accelerating LNG development. Mobil initially developed the North Field through two Qatari companies, RasGas and Qatargas, years after Shell and BP abandoned their plans since there was no obvious market for gas in the 1970s and 1980s. New contracts signed with Japan and Korea changed this reality in the early 1990s, but new and heavy investment was required to fuel further expansion. ExxonMobil now had the size and the means to think very big, as scale was the only way to bring down costs. New projects were managed with great discipline making facilities as standard as possible. Korean shipyards tendered for much bigger LNG carriers and RasGas accepted the bids because higher volumes meant lower costs. With bigger facilities and transport carriers, Qatar arose as a potent competitor in the global gas market by 2002 as they now could deliver gas competitively anywhere in the world. They created a new business model by which buyers and sellers were willing to commit without complete reliance on long-term contracts.  They had become the world’s number one supplier of LNG by 2007, providing almost a third of the world’s consumption. Following Qatar’s trail is Australia as they have long been an LNG producer, thanks to investments from Shell and BP (plus others) after abandoning their plans for the North Field. Based on projects currently under commissioning and startup, Australia could soon surpass Qatar in LNG production. 

Lower production and transportation costs enabled by massively scaled-up LNG projects turned an inflexible and regionally based industry into a flexible international business, transforming natural gas in a global commodity, although not in the single global marketplace as had been anticipated, as a breakthrough in the natural gas industry in the U.S. changed the rules of the game once more. 

Shale gas, as in natural gas extracted from shale rock through innovative horizontal drilling and hydraulic fracturing, started to flow through pipelines in the U.S. in 2007. This technological revolution has disrupted the LNG industry and transformed the U.S. market. Perennial shortage has given way to substantial surplus, which turned the prospects for LNG in North America upside down. This new abundance combined with lower prices has impacted electric power generation, challenged the economics of nuclear power, and displaced coal. It has also had an impact on the debate on both climate change and energy security. As a result of the shale gas revolution, North America now has a natural gas base estimated at 3,400 TCF which could provide for current levels of consumption for over 100 years. This large-scale production phenomenon has changed the dynamics of the global gas business, since the United States was supposed to be a major guaranteed LNG market, instead of becoming a potential LNG exporter. Asia will absorb a significant amount but not all, so the immediate impact will be on Europe as the main contestable market. More freely available LNG sold on a spot basis will take some market share away from pipeline gas price-indexed to oil. This will create greater competition among gas suppliers, driving prices further down, but not without geopolitical impact between Europe, Russia, and Ukraine. 

Natural gas is definitely a fuel for the future. World consumption has tripled over the last 30 years and its share of the total energy market is also growing, fueled by a demand that could grow another 50% over the next two decades. The reasons are clear: It is the lowest carbon-resource and a flexible fuel that will play a larger role in electric power generation on its own and as a necessary complement to renewable power generation. And it is becoming more and more available thanks to technological advancements in drilling, transportation, and production. Rapid LNG growth was the focus a few years ago, with the associated belief that a true single world natural gas market was in the making, one in which supplies would move freely to one consumer or another, and in which prices would converge. The surprising arrival of shale gas has disproved that assumption for the time being. The rise of this new resource in North America is certainly having a worldwide impact, demonstrating that the gas market is indeed global, but not in the way that industry would have expected.

STRUCTURING AND LEGAL ISSUES

LNG projects are one of the most complex energy ventures because of their size in terms of scope and costs, the interdependency of the links in the value chain, and the multitude of players and issues involved. Some the elements that project participants must consider in designing a project structure are Governance, Profit Centre Mechanism, Marketing Agreements, and Expansion/Operations. One of the following three forms is generally utilized for structuring LNG exporting projects: The Project Company, the Tolling Company, and the Unincorporated Joint Venture. Each one has its own advantages and disadvantages, as well as their own key agreements. Projects located outside developed countries usually require the support of special legislation or a foundational contract with the government. Although there is a multitude of issues that arise in structuring an LNG project, the following are the most common: Project participation (buyers, sellers, traders, governments, others), Expansions, Marketing, Governmental and Regulatory Approvals, Taxes, Force Majeure, Maritime Risks, Community Relations, and Engagement, Pricing Disputes, Governmental Action, Construction Completion Risk, Financing, Decision-Making Protocols, Contractual Laws, and Preliminary Agreements, amongst others. Given the natural gas reserves present in the Middle East, Sharia’h Law is another issue that may affect LNG projects. However, it has been demonstrated that Islamic rules deliver similar outcomes to the conventional and globally accepted business methods and legal regimes. Hence, the relatively painless adaptation of Sharia’h compliant methods would provide for a lucrative and sustainable presence in this hydrocarbon-rich region.

SAFETY AND ENVIRONMENTAL CHALLENGES

Safety is a top priority of the U.S. LNG industry. LNG operators have been working closely with both regulators and first responders for decades to maximize safety and reliability. The safety record of the global LNG industry has been excellent due to attention to detail in engineering, construction, and operations. It is the physical and chemical properties of LNG that make it safer than other hydrocarbons, as it vaporizes into the air should a spill occur. LNG facilities are also designed and operated to the highest safety and environmental standards (double-walled containment and several siting, construction, and maintenance standards). LNG has been safely transported for over 50 years (77,000 commercial LNG cargoes have been delivered safely). This is a very impressive, impeccable, and unprecedented safety record for the carriage of liquid hydrocarbons in bulk by sea. LNG shipments have covered more than 100 million miles around the earth without major safety incidents either in port or at sea. The LNG industry has proven its commitment to fully comply with regulations and take extra care to prevent accidents. They work closely with a number of federal authorities to ensure safe operations (FERC, DHS, TSA, USCG). Environmental challenges arise from construction, transportation, and bunkering activities. They have been addressed through the adoption and implementation of risk assessments, technical review processes, international codes, emission safety standards, and emission-controlled areas, associated with multiple regulatory agencies all over the world. 

FLOATING LNG PROJECTS

Back in 2017, the top floating LNG projects in the world included three under construction (Prelude, Cameroon, and Rotan) and five under proposal (Coral, Fortuna, Tortue, Neneh Marine, and Delfin). Should they all go ahead, they will be adding over 20 MMTPA of LNG to the market by 2025. FLNG proponents are navigating multiple new risks and project management challenges as the industry still is in its very early stages. They are also under close watch to see whether the first projects are delivered on-time and on-budget and whether they perform well, without serious design or operational flaws. FLNG plants can emerge as part of a more diverse, faster, cheaper and more agile global industry, which will widen its reach once standardization and experience drive down costs, under one of two scenarios: a niche technology applied to solve specific problems with land-based configurations remaining the default, or a standard approach that eases the industry’s cost inflation problems and opens up a much wider range of fields and companies. FLNG projects are beneficial to companies because they (1) unlock smaller and remote fields, (2) avoid on-shore no-go zones, (3) have reduced environmental footprints, (4) deliver reductions in capital costs, (5) mitigate skilled-personnel supply shortages during simultaneous construction of numerous projects, (6) trust construction to established shipyards with breadth and depth of labor resources, logistics, and infrastructure, (7) achieve peace of mind from security worries by placing facilities offshore, (8) mitigate the political risk of onshore LNG plants, and finally, (9) they have access to other financing options that may not be available to conventional LNG projects. Successful FLNG projects begin with solid engineering design practices inclusive of hazard identification exercises; quantitative risk assessments; fire, explosion, and cryogenic spill risk assessments; ship collision studies; amongst many others. Success also depends on having credible partners, a well defined technical solution, and secured financing. Minimizing risk and uncertainty throughout project stages is key to securing the necessary financing. 

SMALL SCALE LNG PROJECTS

The ongoing LNG supply glut will give small-scale export projects a competitive edge through 2020. Small-scale facilities will likely proliferate in response to regions with smaller demands that have so far been overlooked by large facilities. Operating on smaller budgets, these projects will be able to obtain financing and regulatory permits quickly and with less uncertainty. Smaller-scale projects can get up to about 2 million tonnes a year and bring more gas supply and more potential markets into the frame for LNG development. These modular liquefaction units can be developed and configured up to scale with relative ease practically by bolting them together. This will allow LNG to increasingly compete with piped gas across the world as new pipeline flows materialize. There will be a near-term shift from a seller’s market to a competitive buyer’s market, as large volumes of U.S. exports could be shipped with minimal impact on prices due to a flat supply curve propelled by technologies like horizontal drilling and hydraulic fracturing. U.S. LNG exports could also lead to a break in the oil price indexation of gas supply, and that Asian and European spot LNG prices would converge as global exports increased.

There are clear opportunities for the development of small (i.e. less than 40,000 m3) LNG carriers and barges that would help with peaks in demand, expanding demand over time, supplying small islands, reducing the number of bug receiving terminals, creating flexibility of supply, rebalancing stocks in terminals, coping with changes in demand, and providing fuel for ships. Furthermore, most new small LNG carriers are built with significant differences from their large counterparts, which makes them more flexible and capable of carrying other petrochemicals. This will open new markets with new rules, dominated by new players in small scale LNG shipping. Freights in these new markets will never go as low as in the case of the big carriers because there will alternative cargoes for those ships.

FUTURE OF INTERNATIONAL LNG PROJECTS

The LNG market is globalizing, transforming, and becoming more varied presents all participants with challenges. Uncertainty over demand from traditionally dominant buyers requires competitiveness and eyes for new markets from LNG producers and traders. Buyers, conversely, should make the most of their current string position, while deploying new strategies. The winners along the value-chain will be those who can act counter-cyclically, who can create and maximize markets. Instead of reacting passively to them, who can identify the major long-term trends driving LNG demand, while also staying flexible to seize emerging opportunities.

The U.S. has started exports from the Gulf Coast since 2016, something unthinkable ten years prior. Australia will soon be an exporter on a scale to rival Qatar, while new importers are springing up from all over. LNG importers are becoming exporters and vice versa. In light of these new dynamics, there are six considerations for LNG sellers; they need to: (1) understand demand holistically, (2) segment markets by price-sensitivity and pricing basis, (3) create demand, (4) understand buyer’s business strategies, (5) maintain optionality and competitiveness, and (6) determine a strategy for mixed LNG and pipeline exports.

The LNG industry has experienced significant growth and development in the last 50 years. The future offers the possibility of a continuous increase in the volume and diversification of sources of supply. These developments will be the continuation of a process that has been in progress since the early days of the industry. In contrast with the steady process of growth of supply and demand, it is likely that LNG pricing, commercialization, and contracting practices will undergo a radical transformation. The industry is on the verge of a turning point that will probably soon see a rapid transition towards flexible price-fixing mechanisms based on the market and their interdependence with commercialization to ensure supply and demand and manage price risks. The first 50 years of LNG history were about technology and capital. The next 50 years will be about the markets and their institutions.

This piece was researched and written at the end of 2017 as a requirement for the course Global Business Environment during my Executive MBA program