Current tightness in U.S. natural gas supply-demand fundamentals has generated a tremendous interest among developers, marketers/traders and the financial community to develop, contract for, and finance storage projects in the U.S. – particularly high deliverability salt dome storage in the U.S. Gulf Coast (USGC).
An unprecedented number of underground natural gas storage projects in the USGC are advancing through various stages of development, with more than 140 Bcf of working gas capacity under construction and at least another 400 Bcf in earlier stages of development. This flurry of development activity represents a possible 60% increase in USGC gas storage capacity from current levels (Figure 1).
Figure 1: Existing and Proposed Gulf Coast Storage Capacity.
However, amid the market optimism and development enthusiasm there is a growing concern. The root cause of storage development (i.e. record levels of gas price volatility), may be dampened if and when all the proposed projects come into service, making return on investment targets hard to achieve. Investors are therefore asking whether there is a storage bubble waiting to burst. Should entities build and assume the risks that are associated with being a developer/owner/operator? What will be the extent of capacity-on-capacity competition and its impact on lease rates? Further, what factors would constrain development to a level which supports at least the minimum threshold returns on investments?
Despite an unprecedented level of storage development activity in the Gulf Coast, several market factors will likely prevent the sector from falling into an overbuild situation similar to what happened in the merchant power sector earlier this decade. Significant geological barriers for entry, expectations of high seasonal price spreads, continuation of elevated and volatile commodity prices that are supported by long-term fundamentals, and significant increases in construction costs point toward a tight storage market for the next eight to ten years.
Natural gas storage value has traditionally been driven by the need to balance flat production rates with volatile, weather-sensitive, demand. This balancing need has increased in recent years as rising commodity prices and overseas competition have caused a sharp decline in U.S. industrial demand. Declines in non-weather sensitive industrial consumption have resulted in a significant increase in the weather-sensitivity of overall demand and contributed to greater levels of volatility. This trend is expected to continue as growth in the demand for natural gas in the residential, commercial and power sectors outpaces that of the industrial sector, particularly in the Southeast U.S.
While demand volatility has increased, the ability of domestic production to respond to shifts in consumption has been limited. Recent increases in productive capacity have not alleviated this tightness as the market has absorbed all incremental supplies. While new unconventional resources such as the Haynesville and Marcellus shale are expected to add to domestic supply, these developments will also likely be characterized by both greater production costs and steeper decline rates. Natural gas supply is consequently expected to be highly responsive to price shifts, thus reducing the probability of a supply glut and fostering high volatility as North American markets remain on a “treadmill” of tight supply and demand.
Additional developments in the power sector, such as Renewable Portfolio Standards (RPS) and other clean energy mandates, further strengthen expectations for continued volatility. Tighter environmental requirements and uncertainty regarding future carbon legislation has made it increasingly difficult to build and maintain coal plants, no matter how clean the technology, narrowing generation options in the near term to renewable and natural gas technologies.
Although natural gas will be competing with some renewable generation technologies, the two groups of generation technologies are also complementary in many ways. Many renewable generation technologies, such as wind, provide an intermittent source of energy and require a consistently reliable energy source for back up. The ability to rapidly dispatch natural gas technologies (usually a natural gas-fired combustion turbine) make them best suited to provide that reliability. States where wind is the primary technology choice for compliance with RPS (e.g. Texas) are expected to experience more unpredictable and volatile gas demand which is expected to provide price signals for incremental storage capacity to maintain balance on the pipeline network.
Finally, the scale and profile of USGC LNG imports are positioned to drive significant growth in regional natural gas storage demand as “summer-loaded” LNG supplies comprise a growing share of U.S. natural gas supply. The economics of LNG liquefaction projects require that they operate continuously throughout the year while virtually all of the global demand for LNG is in the northern hemisphere and is characterized by a winter peak. A large number of LNG supply projects are positioned to expand the LNG market in the Atlantic Basin and globally.
All of this off-peak LNG production has to go somewhere. The relatively limited storage capacity in the UK and northwestern Europe, and dearth of suitable geological formations in non-populated areas that can support storage development in the future, limit Europe’s ability to accommodate off-peak gas supply. While European and Asian consumers will pay high “must have” prices for LNG during winter months, summer LNG cargoes will need to seek alternative markets with storage capability.
These dynamics mean that the pace of expansion within the global LNG market and related competing factors will have direct implications for the USGC storage market. Construction delays in upstream LNG projects and development of new domestic resources could very likely curtail LNG import volumes over the next few years. However, growth in global LNG capacity and domestic demand, as well as continued production declines in some major North American basins, is still expected to strengthen demand for imported LNG over the long-term.
Indeed, given the long lead times of greenfield storage developments (particularly salt-caverns), the commencement of operation of many proposed projects may dove-tail with a spike in LNG imports in the 2012-2014 timeframe when significant levels of liquefaction capacity are expected to come online.
While all of these market developments are expected to drive demand for significant levels of incremental storage infrastructure, the market will certainly not support a limitless level of capacity. The recent state of the capital markets, therefore, is seen as a blessing in disguise for the industry as it keeps the pace of development in check. Despite the fact there is a lot of money chasing this sector, there is anecdotal evidence to suggest that the recent credit crunch is “separating the wheat from the chaff.” Only the most commercially viable development projects that can demonstrate long-term customer commitments without offering significant “anchor tenant” discounts will attract available capital.
USGC Gas Storage Investment Risk
Given the uncertainty of the market factors which drive the need for gas storage investments in USGC, three market scenarios with different levels of storage capacity development (i.e. storage capacity supply) and demand for storage capacity are representative of the range of third-party contract rates and asset valuations which may emerge over the next eight years (2008-2016). Given the higher level of uncertainty regarding the evolution of global LNG markets, USGC LNG imports is the principal demand-side variable across the three scenarios.
A ‘Base Value Case’ scenario, in which storage development remains well-matched with growing capacity demand, as shown in Figure 2, is expected to preserve current lease rates of $0.18-0.22/MMBtu/month for eight-turn service in the USGC as market volatility remains at current levels. The Base Value Case is characterized by growing seasonality of natural gas demand and an increase of average annual USGC LNG imports to 6.5 Bcf/d by 2015.
On the development side, the Base Value Case reflects a level of capacity equal to the initial phases of announced projects (and not subsequent expansions) that will be constructed in the region. It also excludes projections for incremental capacity associated with future projects not yet in the development cycle. As the seasonal supply gap grows, these market conditions are projected to support an additional 500 Bcf of working storage capacity in the region, fostering a low-to-medium investment risk environment.
Figure 2: Impact on Average Storage Lease Rates.
Should growth in LNG imports and seasonality of demand exceed expectations, demand for storage capacity would also be expected to rise above estimates in the Base Value Case. In addition, continued tightness within credit markets or growth of other development obstacles, such as pipeline capacity constraints or increased material costs, could curtail storage development rates. Such a scenario of high storage demand and constrained development (High Value Case) could push lease rates above those in the Base Value Case as market volatility rises above current levels (Figure 3).
The possibility for a slowing of development should not be discounted. If project sponsors are unable to contract capacity at levels fundamentally attractive to partners and lenders after considering recent development cost increases, a number of proposed storage projects could be abandoned or shelved. While there may be greater execution risk for project sponsors in the earlier stages of development under such a scenario, the market risk for completed projects is low in the High Value Case.
Figure 3: Storage Capacity Balance: High Value Case.
Alternatively, should a high number of developers be successful in bringing their projects to completion, and projected storage demand fails to materialize, a drop-off in rates would be expected. A rapid collapse in rates is unlikely, however. Even under a Low Value Case in which average annual USGC LNG imports reach only 3.0 Bcf/d by 2015, incremental storage demand in the region is expected to exceed 350 Bcf as shown in Figure 4.
Figure 4: Storage Capacity Balance: Low Case.
The Low Value Case would also likely be characterized by high base-load production volumes emerging from new resources such as the Haynesville Shale that would tend to widen the seasonal spreads while suppressing market volatility. The investment risk for storage development is high under the Low Value Case, but a healthy market for lower-cycling depleted reservoir capacity may thrive under these conditions.
The estimates of storage capacity demand on which these scenarios are based are somewhat conservative because they only reflect total seasonal requirements. The estimates do not reflect the demand for services associated with expected increases in daily volatility of supply, as well as the demand implications of increased gas-fired generation, RPS policies, or other potential drivers of market volatility.
Estimated Impact On Contract Rates
Contract capacity rates can vary widely based on the service level, term and the location of the project, as well as other factors such as the developer’s need for anchor tenants to obtain financing. As a result of the significant increase in price volatility since 2003 (driven by the market’s perception of supply-demand tightness), average salt cavern storage rates in the USGC have exhibited a rising trend. (Figure 5). Data on storage rates indicate that USGC high-deliverability storage field capacity (reservoir and salt) has a wide range of values with contract rates ranging from $0.10/MMBtu/month (two to three turns/year) to $0.32/MMBtu/month (10 to 12 turns/year) with an average rate of approximately $0.21/MMBtu/month adjusted for a contract term of five years. It is typical for storage capacity holders to pay, through contract rates, the full intrinsic value of storage capacity in addition to 30-50% of estimated total extrinsic value, depending on the location and other market variables.
Figure 5: Impact on Average Storage Lease Rates.
As shown in Figure 5 under the Base Value Case, storage rates are expected to stay within reasonable proximity of current levels with a small potential for an over-build given the high natural barriers to entry, significant increases in the development costs and the optimism built into publicly announced development schedules. Rates under the Low Value Case are expected to be significantly lower than the Base Case as abundant storage capacity dampens price volatility. Lastly, a lack of ample storage capacity, increased LNG imports, and reduced domestic supply is expected to enhance volatility in the High Case and, in turn, support average lease rates well above current levels.
Quantifying the need for storage will always be a difficult proposition. Long-term adequacy of storage capacity is highly dependent on the level of price volatility customers consider “acceptable,” their tolerance for price risk, and how that risk is valued. However, volatile demand and growth in the transatlantic LNG trade, in addition to other factors, is well-positioned to drive demand for incremental storage development beyond what is supported by traditional North American supply/demand fundamentals.
At the same time, geology, economics and regulatory hurdles may likely hamper much of the development proposed for the USGC. Combined, these factors are likely to drive the formation of a well-balanced storage market which supports long-term merchant value and attractive returns for investors.
The co-author of this article, Brian Rice, is a manager in the Energy Markets, Assets & Regulatory Strategies practice of Pace. He holds a B.S. degree in industrial economics from Union College. For more information on this subject, contact the author, Amol Wayangankar, at 703-801-8068.
Amol Wayangankar is an executive director at Pace Global Energy Services (Pace) and leads its Natural Gas & Oil Practice. For the past seven years, he has focused on natural gas and oil markets, asset valuations and financing of energy infrastructure projects. His expertise is in natural gas markets (including LNG) and natural gas storage. Mr. Wayangankar has performed numerous fuel-related due diligence reviews of independent power generation facilities, LNG projects, natural gas storage and pipeline infrastructure projects for major lending institutions related to financing greenfield development or acquisition. Mr. Wayangankar holds a bachelor’s degree in industrial engineering from Birla College of Engineering (India) and a dual M.S. degree in operations research and industrial engineering from Penn State.