James Glennie: NZ will be caught in bind when oil prices hit the fan

James Glennie

New Zealand is at an energy cross-roads: Our demand for a reliable supply of electricity is growing rapidly and building of generation capacity is not keeping up.

But that is only a part of the problem. Historically, around a third of New Zealand's total electricity needs have been met by gas and coal-fired power stations, however our known gas supplies are fast running out.

One of the solutions being put forward by those electricity generators with gas-fired plants is to begin importing liquefied natural gas (LNG). This option will certainly provide the fuel for generators, but at what cost?

This is a question - a major decision with significant financial and geopolitical implications - that appears not to have been asked, let alone answered.

Importing LNG would represent a major change in the way New Zealand generates its electricity.

For the first time, New Zealand would be dependent on international oil markets, to which LNG prices are inextricably linked, for the generation of our domestic electricity.

Little analysis has been made public as to what the true costs and risks associated with importing LNG are, but they have the potential to be significantly higher than the LNG proponents would have us believe.

In November 2004, the electricity generators Contact and Genesis released their findings from a joint study they had undertaken into the feasibility of LNG as an energy option for New Zealand.

The Contact statement said that the delivered cost to Auckland of LNG would be in the range of $6.50 to $7.50 per gigajoule. This equates to a cost of generating electricity, using LNG as a feedstock, of around 8 cents per kilowatt hour.

In February 2005, the New Zealand Institute of Economic Research (NZIER) undertook a study of LNG markets. This report sought to provide an independent contribution to the debate about the viability of LNG as an energy option for New Zealand.

The NZIER study broadly agreed with the Genesis-Contact statement and noted that delivered LNG costs would be about $7.80 per gigajoule for gas that was ready for distribution.

The NZIER report noted that LNG contract prices are tied to global crude oil prices and natural gas prices. Given the rapid increase in prices for both crude oil and natural gas over the past 18 months, it is surprising that the NZIER price sensitivity analysis contained only one LNG price scenario: US$3.50 ($5.16) per gigajoule.

Is this realistic? To answer that question requires an understanding of LNG prices: how they are set, what they have been historically and what they are likely to be in the future.

There are three main LNG markets (Europe and the Atlantic and the Pacific basins), and the LNG prices in each are indexed to either natural gas or crude oil prices.

Global LNG prices have typically been higher in the Pacific than in the Atlantic basin, averaging US$4 per million British Thermal Units (MMBtu) in the former and US$3 per MMBtu in the latter over the period 1992-2002. These prices tend to support the NZIER figure of US$3.69 per MMBtu.

However, much has happened, since 2002, which has fundamentally affected LNG prices.

So what is the cost of LNG today? Unfortunately there is no easy answer to this question. The bulk of all LNG is traded on a bilateral basis, and there is only a limited (albeit growing) spot LNG market. What this means from a practical point of view is that there is not a lot of public information about present LNG prices.

Nonetheless there is some evidence of the prices at which current contracts are being concluded: The evidence indicates that that price is almost double historic levels of US$3.50 per MMBtu.

There are two main reasons for this sharp increase in LNG prices.

The first is because of significant increases in the prices of LNG competitor products (natural gas and crude oil) since 2002.

In fact, the price of a barrel of crude oil has risen from US$35 in June 2004 to US$63 on January 3 this year, an increase of 80 per cent. In that same 18-month period the price of US Henry Hub natural gas has risen from around US$6.50 per MMBtu to US$10.62 per MMBtu on January 3, an increase of 63 per cent.

The second reason relates to sharply increased demand for LNG from markets in Europe, the United States and Asia (particularly China and India).

New LNG supplies will be coming online in 2006, 2007 and beyond, but the general view is that demand pressure will win out and that under any scenario prices will rise and the sellers market will become even more consolidated. This view has been exacerbated this month with Russia's decision to cut natural gas supplies to Western Europe.

This is further increasing demand for LNG by causing major natural gas users, such as Germany, to give even more consideration to the LNG option.

So what are future prices for LNG liable to be?

Most industry commentators would agree that the current natural gas spot price, as high as US$13 per MMBtu in recent months, is a price spike and is therefore unlikely to be sustained in the longer term. However, there is a wide range of evidence that LNG contracts are currently being concluded at around US$6 per MMBtu.

This sort of price level translates to a cost of electricity - generated by a gas-fired power station fed with natural gas from an LNG re-gasification terminal and using a long-term average NZ/US exchange rate of 0.60 - of more than 10 cents per kilowatt hour.

If a moderate carbon charge is added to this, the cost of LNG fired generation rises to more than 11 cents per kilowatt hour. This is clearly significantly higher than the 8 cents per kilowatt hour that LNG's proponents have been talking about thus far and is also arrived at using moderate forecasts for future LNG price paths and NZ/US exchange rates.

Wind turbines in New Zealand, by comparison, can generate electricity at an all up cost of around 6-9 cents per kilowatt hour.

Although LNG may provide some security of supply, it does so at significant cost to the nation and to electricity consumers. The decision to lock New Zealand into long-term dependence on expensive imported gas is a major decision for the country.

As the Government comes under increasing pressure to deliver a secure supply of electricity, it is important that any calls for Government underwriting or other financial support for LNG are weighed against the other, much less positive economic and environmental impacts of the LNG option.

New Zealand's future electricity generation mix should consist of a balanced mix of generation assets. It may well be that LNG will be a significant part of that mix.

But before New Zealand commits to the LNG option it is important that major energy users and all New Zealand taxpayers are aware of the financial implications of increasing the nation's dependence on high-priced hydrocarbons.

Strategically developing our renewable generation options instead of importing foreign gas represents a much better deal for New Zealand electricity consumers.

Optimising the use of our world-class wind energy resource and other indigenous renewable energy supplies will lead to an improved balance of payments situation, more affordable and secure electricity, increased security of supply, and a better deal for the environment for this and future generations.

CHANGING NEEDS
* Cheap gas from the giant Maui gas field is running out, meaning more expensive gas from other sources will be needed.

* Newer, smaller fields can help fill the gap, but importing liquefied natural gas (LNG), which can fire existing power stations, looks more likely.

* In November 2004, power giants Contact and Genesis said shipping LNG to New Zealand "is a feasible and practical alternative".