Plunging oil price could see gas prices plummet and renewables hurt

The recent huge spike in Australian gas prices has been driven by LNG contracts - contracts that tie its price to that of oil. The plunge in the oil price could mean cheap gas again with flow-on implications for the competitiveness of wind and solar power.

It’s quite astounding to go past petrol stations and see the price below a dollar per litre. It’s something I never thought I’d see again.

Since September the oil price has fallen off a cliff. The price of a barrel of Brent crude has been cut in half from above $100 to now sitting below $50.

What people don’t seem to have touched upon, however, is that if the oil price remains at these low levels it could flow thorough to abruptly curb and reduce the spiking price of gas in eastern Australia. If this drop in the oil price followed what occurred in the 1980s where oil prices slumped for years, it could even alter dynamics in the electricity market, undermining the long-term competitiveness of renewable energy and reviving prospects for gas.

In the last few years there has been report after report released expressing alarm about how the development of LNG export facilities will drive a sharp spike in the price of gas in this country as gas producers can now sell their output to high-paying Asian customers. Indeed, just yesterday Melbourne University’s Energy Institute released a study outlining that gas demand in NSW could halve within 10 years in response to expected major price rises.

However, one needs to recognise that these Asian customers have signed up to contracts which price this gas as a function of the oil price. With oil at more than $100 per barrel this has meant a very large step-up in the gas price.

But it now should logically mean gas price decreases, and very big ones.

While the precise details of the gas contracts between LNG developers and big Asian customers are confidential, it is understood that they operate on a formula that links the price of gas to the price of what is known as the Japanese Crude Cocktail – a mixture of crude oils which are linked to the price of Brent crude.

A range of analysts have suggested that recent LNG contracts have been signed at levels where the gas price per MMBTU is set at between 0.12 and 0.155 of the price of a barrel of oil (an MMBTU is an old imperial unit of energy which is 1.055 of a gigajoule).

The chart below illustrates how the price of LNG would vary with the price of a barrel of oil at a linkage of 0.14 in the blue line. Now, Australian customers wouldn’t need to pay as high a price – that’s because gas supplied to a domestic customer avoids the costs involved in liquefaction of the gas, and possibly also additional pipeline transportation to get it to Gladstone in the north of the country, which is distant from many gas fields. The red line at the bottom is a very rough approximation of how this LNG price might translate into a price in eastern Australian capital cities taking into account those avoided costs.

Figure 1: Price of gas assuming linkage to price of barrel of oil of 0.14

Note: assumes $A1 = US80 cents

Source: Climate Spectator analysis based on information from Jacobs SKM (2014) New Contract Gas Price Projections for IPART; and Intelligent Energy Systems (2013) Study on the Australian Domestic Gas Market

If this oil price linkage extended all the way down to current oil prices of about $50 per barrel, then you end up with wholesale gas prices of $3.25 per gigajoule. This completely unwinds all the price rises that occurred since the LNG facilities were proposed. It would make Australian gas some of the cheapest in the world, at least 25% below the US Henry Hub price that prevailed over 2014.

Recent Australian gas price contracts are reported to have been struck at around $7 to $9 per gigajoule by comparison.

Unfortunately, we probably won’t see such a miraculous drop. According to a range of energy market analyst assessments, illustrated in the chart below, $3.25 per gigajoule would be below the marginal cost of production.

Figure 2: Different assessments of the supply cost curve for eastern Australia gas ($ per gigajoule)

Source: Jacobs SKM (2014) New Contract Gas Price Projections for IPART

In addition, LNG contracts traditionally have caps and floors on how far the gas price might move up or down in lockstep with the oil price. For example, the gas price might cap out at a level of $140 per barrel of oil and have a floor at $50 per barrel. Alternatively the rate of gas price increase or decrease will reduce relative to the price of oil at such levels.

Yet even at, say, $4 or $5 per gigajoule Australian gas becomes relatively cheap again.

It is now widely expected that the use of gas in power generation in the east Australian power market will plummet. The price rises gas had experienced meant that a much anticipated transition from coal to gas to reduce Australia’s carbon emissions was dead in the water. Wind power and even large-scale solar a few years into the future have been estimated to be cheaper options than gas-fired power.

But the dive in the oil price could change this if it were sustained for a long period. The chart below takes the gas to oil price linkage a step further, showing how it would translate into a cost per megawatt-hour of electricity generated by a combined-cycle gas turbine. At an oil price of $100 gas-fired power comes in at $115MWh – wind power is cheaper. But at $60 per barrel, the gas price is closer to $5 per gigajoule and power can be produced below $65MWh, notably cheaper than wind and not much worse than a new coal plant.

Figure 3: Cost of power from a gas combined cycle power plant assuming linkage of gas to oil price

Source: Climate Spectator analysis based on data from ACIL Tasman

Of course, the pivotal question in all this is whether the oil price will really stay at such low levels.

We are already seeing a number of oil producers curtailing activity and planned production expansions. A range of US shale producers were already quite marginal even before the plummet in the oil price.

If there is one certainty in energy, it is that just when you start to think things are headed in one direction they then suddenly change direction.