NBP: Weak Demand To Keep Prices In Check Over 2014/2015

BMI View : Despite 2014 opening with a steep fall in the price of NBP owing to a milder-than-expected winter, we note that this is a price correction indicating the real level of gas demand in the UK and Europe once the effect of weather-related needs (exacerbated by limited gas storage capacity) has been stripped away. However, we expect prices to eventually stabilise and be supported by some slight increase in demand alongside economic recovery, and more importantly, the continued fall in domestic gas supplies that will increase the UK's reliance on more expensive gas imports. Continued weakness in gas demand from the power sector will keep any run-off in gas prices in check, notwithstanding any drastic changes in weather patterns. However, we highlight that the sector could see some increase in gas consumption as older coal-fired power plants reach the end of their production cycles in 2015 as stipulated by EU regulations. This would put some upward pressure on the NBP particularly in the second half of 2015.

Having been the first liberalised gas market in the region, sizable domestic gas production, access to both pipeline and LNG imports as well to markets in Europe, the National Balancing Point (NBP) has become one of the more favoured references for gas prices in Europe. While still not as transparent as the US' Henry Hub contract that is traded on the NYMEX, the relative liquidity of the exchange vis-a-vis others in the region and the rise in trade volumes for NBP makes it a good reflection of the supply/demand dynamics in Europe.

2000-2009: Rise And Crash

Higher Import Requirement Contributes To Price Climb
Average Price Of Front-Month NBP (LHS, GBp/therm) & UK Net Gas Imports (RHS, bcm)
Short-Term NBP Price Forecast
2010 2011 2012 2013 2014f 2015f
NBP (GBp/therm) 42.31 59.41 59.89 66.99 59.43 60.02
f=forecast. Source: Bloomberg, BMI

BMI View : Despite 2014 opening with a steep fall in the price of NBP owing to a milder-than-expected winter, we note that this is a price correction indicating the real level of gas demand in the UK and Europe once the effect of weather-related needs (exacerbated by limited gas storage capacity) has been stripped away. However, we expect prices to eventually stabilise and be supported by some slight increase in demand alongside economic recovery, and more importantly, the continued fall in domestic gas supplies that will increase the UK's reliance on more expensive gas imports. Continued weakness in gas demand from the power sector will keep any run-off in gas prices in check, notwithstanding any drastic changes in weather patterns. However, we highlight that the sector could see some increase in gas consumption as older coal-fired power plants reach the end of their production cycles in 2015 as stipulated by EU regulations. This would put some upward pressure on the NBP particularly in the second half of 2015.

Having been the first liberalised gas market in the region, sizable domestic gas production, access to both pipeline and LNG imports as well to markets in Europe, the National Balancing Point (NBP) has become one of the more favoured references for gas prices in Europe. While still not as transparent as the US' Henry Hub contract that is traded on the NYMEX, the relative liquidity of the exchange vis-a-vis others in the region and the rise in trade volumes for NBP makes it a good reflection of the supply/demand dynamics in Europe.

2000-2009: Rise And Crash

Gas prices climbed sharply between 2000 and 2008 as a result of overly bullish expectations about the future of gas. This was driven in part by European Union policies, and also by a seemingly upward trajectory in gas demand although cracks of a looming financial crisis were already showing:

  1. 2005: Launch of the European Union Emissions Trading Scheme (ETS), raising costs of carbon emissions;

  2. 2007: The European Council approved of binding carbon emission reduction targets, most notably a cut of at least 20% in carbon emissions from 1990 levels from all primary sources by 2020.

Within the UK in particular, the change of its status as a net exporter to a net importer also led to a sharp spike in NBP prices in 2005. This was accompanied by bullish expectations of the country's gas consumption outlook in light of its carbon emission targets.

Higher Import Requirement Contributes To Price Climb
Average Price Of Front-Month NBP (LHS, GBp/therm) & UK Net Gas Imports (RHS, bcm)

Unsurprisingly, front-month NBP prices on the ICE took a tumble after reaching a peak of nearly GBp90/therm in Q308 alongside the onset of the 2008 global ginancial crisis. By Q309, the price had fallen to nearly a fifth of its peak value, which can be attributed to the combination of the following factors:

  • Fall in demand: The financial crisis dampened UK gas demand as it fell 7.24% year-on-year (y-o-y) in 2009. A 4.74% y-o-y drop in demand across the whole of Europe also meant that the continent did not take up the slack from weaker UK consumption.

Financial Crisis Hits Demand All Around
% Year-on-Year Change In Gas Consumption
  • Oversupply in the market: With long-term buyers taking less gas within the permissible limits of their take-or-pay agreements, gas producers started directing some of these supplies to the spot market instead. In addition, wholesale buyers inundated with gas in a weak demand climate - particularly demand from utilities - also sought to re-sell some of these supplies in the spot market.

2009 also saw the opening of several LNG import terminals in the UK - most notably the South Hook terminal by Milford Haven. The beginning of the shale gas revolution in the US, coupled with its economic downturn, had weakened US demand for LNG, with US-bound supplies directed to other gas markets in the world, Including Europe.

Weak Demand Sees Price Crash
Front-Month NBP, 2007-2009 (GBp/therm)

2010-2013: Price Rebound

However, as seen in the price chart above, NBP did not take long to rebound despite weak economic recovery in the UK and the wider European market. The fall in domestic gas production continued to drive up prices at the NBP as the country increasingly sourced for more expensive import alternatives. Periodic supply disruptions from Norway have also cut spot availability, as deliveries to long-term contract buyers are prioritised over UK demand, leading to occasional spikes in prices.

High Oil Prices Fuel Turn To Gas Markets
Front-Month NBP (LHS, GBp/therm) & Brent (RHS, US$/bbl)

High oil prices also contributed to greater trading activity in the gas markets, particularly as large wholesale buyers reduce gas taken from their long-term take-or-pay contracts indexed to oil prices to buy gas in the cheaper spot markets. Greater demand for gas in the spot market in turn supported an upward climb in prices.

Trading Activity Increases

The ripple effects of the Fukushima nuclear crisis in Japan in March 2011 were also felt in Europe. Japan's sudden spike in gas demand saw LNG cargoes diverted from Europe to the higher premium Asian market, tightening supplies in the European markets. This eased some of the loosening in the global LNG market that the decline in US import demand had brought about.

Fukushima Fallout Also Prompts NBP Rise
Japan & UK Average Monthly LNG Import Price (US$/mnBTU)

Price Hike Defies Consumption Trends

However, the rise in prices especially in 2011 and 2012 stands in contrast to consumption trends in the UK. Demand fell 18.3% between 2010 and 2012, much of which was led by the power sector as its consumption of gas dropped 40.2% over the same period.

Gas Demand In Power Sector Slumps
UK Gas Demand By End-User, 2010-2012 (mcm)

In fact, this fall in consumption had been greater than the fall in domestic gas production, resulting in the UK's net import requirement to fall between 2010 and 2012.

Fall In Domestic Supply Hits Prices
UK Gas Production, Consumption & Net Import, 2000-2012 (bcm)

Neither did continental demand for UK gas exports grow. In 2012, the UK's gross exports to Belgium fell sharply, which broadly corresponds to the fall in gas consumption across the whole of Western Europe starting from 2011.

European Demand Fall Sees Continental Demand For UK Gas Weaken
Western Europe Gas Production, Consumption & Net Import Requirement (Top, bcm) & UK Exports To Western Europe By Country (Bottom, GWh)

Indeed, it appears that weather-related demand (represented by the increase in gas use at the household level) has been responsible for driving up NBP, as it exacerbated gas shortages in the system particularly when peak demand met unexpected outages in the UK and the Norwegian North Sea area. For example, the outage of the Elgin-Franklin group of fields in the UK took a significant portion of local gas out of the system in 2012, as it struggled to meet demands from the early and long winter that persisted through to April 2013. We note that weather-related demand and the extent to which it makes up for the decreasing use of gas in the power sector in light of the UK's falling gas production will be a key determinant of the price of the NBP in the short-term.

Cold Weather Seeks Household Gas Demand Up
End-User Share Of Total Gas Consumption In The UK, 2011 vs. 2012

Short-Term NBP Forecast: Weather, Recovery To Support Prices

In the first nine months of 2013, UK's gas consumption rose 2.6% over the same period in 2012 but nearly all of this gain was made at the household consumption level. According to data from the Department of Energy and Climate Change (DECC), household gas consumption increased by 10.3% during this period. Most of these gains were made in Q113 as an unexpectedly long and cold winter pushed up household heating demand for natural gas.

Weather Supports Household Demand
UK Gas Demand For Period Jan-Sep, 2011-2013 (bcm)

Meanwhile, the power sector's consumption on gas continues to trend downwards, in line with the weak margins it is earning from gas-fired power generation vis-a-vis coal. Indeed, the UK power sector had increased coal power generation over gas to capitalise on the larger margins available from burning coal.

Unpromising Spreads See Utilities Dump Gas
UK Front-Month Winter Baseload Spark vs. Dark Spread (GBP/GWh)

However, there are indications that demand could recover slightly to put some upward pressure on prices:

  • The slower rate of decline in gas consumption from the power sector in the first nine months of 2013 suggests that the sector has likely hit the maximum capacity at which it can switch from gas to coal;

  • A slight closing of the difference between the dark spread (measuring the profit margins to a utility from coal generation) and the spark spread (measuring the profit margins to a utility from gas generation) could see the return of some - even if slight - gas-fired generation;

  • Economic recovery in the UK would also prompt a pick-up in gas and power demand from the industrial sector.

This is even as domestic gas production continues to trend downwards in the UK, as new developments prove too small to replace the decline in output from major fields in the UK North Sea. From a fundamental perspective, these forces are likely to support gas prices in the UK.

However, we highlight that the rise in NBP will be capped by the following:

Dark vs. spark spreads

If NBP were to rise too quickly, it could prompt a widening of the dark/spark spread and see utilities again cut back on gas consumption. This is particularly in light of rising public attention on the cost of utilities in the UK, restricting the extent to which firms can raise electricity and gas prices. A victory by the Labour Party in the upcoming election (expected before May 2015) could also see the Party freeze energy prices. Although the incumbent Conservative and Liberal Democrat coalition government has not given hints that it would follow suit, electoral success would also likely be closely linked to their policy on the politically-sensitive issue of energy prices.

Therefore, there is significant political pressure on utilities to reduce the cost of power generation wherever possible to maximise their profits. In light of the lack of policy clarity regarding the UK's energy policy - which is unlikely to be made clear before the elections - and time left before the European Union's Large Combustion Plant Directive (LCPD) kicks in by end-2015, utilities retain the leeway to rely on cheaper coal substitutes where possible.

Although dark spreads are coming down, they remain significantly higher than spark spreads. The spread for front-month summer baseload in particular still favours coal significantly over gas. Unless the price of coal dramatically increases - which our Commodities team does not currently expect - or NBP further sink, we see little likelihood for a dramatic closing of the dark-spark spread that is necessary to see a dramatic return to gas consumption from the power sector.

Negative Margins Will Continue To Constrain Power Usage
Front-Month Summer Baseload Dark & Spark Spreads (GBP/GWh)

As such, we expect NBP to trade mainly sideways though leaning to the downside in 2014. This reflects the pressure that falling domestic output is putting on prices, even as a cautious power sector keeps its gas consumption in check.

Weather As The Biggest Swing Factor For Prices

As highlighted above, gas prices had been kept high by household demand arising from weather-related needs. Given that the power sector's appetite for gas would only make a slight recovery at best, weather would thus be the largest swing factor in determining NBP prices in the coming years, unless there is a dramatic surge in domestic supply. However, we do not anticipate a rise in supply in our short term forecast.

The household sector's burgeoning share of the UK's gas consumption in 2012 and 2013 is a result of abnormally cold and long winters that raised heating demand for gas. More importantly, the spike in short-term prices is also a function of the UK's limited gas storage capacity, which makes the country more dependent on the immediate availability of gas supplies to meet unexpected demand hikes. For example, the spike in NBP to more than GBp75/therm in March 2013 was both a result of an extended winter and a cut in supplies from Norway owing to a power failure at the large Ormen Lange gas field.

Weather Commanding Prices
Front-Month NBP, Jan 2013-Jan 2014 (GBp/therm)

Likewise, an unexpectedly mild winter is also responsible for the downward movement of NBP since December 2013, which has seen NBP broke through long-term support line and prompted prices to fall to an 18-month low. This downward movement is a correction reflecting real demand in the UK market after weather effects on market demand has been stripped away.

We expect this downward correction to persist through 2014, but only slightly as domestic supplies continue to dwindle. In 2015, expectations that economic growth, a decrease in domestic production and slightly greater return of gas-fired power plants to the market support our view for a slight increase in the price of NBP. On the whole, assuming no weather and oil price shocks, we expect NBP to trade sideways as falling supplies exert pressure on NBP in face of still-weak demand, which we expect to only grow marginally in 2014 and 2015.

UK Gas Consumption
UK Gas Consumption (LHS, bcm) & % Y-o-Y Change (RHS)

Risks To Outlook

While utilities' cost concerns would see them cut gas consumption and correct any excessive rise in NBP, we cannot rule out the high upside risk that weather poses to our forecasts as it will lead to unavoidable but unpredictable spikes in NBP. This is particularly in view of the UK's growing dependency on imports to meet its energy needs in face of falling domestic production and increasingly inadequate gas storage capacity. At the same time, we also note that warmer weather will see the weakening in prices as we highlight that household consumption of gas is the biggest swing factor in determining gas prices.

In the short-term, the government's decision not to subsidise new gas storage facilities in the country will keep prices vulnerable to sudden unexpected changes in gas availability and demand. BP is the latest company to abandon investment in a gas storage project, having announced on January 28 that it would not exercise the option for a majority share in a firm that would develop the Islandmagee gas facility, which reportedly can hold enough gas to meet Northern Ireland's gas needs for 60 days. This follows a decision by Centrica to drop plants for two gas storage facilities in East Yorkshire and in the North Sea in September 2013.

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Sector: Oil & Gas, Commodities, Power
Geography: Global
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