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Jumpin’ Jack Flash? It’s ‘bout gas, gas, gas!

By Geoff Carmody - posted Friday, 12 May 2017


Australia has lots of gas. Some is already being extracted, used here and, increasingly, exported. We have more that could be used, if permitted. There's talk we might even become the world's largest gas exporter.

Really? Then why all the hand-wringing about an east coast gas supply shortage?

What's the problem?

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The east coast gas market is behaving strangely:

  • The local gas price is soaring (now up to, and beyond, $20 per gigajoule). Yet we are exporting increasing amounts of local gas for only about $10 per gigajoule. On a 'netback' basis (ie, excluding shipping and processing costs for exports), this translates to a domestic price of around $8-$9 per gigajoule, or 40%-45% of the domestic price.
  • Some worry gas supplies in Australia will be diverted to exports so much that they may not be available here at any price (or, at least, at a price consistent with ongoing business viability).

Where's market arbitrage? If local gas prices are high, and export prices are low, why isn't gas supply – both Australian and imported – shifting from overseas demand to meet local demand?

What's forcing exports up despite better local returns (increasing local prices in the process)? What's stopping more imports seeking those same better local returns (and increasing local prices in the process)?

Gas is a major household and business energy input. Quite recently, Australians were encouraged to switch to gas from coal-fired electricity. It was cheaper, with lower greenhouse gas emissions. We did.

Now local gas supply is becoming very expensive or even (some assert) unavailable.

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Alternative currently-available base-load energy sources are also less available.

Existing coal power generation is being shut down. New coal investments are limited, shunned by some banks, and under a policy 'sovereign risk' cloud. It's low-cost base-load power, but with low investor interest.

Some, including official sources, express concern about business closures, greatly increased household budget pressures, and a broader chilling effect on Australian economic activity.

This could be a big deal.

We've long traded on our rich endowments and comparative advantage in energy.

Is our gas situation unusual?

Very. Consider some examples.

The way market arbitrage should work: real examples

Some countries (including some OPEC members and developing countries) subsidise local energy input costs to support (protect) local business and consumers. In such cases, export prices exceed after-subsidy local prices, sometimes substantially. But export and pre-subsidy local prices converge because of arbitrage: it's the subsidy that drives the lower local price (and costs the local government budget heaps).

In Australia, there have also been periods where export prices have well exceeded local prices (eg, for beef). In such cases, supply shifted – quite sensibly – from local markets to exports, and local prices were pushed up towards the international market price. That's also arbitrage in action.

Australia's import parity pricing policy for local oil supplies broadly reflects what arbitrage would deliver. Without it, local oil supplies (if priced lower when delivered here) would migrate offshore until local prices approached world prices, delivering a similar market price result.

The antithesis of market arbitrage: two absurd examples; one hypothetical, the other real

If you sold your house to a buyer offering only 40%-45% of the highest bid price, other sellers, most buyers, (and obviously your real estate agent!), would think you stark raving mad, or, at least, a bit 'unusual'.

The current local gas market seems to be like this: mad or at least 'unusual'. Why isn't the local gas market working properly? Is it government failure or market failure – or both?

Are governments to blame?

Probably.

At present, Australian governments are intervening to affect gas supply, and where it goes:

  • Some state governments have refused to permit the development of some (on-shore) gas deposits for various reasons.
  • Most recently, the Commonwealth Government has threatened to use export control powers to restrict the allocation of local gas production to exports from 1 July 2017.

On the face of it, the second of these is an example of governments trying to get an arbitrage-like market result (diverting more local supply to local demand to meet high local prices, with less exports into lower-priced markets).

The first is just curtailing local supply, wherever it might be sold. This behavior comes despite official advice (such as that from the NSW Chief Scientist in 2014) that:

Unconventional gas production is now a major industry especially in North America where, on balance, it is generally highly valued because of the energy security it provides. On the back of this, there is now considerable investment and experience in the development and refinement of technologies to maximise production while minimising adverse impacts. In Australia related technologies have now been extensively deployed successfully for some years (including at Camden in NSW). The independent petroleum engineering, geological and geophysical experts advising the Review consider that such technologies (including fracture stimulation and horizontal drilling technologies), with appropriate safeguards, are suitable for use in many parts of the sedimentary basins in NSW, noting that drilling in any new location is, to an extent, a learning-by-doing activity as there will always be local geological attributes specific to an individual resource development. These activities can and should be guided by companies investing in geophysics and other characterisation techniques to inform the best drilling and extraction approaches to take.
(Emphasis added.)

If the focus is on immediate market symptoms, you might want to give a tick to the second response, but a cross to the first. But does either increase supply, thereby lowering prices, over time?

All government interventions have longer term effects. Both of these responses will reduce total gas supplies over time. Instead, they increase the supply (yet more) of 'sovereign risk', both ex ante, for possible future investments, and ex post, via retrospective impacts on income flows from past investments made under a different set of rules. (Of course, if current governments don't care about anything beyond the next year or three, they probably won't give a stuff about anything but 'announceable appearances' of delivering symptomatic relief.)

Governments are at least partly to blame for the current gas market situation. The longer term effects of their policy interventions, if they are maintained, are likely to be perverse.

Is business to blame?

Maybe/don't know. Two central questions:

  • Do contractual commitments prevent market arbitrage operating right now? If so, why and how?
  • Is the policy environment right now chilling the investment climate for boosting local gas supply?

On the first question, are businesses signing up to deals that cause market failure by eliminating arbitrage?

On the second, are governments gumming up the market with impediments to effective arbitrage?

Media commentary suggests longer-term contractual obligations bind major gas suppliers and prevent arbitrage. Really? If suppliers can buy from here or overseas, this is nonsense. If they can't, why not?

On the second question, beyond banning further gas supply in some states, are there government controls stopping increased gas imports? If yes, why try to stop imports if you are threatening to stop exports? This is hardly a business failure. It is fixable quickly by changing government policy. If no, are government policies adversely affecting investment expectations, undermining investment in base-load supply?

Some simple, urgent, questions to suppliers

Why can't we get answers today to the following obvious questions (the answers must already be known):

  • Do existing export contracts force local suppliers to divert local gas to low-priced export markets?
  • Are contracts to deliver gas supplies to contracted buyers typically so specific on sources of supply?
  • When were such contracts signed? Were existing supplier managements and boards involved?
  • On what basis were they signed? What were suppliers' expectations about gas market prospects?
  • If those expectations were wrong, who formally takes responsibility for them? With what penalties?
  • Should shareholders and management accept their standard responsibilities? If not, why not?
  • Should Australian business and consumers generally cop the cost of suppliers' business mistakes?
  • Are there ways, consistent with existing contracts, to arbitrage away from local sources of supply to foreign supply to meet contractual obligations to foreign buyers (so-called 'swaps')? If so, why isn't the market itself sorting this out already? If not, why not?

On the wider investment environment, what are governments doing that affects investment incentives?

Do we have to wait months (or more?) for an ACCC probe to get the answers? Surely they are known right now (to some anyway). Surely 'commercial-in-confidence' isn't a cover for commercial incompetence? Is it?

Has traditional base-load energy supply been cut before alternatives are available? Why?

Governments want more renewables to cut emissions. Some emissions reduction urgers are now arguing that we should bypass even gas and go straight to more – not less – reliance on renewables! The rich (eg, some in Point Piper and even people like me), and possibly some academics (eg, at the ANU) quite possibly can afford to do so. Lower income groups wanting reliability can't.

Gas is a lower-emissions reliability back-up energy source for intermittent renewables. But local gas supply is shrinking relative to local demand, while renewable supply (and grid volatility and unreliability) surges. Coal is on the outer.

Policy alternative 'announceables' such as 'pumped hydro', if feasible, at best, take many, many years to bring on line. Whither energy reliability (even regardless of cost) in the meantime?

Without gas, or coal, what can we draw on, right now, as base-load back-up for intermittent renewables?

Lots of diesel generators, maybe?

It's clear, right now, that:

  • Electricity unreliability and high cost are political and economic killers.
  • Reducing emissions by reducing economic activity will prove unsustainable.
  • Government policy needs to take this into account.
  • At present, it doesn't.
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About the Author

Geoff Carmody is Director, Geoff Carmody & Associates, a former co-founder of Access Economics, and before that was a senior officer in the Commonwealth Treasury. He favours a national consumption-based climate policy, preferably using a carbon tax to put a price on carbon. He has prepared papers entitled Effective climate change policy: the seven Cs. Paper #1: Some design principles for evaluating greenhouse gas abatement policies. Paper #2: Implementing design principles for effective climate change policy. Paper #3: ETS or carbon tax?

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