V Shunmugam & Jayati Mukherjee
Transparent and efficient energy markets can provide a solid foundation to Indian economy’s growth ambitions. Given the increasing share of India in global energy consumption, efficient energy markets can place the country into the league of ‘movers and shakers’ as far as ‘energy price discovery’ is concerned. This, in turn, will provide healthy opportunities for exploration and production of energy products—crude oil and natural gas—critical to the strengthening of self-sustainability of investment in energy/related businesses. While efforts have been taken in terms of ending end-product subsidies by moving their prices to markets, they are yet to result in reduction of dependence on energy imports, given the pending development of market infrastructure.
Within oil and gas as popular sources of energy, the country’s future lies in shifting the demand from oil to gas not only due to economic and diversification purposes, but also in the context of green considerations. As against the global average basket share of 24.1%, India’s share of gas in primary energy basket is only 6.2% for 2016, according to data by BP Statistical Review of World Energy. The consumption ratio of oil to gas for India stands at 4.72 against a global ratio of 1.38, indicating that not only we are more dependent on crude oil and comparatively less on natural gas, but it also calls for introspection and accordingly streamlining of our efforts on pushing India’s gas economy towards global benchmarks. This involves multi-pronged efforts, driven by market development to be holistically pursued and supported by enabling policies.
The US gas market as benchmark
With about 32% of energy consumption in the form of gas and having one of the lowest crude oil versus natural gas consumption ratio, a peep into the development of US gas markets, various policy changes and the role of Henry Hub surely provides useful takeaways for the development of Indian gas markets. Apart from boosting of a robust physical gas marketplace, Henry Hub Natural Gas Futures as traded on NYMEX (CME) are also the largest gas derivatives globally.
The watershed in US natural gas markets (1980s and 1990s): The US gas market has evolved over the last five decades, primarily over three main phases. During the first phase, which covers the period before the 1970s, the government imposed price caps on producers in an attempt to artificially fix gas prices at relatively low rates. However, these low rates did not provide sufficient incentives to producers to invest in upstream projects to build reserves and, as a result, by the mid-1970s, the US market was in gas supply shortage.
In the second phase, the Natural Gas Policy Act of 1978 was introduced to address this gas shortage by providing incentives for increasing production by way of higher mandatory prices. Although these changes led to higher E&P activities, demand fell down significantly in view of high gas prices, leading to crippling of gas markets for the next few years.
The third and the most important phase commenced during the mid-1980s and 1990s, with the introduction of the Federal Energy Regulatory Commission (FERC) Orders 436, 636 and 637, which transformed the way interstate gas pipeline businesses were regulated, besides unbundling other services from transportation. Of the above mentioned three orders, FERC Order 636 was critical; it mandated unbundling of production from transport, allowing producers to sell gas directly. Pipelines were removed from the merchant function and required to provide open access to all parties. Further, pipeline rates were regulated to provide a fair price to all. Next to unbundling, the most influential change in natural gas markets brought about by Order 636 has been the creation of the capacity release programme. For the first time, a secondary market for pipeline capacity became available.
Thus, it provided pipelines’ customers with the opportunity to resell unused capacity to others. Order 636 was, therefore, hugely successful and literally transformed the structure of the gas market. As per FERC reports, the physical trading volumes of natural gas sky-rocketed from a mere 13 trillion British thermal unit (TBtu) in 1994 to 1,454 TBtu in 1998, a 110 times increase. This shows how these regulations opened up the markets in the 1990s by paving way for increased flexibility between receipt and delivery points in the US natural gas market, supporting the growth and transparency in market pricing and the successful emergence of a gas trading hub, i.e. the Henry Hub.
Success behind Henry Hub
Henry Hub is the world’s biggest natural gas hub, located in Louisiana. It’s owned by Sabine Pipe Line, a subsidiary of Chevron. The entire hub can transport 1.8 billion cubic feet per day (Bcf/D). For decades, natural gas prices at Henry Hub have been the benchmark for US natural gas contracts and also used as reference for setting gas prices across the globe. Besides being at a strategic location, the major reason of Henry Hub emerging as the world’s biggest natural gas hub is its deep and liquid pricing mechanism, driven by the participation of multiple stakeholders, and well supported by necessary logistical infrastructure functioning under a market-friendly policy regime.
Notably, as the delivery point for Henry Hub Natural Gas Futures, the Henry Hub is a nexus of several natural gas interconnections, thereby offering the stakeholders with ready access to pipelines serving markets across the US and beyond. The success of FERC policy reforms can be gauged by the fact that oil and gas infrastructure has attracted investment worth $390 billion over the past five years, according to the American Petroleum Institute (2017). This should be appreciated from the perspective of recent lows in natural gas prices spurring demand and hence investments in infrastructure.
Unbundling transportation is key to liberalising Indian gas markets: The US model of a well-developed natural gas market suggests that a gas trading hub which provides for efficient reference pricing remains at the heart of increased private investments and sustainable development of the entire value chain comprising of network of pipelines and storage operators, producers, distributors and end-users. In this context, it is unfortunate that a 2017 Thomson Reuters article on gas trading hubs talks about Japan, China and Singapore aiming to set up price benchmarks despite the fact that India was the fourth-largest importer of LNG in the Asian region. Perhaps it shows that reform initiatives are critical to make the Indian market much highly participated without any constraints.
For India to develop into a successful and genuine gas trading hub, apart from promoting private investments in necessary infrastructure, a strong political will with enabling market-friendly policies are key. Currently, the major producers and importers of natural gas in India hold access to the pipelines and, as a result, natural gas supplies cannot be freely accessed by third parties at a short notice, which can help open up a free pricing trading hub as in the US.
Unbundling of transportation business from all parts of the value chain and creating a secondary market for pipeline capacities ensures independence of intermediaries, avoiding conflict of interest situations that will impair the impartiality of price discovery process. Independent transporters and trading in their capacities are critical to the success of a vibrant trading hub. Besides, what differentiates natural gas from electricity and makes it similar to crude oil is the ability to store.
Accordingly, apart from independent pipeline operators, development of storage capacities by independent storage operators is critical to a well-functioning trading hub. CRISIL market research of late 2016 mentions that if India were to achieve the goal of doubling the share of gas in its energy mix to 15%, it needs augmented investment of $10 billion in pipelines and gas import infrastructure. A well-functioning liberalised market regime will help promote private investments in the sector. With these structural changes in place and buoyed by a supportive policy environment, the natural gas market in India can truly be energised.
V Shunmugam is head and Jayati Mukherjee is senior analyst, Research, Multi Commodity Exchange of India Ltd. Views are personal