Oil – gas competition

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Oil – gas competition

Understanding of inter-fuel substitution in key LNG markets

Groningen, August 2007

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Shell Gas & Power - Public 4

Oil – gas competition

Understanding of inter-fuel substitution in key LNG markets

Groningen, August 2007

This study has been carried out for Shell Gas & Power and its contents are confidential.

The author is responsible for the contents of this report and holds the copyright.

Author: Christiaan Burggraaff Supervisors University of Groningen: Dr. Boris Goldengorin Prof. Dr. Gerard Sierksma Supervisors Shell Gas & Power: Dr. Hadi Hallouche Fiona Hall

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Executive summary

STUDY

This study has been carried out for Shell Gas & Power and is a Master thesis of the University of Groningen. The main clients of the study are the Global LNG Strategy & Portfolio Team and the Commercial Advice Team of Shell Gas & Power, GPG-R. The topic of the study is oil-gas competition in key LNG markets. This competition is an important determinant of natural gas demand, and hence also of LNG demand. The purpose of this study is thus to better understand LNG customer markets. Shell LNG is the market leader of international oil companies in the LNG industry. More specifically the present study has four objectives:

• Gain further understanding of competition between oil and gas. • Apply this understanding to forecast:

o Oil replacement in key LNG markets for 2020 o Price sensitivity of gas demand forecasts

• Develop a tool with which oil-gas competition can be studied

Below the findings for each of these objectives are discussed. In addition to these the impact of three additional scenarios, identified in the process, is also addressed.

OIL – GAS COMPETITION

Product characteristics: oil is easy to transport, gas is easy to use

Oil and gas have quite different characteristics as products; oil is a liquid fuel, has impurities and is easy to transport. Gas is a gaseous fuel, is relatively clean and is convenient to use, however it requires a substantial infrastructure. These characteristics result in lower non-fuel costs and lower negative externalities from the use of gas and lead to preference for gas over oil products in the power, industrial (final energy) and gas sectors. Oil products are preferred in the transport sector and non-energy use (mainly (petro-) chemical feedstock).

Development path: trend to gas as countries become more advanced

The trends of oil and gas demand in the power, industrial and residential sectors differ along the development path of a country. When the gas infrastructure has not been developed and energy demand for fossil fuels starts to increase, demand for oil products rapidly increases as they are easy to transport and store and can use the same distribution channels used for gasoline. Once, a country reaches higher levels of income gas infrastructure gets developed and customers are willing to convert to a more convenient fuel. Oil product demand in the power, industrial and residential demand starts to decline and is being replaced by natural gas.

Relative end-user fuel prices: influence the speed of the trend, but not the direction

The trend towards gas is quicker in some countries than in others, e.g. Korea has achieved the same penetration rate as Japan in roughly half the years. One factor that can explain this difference is the fact that end-user gas prices are at parity with competing oil products. In Japan, on the other hand, end-user gas prices have been two to three times those of competing oil

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Shell Gas & Power - Public 7 products. Note that the preference for gas is so strong that gas demand is increasing in the power, industrial and residential sectors in Japan, while oil product demand is decreasing. Analysis shows that with these relative prices Japanese penetration will not reach the same level as Korea though. With regards to developing markets, analysis shows that gas demand can grow up to 1% faster per year in when relative oil product prices are 10% higher (relative gas prices 10% lower). International and end-user fuel prices: Same dynamics, price difference varies between countries End-user oil product and gas prices are found to follow the same dynamics as international fuel prices and international fuel prices therefore have an impact on end-user fuel prices and user fuel choices. However, the price difference between international and end-user fuel prices can differ substantially between countries, from less than 1$/MMBtu in the USA to more than $20/MMBtu in Japan. Gas distribution companies in markets such as Japan are able to charge substantially higher gas prices than international fuel prices (in terms of energy content) because gas trade requires an infrastructure and companies can take advantage of their monopoly position.

FORECASTS

Forecast of oil replacement 2020: still oil replacement in mature energy markets

Applying these insights for forecasting, two different markets need to be distinguished: mature markets, where oil demand in the power, industrial and residential sectors is being replaced by gas. And developing energy markets, where oil product demand and gas demand are both still increasing.

Forecasts: confidential

Developing energy markets: developing large potential for oil product replacement

While these amounts are relevant from an LNG market perspective, especially for the case of Japan, more interesting potential oil replacement is currently developing in developing energy markets such as China and India.

Forecasts: confidential

As natural gas is a ‘next generation’ fuel and gas demand in the end surpasses oil product demand in this three sectors, these amounts give an indication of the large potential for gas and LNG demand in the medium run in India and China.

Price sensitivity: relative fuel prices matter for end-user fuel choices

While some consumers seem to prefer one fuel over the other no matter what (e.g. in Japan natural gas trades at a large premium to oil products in end-user residential and industrial markets), the relative gas price to oil products has been found to have an impact both in mature and in developing gas markets. While gas demand is still found to grow at the expense of oil products this happens much faster when relative gas prices are lower, as more consumers convert to gas. In developing markets analysis shows gas demand grows 1% faster when the relative gas price is 10% lower. The price sensitivity of gas demand to international prices differs per markets as the price differences between oil/gas and Brent/Henry Hub differ per market.

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Shell Gas & Power - Public 8 TOOL

Criteria

Criteria identified for the tool are: user-friendliness, good interface, compatible with many other methods, allow judgment and it should not rely on extensive modelling by the end-user.

Tool

Considered alternatives were graphical analysis, price elasticity, regression analysis and simulation models, as these methods were applied successfully in the present study. Based on the criteria graphical analysis was found to be the most suited method. An Excel tool has been developed that provides historic IEA data, allows the input of own forecasts and directly generates graphs of the historic data and the forecast in the same figure, and with benchmarks of other countries. Since it uses the PivotTable functionality, it is easy to browse between sectors, fuels and graphs. SCENARIOS

During the research process, three scenarios were found to have a potential interesting impact on oil-gas competition. Therefore these are briefly addressed in an additional chapter.

Carbon tax

There are policy discussions of introducing a carbon tax on fossil fuels. As the amount of CO2 emission per energy content is 33% lower for natural gas than for oil products, this will have a downward effect on the relative price of natural gas. For carbon taxes of 20 and 40 $/ton CO2 this entails taxes of 1-2 $/MMBtu for natural gas and 1-3 $/MMBtu for oil products, resulting in differences smaller than 1 $/MMBtu. At present energy prices, this is 10% of the relative gas price and that can have a significant effect as noted above.

Higher indexation of LNG contracts

Many LNG contracts are noted in percentage of Brent (in $/barrel). Assuming Brent trades at 60 $/barrel, a 1% increase would be 0.6 $/MMBtu. In markets such as Japan, where end-user gas prices are very high and trading at large premium to oil products in end-user markets, this is not a very substantial monetary amount. 3%, or 1.8 $/MMBtu, would mean an increase of 10-20% of the relative gas price, which will slow penetration, but will not entice large scale switching away from gas.

Opening up of transport sector

More than half of the worlds oil product demand is consumed by the transport sector, a sector where gas demand is marginal. The demand of this sector has also been growing very fast over the past decades, both in mature and in developing markets. This provides incentives to start to look for alternative fuels, in addition to the growing importance of environmental targets in the public debate. In the power, industrial and residential sector, natural gas is the best substitute for oil products and the transport sector might very well be the next sector. Currently, technological advancements and both government and business initiatives are supporting the start up of a natural gas infrastructure for the transport sector. The potential for oil replacement in this sector may be much larger than the power, industrial and residential sectors.

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Shell Gas & Power - Public 9 LIMITATIONS

Limitations of the present study are: the strong focus on oil and gas, the study ignores others fuels and this gives an incomplete view of energy market dynamics. The same holds for the relation between oil-gas competition and gas demand: oil-gas competition is only one of the determining factors. Thirdly, the focus is mainly on general factors, since it is impossible to take account of specific country circumstances. Furthermore, one should always be careful with extrapolating trends identified in the past, the dynamics may not always be repeated in the future. The aggregation decisions (counties and oil products as levels) and the applied estimation techniques may an impact on the results. For all these reasons, the results of this study should therefore always be combined with a wider analysis

RECOMMENDATIONS

• Include oil-gas competition in gas demand forecasting.

• Study benchmarks of other countries as general trends can be distinguished.

• Monitor end-user prices of oil and gas, as they have an impact on demand dynamics. • Investigate link High Sulphur Fuel Oil-gas price: will HSFO price move with Brent or

stick with gas?

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Preface

This report is one of the end-results of my internship at Shell GPG-R from January to August 2007, and marks the end of my study Technology Management (MSc.) at the University of Groningen. I have really enjoyed my internship in The Hague with Shell and I want express my gratitude for the opportunity given to me. The exposure to a dynamic business environment, the cooperation with many interesting colleagues from a diversity of backgrounds and nationalities, the responsibility for, and challenge, of this project have all made the internship it a very valuable experience. Many people within Shell have aided me in this research, they have always been willing to make time and to offer their views on the matter and have been kind enough to provide data and earlier studies. I could not have completed the project without them, many thanks to all of you.

Special thanks to my supervisors in Shell, Hadi Hallouche and Fiona Hall, for their support during both the ups and the downs of my internship and their valuable comments along the way; to my supervisors at the university, Dr. Boris Goldengorin and Prof. Dr. Gerard Sierksma, for their guidance in the final project of study and their contributions; and to all members of the GPG department whose company I enjoyed the past seven months.

Christiaan Burggraaff Groningen, August 2007

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Introduction

This study was carried out for the Strategy & Portfolio Team and Commercial Advice Team of Shell LNG (GPG-R department) and focuses on oil-gas competition in key LNG markets and its relevance to Shell LNG. It aims to accomplish four objectives:

1) General understanding of oil-gas competition

2) Forecast of oil-replacement by natural gas on the medium run 3) Price sensitivity of gas demand forecasts to relative oil/gas prices 4) The design of a methodology to incorporate the generated insights

Oil-gas competition is an important determinant of gas demand of LNG demand and understanding of it is important to Shell LNG as the LNG industry is developing from a regional market with few buyers and suppliers and long term contracts, to an increasingly global market with more customers, suppliers and competitors, and with more flexible contracts. This makes it more important to be able to forecast who is looking to buy LNG for which years and for which price. General understanding will be applied to give forecasts of oil replacement and price sensitivity (as there is speculation whether oil and gas prices might decouple in the future, as they have been linked traditionally) and to develop a tool that local operating units of Shell can use. To accomplish these goals five questions have been formulated which formed the guideline to the research:

1. In which markets do oil and gas compete with each other? 2. Which factors have an influence on oil-gas competition? 3. What is the impact of fuel prices on oil-gas competition?

4. How should oil-gas competition be included in gas demand forecasting? 5. How should we incorporate oil-gas competition in a tool?

The conceptual model in Figure 1 depicts how the various concepts in these questions are linked. To understand the fuel choice of end-users (oil or gas), the factors which influence this decision are studied, with a special focus on the prices end-users face and the impact of international fuel prices on the end-user fuel prices. The pink blocks represent the linkages with the LNG market.

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Shell Gas & Power - Public 19 Figure 1. Conceptual model

These questions have been investigated by a range of methods. The first three questions have been answered on the basis of data analysis, interviews with experts, literature research and the use of price elasticity, regression analysis, and simulation models. The results of these questions may also be of interest to a wider audience than Shell LNG. The impact of relative prices, price elasticity, market liberalisation, country development, product lifecycles and product characteristics have been analysed. Subsequently, the fourth and the fifth question aim to apply the generated understanding using trend extrapolation forecasting methods and for the development of a software tool to aid gas demand forecasting.

As this study is carried out for Shell LNG the units used for energy volumes and prices are those which are customary in the LNG industry, energy volume: million ton of LNG equivalent per annum (mtpa of LNg eq.); energy price: $ per million British thermal units ($/MMBtu). See Appendix C for a conversion table.

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THIS IS THE PUBLIC VERSION OF THE REPORT SOME THINS HAVE BEEN CHANGED OR DELETED

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Overview of the report

This reports consists of 10 chapters, divided over three parts, which each have a distinct focus. The first part provides relevant background information, the second part discusses the design of the research and the third part presents the results of the study and conclusions.

The first part is Background and this part consists of three chapters that cover the energy market, the LNG industry and Royal Dutch Shell & Shell LNG. Together these topics set the stage for the design and discussion of the research in later parts. The first chapter discusses the energy market, the market in which oil and gas compete as fuels for energy demand, and pays attention to the structure of the market, the two levels of the system (crude fuels and carrier fuels), the main demand sectors, the purposes for which natural gas and oil products are used, different relevant fuel prices, the energy system supporting the energy market and the way it evolves along the development path of a country. The second chapter discusses the LNG industry; topics which are discussed are the value chain of LNG, which requires large investments and is characterized by long-term commitments, the LNG market and LNG contracts and pricing. The third chapter, Royal Dutch Shell & Shell LNG, goes into the role of Shell LNG in the LNG industry, its organization, strategy and business activities.

Following the laying of the foundations in the first part, the second part, Research design, covers the design of the research. This involves the discussion of the problem that spurred this study, the design of the research itself and the introduction of the applied theoretical concepts. First, in Chapter 4, the problem that is the focus of the study is defined. The purpose of the study, based on discussion with the client, and a specific background are discussed, which form the basis for the statement of research objectives and research questions. These provide the guideline for the research, which starts in Chapter 4 with the formulation of an approach to the problem and sub questions. Chapter 5 proceeds with the design of the research that will answer the sub questions, and thereby answer the research questions and accomplish the research objectives. Chapter 5 focuses on the methodology of the study, while the theoretical concepts which will be used in the study are discussed in Chapter 6.

The third part is Results & Conclusion and this part handles the outcomes of the study and what they imply for Shell LNG. In Chapter 7 the results are presented, which provide the answers to the sub questions formulated in Chapter 4. On the basis of these results, Chapter 9 draws conclusions and makes recommendations to Shell LNG that aim to provide an answer to the problem that was the reason for the present study. In between Chapter 8 discusses three additional topics, that were no part of the initial scope of the study, but which emerged during the study. Finally, Chapter 10 discusses the limitations and caveats of the present study.

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Part I: Background

• Chapter 1: The energy market • Chapter 2: The LNG industry

• Chapter 3: Royal Dutch Shell & Shell LNG

The first part provides a discussion the background of three topics that are essential to the present study. The first chapter covers the energy market, which is the market where oil and gas compete for energy demand. The market for energy is no ordinary market and has several special features that have an impact on the nature of oil and gas competition. Topics which are discussed are the main demand sectors, oil and gas as fuels and their respective uses, fuel prices, the system underlying the energy market and the influence of the development stage of a country on the development of its energy market.

The LNG industry is the second chapter and discusses Liquefied Natural Gas (LNG), its history and its value chain. The large investments and long-term commitments, combined with an illiquid market for LNG have implications for LNG contracts and pricing and why specific questions asked in this study are relevant for participants in the LNG industry.

Subsequently, the third chapter zooms in on Shell LNG as a player in LNG industry. Shell LNG is the leading international private energy company in this industry and intends to attain that position. The organization, strategy and main business activities of Shell LNG are all discussed.

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1. The energy market

Oil and gas are competing fuels on the market for energy. Inter-fuel competition is one of the determinants of gas demand, and gas demand drives demand for LNG, which competes for gas demand with pipeline gas and domestic supply In order to provide a background for the discussion of oil-gas competition in later chapters, this chapter discusses the energy market and the energy system that allows the energy market to function. In Section 1.1 the energy market is discussed in general, and in particular the fuels, demand sectors and energy prices that are of interest to the present study. Section 1.2 discusses the energy system, also paying attention to the impact of the development phase of a country on the energy system and market, after which Section 1.3 will conclude.

1.1 Energy market

Energy is used to produce the goods we consume, to provide lighting and electricity, to transport people all over the world and to heat our homes and prepare our food. For all uses of energy different options can be chosen to provide the energy, for example you can cook by burning natural gas, LPG, wood or using an electrical equipment. The energy market is the market where demand and supply of energy meet each other. Furthermore, two levels of competition can be distinguished within the energy market:

1. The market for final energy demand, on which carrier fuels, or secondary sources, compete 2. The market for primary energy demand, the demand of carrier fuels for crude fuels.

Electricity is a typical example of a carrier fuel, since it is generated using other energy sources (such as fossil fuels, hydro or nuclear plants), and used to meet final energy demand. Figure 2 shows how the energy market is modelled in the Shell World Energy Model, which distinguishes 8 demand sectors, 8 carrier fuels and 16 primary energy sources.

Figure 2. Energy system as represented in the Shell World Energy Model1

HC: hydrocarbon, PV: photovoltaic Solar Thermal Heavy industry Light industry Services Transport - Passenger Transport - Freight Residential - Heating Residential - Appliances Non-energy use Demand Solid HC Fuels Liquid HC Fuels Gaseous HC Fuels Electricity Hydrogen Solar PV Heat Biomass & Waste

Crude oil Unconventional oil Natural gas Coal Biomass Waste Nuclear fission Hydro-electricity Wind Wave Tidal Geothermal Solar PV Solar Conc Unconventional gas Consumer choice Producer choice Carrier fuels Crude fuels

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Shell Gas & Power - Public 24 Note that in this model crude oil and natural gas are crude fuels, while the model has liquid hydrocarbon fuels and gaseous hydrocarbon fuels as carrier fuels. This is because similar products as produced from oil, can also be produced based on natural gas or coal; and the same holds for gaseous hydrocarbon fuels. Although there is no one-to-one relation, in practice most liquid hydrocarbons are produced using crude oil, and most gaseous hydrocarbon fuels are derived from natural gas.

The goal of the present study is to understand oil-gas competition and its impact on overall gas demand. From this perspective the competition between natural gas and crude oil for carrier fuels other than electricity is negligible. The power sector, which generates electricity, will be considered as an end-user for natural gas and oil products, although it is not a final energy demand sector. The present study will thus mainly focus on oil-gas competition in end-user markets of natural gas and oil products and will distinguish the following sectors and fuels: Demand sectors:

• Industry (no feedstock) • Residential

• Power • Transport

• Non-energy use (mostly feedstock (petro-)chemical industry) Carrier fuels:

• Natural gas • Oil products

1.1.1 Fuels

Energy sources thus compete on two levels: primary energy consumption (crude fuels) and final energy consumption (carrier fuels). In figure 3 the evolution of both markets is depicted for the last 35 years. It is clear that oil (products) and gas are important energy sources in both markets. Note that the total final energy consumption is less than primary energy supply; this is due to distribution losses and efficiency losses in the transformation of energy sources in carrier fuels.

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Shell Gas & Power - Public 25 Figure 3. World total primary and final consumption 1971-2005

(IEA Key World Energy Statistics 2007)

1.1.1.1 Crude oil & oil products

There is a distinction between crude oil, which competes on the primary energy market, and oil products, which compete on the market for final energy.

Crude oil - Crude oil is a liquid mixture of primarily various compositions of hydrocarbons, the exact mixture will differ per well. After refining and cracking the crude oil a number of oil products are produced. Different refining processes result in different mixtures of oil products. The world market for crude oil is liquid, there are many buyers and sellers, many tankers transporting oil over the world and in case of a regional shortage there is always the possibility to divert a tanker. Crude oil can be moved by ship, pipeline and truck and can be stored easily and by a variety of containers.

Oil products - Oil products are mainly produced by refining crude oil, but a small part is also produced by extracting certain components from natural gas (extraction Natural Gas Liquids), and on the basis of Gas-To-Liquids or Coal-To-Liquids. These are assumed to be oil products and not as natural gas or coal products, which is in line with assumptions used by the International Energy Agency. Figure 4 shows the refining process and the main oil products,

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Shell Gas & Power - Public 26 which mainly differ by the number of carbon atoms in the hydrocarbon molecules (Cx where x is the number of carbon molecules).

Figure 4. Petroleum refining process and the main oil products

From light to heavy fractions the main oil products are: • Ethane (C2)

• LPG (mixture C3 and C4)

• Naphtha (C5 – C9)

• Gasoline (C5 - C12)

• Kerosene (C10 - C18)

• Gas oil/diesel/light fuel oil (C12 or more)

• Lubricants (C29 - C50)

• Heavy fuel oil/residual fuel oil (C12-C70)

• Residual (C70 and higher)

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In Appendix E a brief description of each oil product is given. The characteristics of the products and their uses can differ substantially. With the exception of ethane and LPG, all oil products are liquid and their main uses are in the following sectors:

Residential sector: LPG, kerosene, light fuel oil

Industrial sector: Mainly heavy fuel oil, some light fuel oil Power generation: Mainly heavy fuel oil, some light fuel oil Feedstock: Ethane, LPG, naphtha.

Transport: Gasoline, kerosene, LPG Other uses: Lubricants, residuals

As we will see further on, the main competing oil products for natural gas at the moment are LPG, kerosene and light fuel oil in domestic heating, cooling and cooking and heavy fuel oil in industrial heating and cooling and electricity generation.

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Shell Gas & Power - Public 27 Lighter fractions more popular

Residual fuel oil has been undergoing a secular (longer-term) decline in the global power generation sector, where it has been increasingly replaced by consumption of cleaner-burning and more efficient natural gas. The same holds for the use of residual fuel oil in other demand sectors. The demand for lighter fractions (gasoline, diesel, and kerosene) has been increasing however. This is because these products are used as transportation fuels, for which there are few substitutes. Growing demand for light products combined with declining demand for heavy fuel remains the key dynamic driving the relative pricing of refined products, lighter fractions are thus relatively more expensive (per energy unit) than heavier fractions.

It is possible to adjust the mixture of oil products in the refining process and the refineries with the capability to produce most light fractions have the highest utilization rates, this trend can be expected to continue. Figure 5 shows the shares of oil products in refinery production in 1973 and 2005, the share of Heavy Fuel Oil has been reduced by 50%.

Figure 5. Shares of refinery production by product (IEA Key World Energy Statistics 2007)

Demand sectors

Figure 6 provides a split of oil demand over the five distinguished sectors. The sector responsible for the largest share of oil demand is the transport sector, followed by non-energy use. This is especially the case in the USA and the European Union (EU-15). Data are in mtpa of LNG equivalent, see Appendix C for a definition and a conversion table. The sectors that primarily use light fractions are thus also the largest demand sectors for oil products.

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Shell Gas & Power - Public 28 Oil demand split per sector (2004)

0 100 200 300 400 500 600 700 800

China EU-15 India Japan USA

m tpa L N G e q ui va le n t

Relative oil demand (2004)

0% 20% 40% 60% 80% 100%

Residential Sector Industry Sector Power Non-Energy Use Transport Sector

Figure 6. Oil product demand split per sector for a number of key markets (based on IEA data, source: IEA World Energy Balance)

1.1.1.2 Natural gas

Natural gas as a crude fuel consists primarily of methane (C1), but also of ethane (C2), propane (C3) and butane (C4), as well as, carbon dioxide, nitrogen, helium and hydrogen sulphide, see figure 7. The natural gas is treated before it goes into the gas-grid to final consumers. The ethane, propane and butane are also referred to as Natural Gas Liquids (NGLs) and are often extracted and sold separately. When these components are extracted from the natural gas, they are assumed to be oil products, even though they are not produced using crude oil (note that sometimes crude oil and natural gas originate from the same fields, so the distinction between crude oil and natural gas as crude fuels is not always clear-cut). This is in line with the methodology adopted by the IEA (see IEA Key World Energy Statistics 2007).

Figure 7. Natural gas/LNG

The world market for natural gas is an illiquid market, because gas is difficult to transport and to store. Traditionally, gas trade was very limited; due to a lack of pipeline infrastructure (a capital intensive and inflexible transportation system) and little availability of LNG transport capacity

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Shell Gas & Power - Public 29 LNG trade has led to an increased integration of world gas markets, but at the moment the gas market can better be considered to be a regional market (Silverstovs, 2003).

Carrier fuel

The carrier fuel natural gas is the mix of the gas in the gas-grid to final consumers and consists primarily of methane.

Demand

Natural gas is used in a number of different sectors: for cooking, heating and cooling in the residential and industrial sectors, electricity generation, as chemical feedstock for the production of fertilizer and hydrogen, and finally also in the transport sector. It is thus used in all the sectors in which oil products are also used. The split over these sectors is however quite different when compared to oil products, as can be seen in figure 8. The transport sector and non-energy use are no important sectors for gas demand at all, instead power, industrial and residential demand are responsible for most of the gas demand. Also note the difference between the USA and the EU-15 and the Asian countries in terms of gas market development.

Gas demand split per sector (2004)

0 50 100 150 200 250 300 350 400

m tpa L N G e q ui va le n t

Relative gas demand (2004)

0% 20% 40% 60% 80% 100%

Residential Sector Industry Sector Power Non-Energy Use Transport Sector

Figure 8. Gas demand split per sector for a number of key markets (based on IEA data, source: IEA World Energy Balance)

The split of demand over the demand sectors furthermore also differs over the countries. The share of the power sector is especially large in Japan (60%) and India (55%), while it is a lot smaller in the European Union (20%) and the USA (25%).

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1.1.1.3 Oil products compared to natural gas

Oil products and natural gas are both fuels that can be used as energy sources or for non-energy use. However, both fuels do differ on a number of characteristics, which is important for their competition.

• Natural gas has in general less impurities than oil products (e.g. sulphur) and this makes it a cleaner fuel

o This allows more efficient burning processes in electricity generation in Combined Cycle Gas Turbines (CCGT), because the waste heat can be used to generate steam in an additional turbine. The waste heat when oil products are burned would contain so many impurities that it would damage the equipment too rapidly to be economically viable.

o The quality of the flame is better (purer) and this is preferred in many industrial processes.

o Maintenance costs in terms of personnel and downtime are lower because the damage to the equipment is less severe.

• Natural gas is cleaner from an environmental perspective

o Burning natural gas has fewer emissions of impurities per energy unit (sulphur, nitro dioxide).

o Burning natural gas results in less carbon dioxide as by product per energy unit (30% less per energy unit).

• Natural gas is delivered to end-consumers trough the gas-grid. Oil products are often moved per tank wagon to end-consumers.

o This requires investments in a gas infrastructure.

o But it does not require storage facilities on site and requires less effort from employees.

• Many oil products are liquid at standard temperature and pressure, and therefore the energy content per density is high compared to gas and this makes gasoline a very suitable fuel for transport equipment.

• The different chemical structures of the main component of natural gas (methane) and the various oil products make these products more and less suited as feedstock for different chemical processes. Using the other fuel might require a substantial increase in capital and operating costs, or might even be impossible.

Above points result in a greater convenience of the burning of gas for both residential, industrial and power plant users and in lower non-fuel costs (storage, maintenance, training of personnel). Oil products are, however, easier to distribute without an extensive infrastructure and suited for transport equipment.

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1.1.2 Demand sectors

The five distinguished demand sectors in the present study will now be discussed in more detail. What is important to realise in the discussion of energy demand sectors is that the choice between one fuel and another is not as simple as it might seem, because it not just about buying the one fuel or the other, it is also about having the equipment and processes in place to be able to handle the fuels in question. Demand can therefore sometimes only change when a facility, or equipment, is converted or replaced. Fuel demand is therefore determined by three questions:

- Is the right equipment installed? - Is the equipment switched on?

- How much of the fuel will be consumed?

1.1.2.1 Power

The power sector is concerned with mainly one thing: to generate electricity at the lowest possible cost given the regulatory environment, as determined by the government. Many different energy sources can be used to generate electricity, from the burning of fossil fuels to hydro power, and from nuclear plants to wind energy parks. The equipment that is important for the use of certain energy sources is the power plant: how much of which types of plant are available determines the potential use of each fuel. What is important to realize is that electricity is hard to store and that energy demand is not constant throughout the day/year, and can be characterized by a so called load curve: a curve showing the required electricity per number of hours per year. A typical load curve is depicted in figure 9.

Figure 9. Load curve; power demand in required capacity (source: Shell Natural Gas Course: Power Generation, November 2006)

The decision which power plants to use to generate the electricity is made on the basis of cost minimisation. The available plant with the lowest variable costs is dispatched first, and if the plant is capable of burning multiple fuels the fuel with the lowest variable cost is chosen. A typical use of fuels/types of power plants is depicted in the right panel of figure 9.

• The base demand is met by hydro, nuclear and coal: types of plants with high capital costs and low variable fuel and non-fuel cost.

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Shell Gas & Power - Public 32 • The middle of the load curve is met by gas Combined Cycle Gas Turbines (CCGTs)

and thermal power plants which burn heavy fuel oil. These plants do not have to run all year long, are flexible to switch on/off and have low capital investments, but higher variable costs.

• The peak demand is met by Open Cycle Gas Turbines (OCGTs), older gas and/or fired power plants which are less efficient than CCGTs. These plants have high variable costs, but have already been built and replacing them with more efficient plants does not always make sense.

Note that different types of power generation could shift up or down the curve, or even shift places, depending on fuel prices and local circumstances. Also note that the surface of the curve (which is equal to electricity demand, which determines associated input fuel demand) is much smaller for the peak demand than for the mid-merit demand.

Oil and gas compete for peak power demand. Gas competes mainly with coal for mid-merit power demand. Some power plants allow the burning of multiple fuels, especially the older plants, which does require additional facilities and processes in place at the power plant. Oil-gas competition is therefore taking place through two channels: switching fuels in the same power plant, and through inter-plant substitution between plants burning different fuels.

Combined Cycle Gas Turbine (CCGT)

CCGTs are popular gas-fired power stations, because they have low capital costs, are flexible to operate and have low variable costs relative to other gas and oil power plants because of their higher efficiency. Only when natural gas prices exceed 140 percent of residual oil prices generation from oil steam plants can displace generation from gas-fired combined cycle plants (Yeasting, 2006). CCGTs can be run as dual gas/oil-fired plants, but they then require lighter oil distillates (e.g., gas oil), which are generally more expensive than heavy fuel oil. In addition, dual-firing in a CCGT normally leads to an increase in capital costs since a bigger water treatment plant often is needed to comply with existing NOx regulations (IEA, 1995). Because of this the power capacity that can switch between gas and heavy fuel oil is slowly declining.

Demand

In figure 10 absolute and relative energy demand for the power sector are given. Considering the above discussed load curve it is no surprise that the largest part of energy demand is fulfilled by fuels other than oil and gas.

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Shell Gas & Power - Public 33 Fuel demand power sector

0 200 400 600 800 1000

mt pa L N G e q.

Relative fuel demand power sector

0% 20% 40% 60% 80% 100%

0 1000

Nuclear Hydro Renewables Coal Combustion Oil Gas

Figure 10. Energy demand power sector for a number of key markets by fuel (based on IEA data, source: IEA World Energy Balance)

The share of gas demand is larger than oil demand in all countries, except in China, where the oil and gas use in the power is very limited. In China coal is primarily used for power generation, of which the country has abundant reserves. The combined share of oil and gas is especially large in Japan.

1.1.2.2 Industry

Final energy demand by the industrial sector falls basically in two categories: fuel demand for process heating/cooling for which fuels are burned on site in boilers, turbines, furnaces and electricity, which is required for the operation of all kinds of devices. Oil and gas compete in the first category, for which the installed equipment in the factory is important, as are the facilities and processes in place on site. Some boilers allow the burning of multiple fuels. The fuel of choice in the industrial sector can sometimes change rather slowly because it is dependent on the rate and timing of additions to the manufacturing capacity, which depend in turn on the retirement rates and industry growth, typical retirement rates range from 1 percent to 3 percent

annually2_{. Growth of the industry sector will lead to new demand and when this growth is high} the relative fuel use can change more quickly. Because of technological improvements, and changes in the industry mix, the energy efficiency of the industrial sector improves over time, which will depress fuel consumption.

The efficiencies of burning oil products or natural gas are more or less the some, other than is the case in the power sector (because of the CCGT power plant). The quality of the flame is higher, however, when natural gas is burned and this is preferable for some industrial processes (other processes prefer dirty flames and burn coal, e.g. steel and cement). Heavy fuel oil is relatively cheap to burn, but requires waste gas treatment and pre-heating, resulting in higher maintenance and personnel costs. Light fuel oils have a lesser impact on non-fuel costs, but are usually more expensive than heavy fuel oil plus the additional costs.

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Shell Gas & Power - Public 34 Demand

In figure 11 it is shown that gas is the preferred fuel in the USA and the EU, while oil is used relatively more in the Asian countries. The combined share of oil and gas together is also relatively low in the Asian countries, especially in China (again because of the large use of coal).

Fuel demand industry sector by fuel (2004)

0 50 100 150 200 250 300 350

mt pa LNG eq ui va le nt

Relative fuel demand industry sector (2004)

0% 20% 40% 60% 80% 100%

Gas Oil Other

Figure 11. Energy demand industrial sector for a number of key markets by fuel (based on IEA data, source: IEA World Energy Balance)

1.1.2.3 Residential

Just as in the industrial sector there are two main categories of energy use in the residential sector (which also includes the commercial and public sectors, e.g. hospitals, hotels, offices). The first category is heating and cooking for which fuels are burned at the location, although electric heating and cooking are also possible. The second category is the demand by appliances, and for lighting, for which electricity is used. Often, equipment decisions are made when a house is built or people move house. The investment decision for space heating comes up every 10-15 years, cooking equipment lasts somewhat longer.

Oil and gas compete for space heating, cooking and cooling and in general the switch to natural gas is quite irreversible, because you do away with the required storage facilities for oil products. The availability of gas, through a connection to the gas-grid, is however a very important enabler and the gas-grid requires substantial investments. Factors with an impact on residential energy demand are furthermore: population, size of households, weather, efficiency savings and GDP.

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Shell Gas & Power - Public 35 Demand

The share of oil products and gas is between 50 and 60% in the USA, the EU-15 and Japan where hardly any other fuels are used in the residential sector; the remainder is electricity. In China and India the share of oil and gas is much lower though, this is because combustion of natural materials (biomass) such as wood is responsible for most of the energy demand in the residential sector in these two countries; although coal also has a substantial share in China. Clearly, the oil and gas markets are not yet developed in China and India.

Relative fuel demand res. sector

0% 20% 40% 60% 80% 100%

Fuel demand res sector

0 100 200 300 400 500

m

tp

a L

NG e

q.

Coal Gas Combustion Oil Electricity

Figure 12. Energy demand residential sector for a number of key markets by fuel (based on IEA data, source: IEA World Energy Balance)

1.1.2.4 Non-energy use

Non-energy use demand for energy is primarily the demand of the (petro-) chemical industry for feedstock and some demand for lubricants, asphalt and waxes. As depicted in figure 12, oil basically has a monopoly in this demand sector, as it is by far the most consumed fuel in all five countries. Some natural gas is used, as well as some coal in China, and this is used for distinct uses such as fertilizer and ethylene. The suitability of certain fuel for specific (chemical) processes makes fuel substitution unlikely in this sector, or requires completely different factories. As fuel prices are rising, Foss (2007) states, few alternatives exist for high marginal cost industries that use natural gas, other than shut down (ammonia fertilizer and methanol in particular). Some industrial feedstock uses of natural gas have been, or are being, phased out in countries such as the USA and it is questionable whether investment in major new natural gas feedstock industrial capacity will be made. Large chemical and materials companies that use natural gas (and petroleum products) in process applications are searching for feedstock substitutes, often by investing in new locations.

Demand of oil products is high because certain fractions are a by-product of the refining process anyway and have no real use other than as feedstock in the chemical sector (e.g. ethane and naphtha).

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Shell Gas & Power - Public 36 Fuel demand non-energy use by fuel

0 20 40 60 80 100 120 140

mtp a L NG eq ui va le nt

Relative fuel demand non-energy use

0% 20% 40% 60% 80% 100%

Figure 13. Energy demand transport sector for a number of key markets by fuel (based on IEA data, source: IEA World Energy Balance)

1.1.2.5 Transport

In the transport sector oil products have practically a monopoly over other fuels, even though the use of other fuels is imaginable. The entire infrastructure (petrol stations, cars) is however geared up for the use of gasoline and other oil products and it is difficult for other fuels to easily match this advantage. Some natural gas is used in the transport sector, most notably in the USA; see Chapter 8 for a more elaborate discussion of the potential for natural gas demand to increase substantially in this sector. The oil product demand of this sector is also big in absolute numbers and this why oil is the leading energy source in the world. See figure 14 of present day fuel demand by the transport sector.

Fuel demand transport sector by fuel

0 100 200 300 400 500 600

mt pa L N G eq ui va le nt

Relative fuel demand transport sector

0% 20% 40% 60% 80% 100%

Figure 14. Energy demand transport sector for a number of key markets by fuel (based on IEA data, source: IEA World Energy Balance)

Gas Oil Other

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1.1.3 International fuel prices

One difference between fuels is the difference between crude and carrier fuels, which both have separate prices. Another important difference between fuel prices is the difference between the prices charged on the international markets and the prices end-user face. This section will discuss the prices of gas and oil on the (inter)national markets. Fuel prices are always noted as a monetary value per energy content, or mass, or volume. Appendix C provides a conversion table, in this study prices are most often denoted as $/MMBtu (million British Thermal Units) a notation which is customary in the gas industry.

A central concept in every discussion on international prices and price differences is the law of one price (LOOP). The LOOP states that in the presence of a competitive market and in the absence of transport costs and other barriers to trade, identical products which are sold in different markets, will sell at the same price, when expressed in terms of a common currency (Obstfeld and Rogoff, 1996). If commodities are not completely identical, the elasticities of substitution in production and/or consumption have to be high. Of course, these assumptions do not describe reality in many instances and the LOOP should therefore be considered to be describing a sort of an ideal situation. Fuels used for as energy sources are however substitutes and their price per energy unit should be expected to be related according to the LOOP, unless one of the following factors causes the LOOP to break down substantially:

• Uncompetitive market

• The substitutability of the fuels for the application in question is low • High transport costs or barriers

• Other barriers

This can help us understand why fuel prices differ when expressed in the same unit per energy unit.

1.1.3.1 Crude oil & oil products

As was discussed in section 1.1.1; crude oil and most oil products are liquid at standard temperature and pressure and are therefore easy to transport and store. This is an important reason why the crude oil and oil products markets are global and liquid, in add to the fact that there are many buyers, sellers, large spot markets and arbitrage between the markets (e.g. because of tankers which are diverted). Therefore, prices around the world for the same type of oil are correlated. Prices of different types of oil are correlated as well, since they are all produced on the basis of crude oil and because they compete for shares of refinery production. As was noted in section 1.1.1. Heavy fuel oil trades at a discount to the less popular lighter fractions.

For crude oils a number of reference prices exist, to which other oil contracts are linked. Most large production and consumption areas have an own reference price, the most important ones for the present study are:

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Shell Gas & Power - Public 38 • JCC (Japanese Crude Cocktail) – a mixture of reference prices of crude oil source

Reference prices are only useful if they are very hard to be influenced by one company or country, otherwise people would not trust them and not be willing to use them. This is why the best reference prices are those which correspond to geographic locations were sizeable physical demand and supply from a number of sources meet each other. Although crude oil prices and oil product prices at different locations around the world are correlated, they can still differ because of transportation costs and differences in composition.

1.1.3.2 Gas

In contrast to crude oil and oil products, the natural gas market cannot be considered to be liquid or to be global and there is no world price of gas, or reference price which is used throughout the world. The fact that gas is hard to transport and store, which both requires substantial investments is the main cause of this. Natural gas markets can better be considered to be regional, with the USA, the UK, continental Europe and Asia as the most important regional markets. Since a gas reference price was lacking, and partners in gas deals needed a reference price to determine the value of gas, reference price of oil products were originally used in gas contracts, which were also long term in order to justify the large investments necessary in infrastructure. Another reason for this was the fact that oil products are the best alternative fuels to gas for a number of applications and by linking the gas price to oil product prices, gas suppliers could control the competitivity of gas. See figure 15 for an example of how the gas price is chosen:

Figure 15. Market value pricing method

Later, the gas markets of the USA and the UK were liberalized and trade in gas between gas suppliers and buyers became possible and gas was traded both physically and on financial markets. This way reference prices for gas in the USA and the UK came into existence, the most important ones being:

- Henry Hub (HH) – a point in Louisiana (close to the Gulf of Mexico were a lot of gas is produced) were 13 gas pipelines are connected. HH exists since 1993.

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Shell Gas & Power - Public 39 In these two markets reference prices could now be used in gas contracting that are determined through gas-to-gas competition. Because of transport barriers these reference prices are not (yet) applicable to all gas trade in the world. Continental European gas contracts have traditionally been linked to Brent, Asian contracts to JCC. As European gas markets are being liberalized reference prices (also called hubs) are also starting on the continent (Zeebrugge in Belgium, Bunde in Germany, TTF in The Netherlands) so this market could be the next to abolish direct links to the oil price in gas contracts.

Although trade in gas across the globe is limited, being only possible through existing pipelines or LNG, gas prices do correlate as was found by a number of studies (e.g. Siliverstovs et al. 20005). The reason for this is that natural gas competes with oil products in all markets around the world and the oil products markets are liquid and global. This creates a mechanism that links the gas prices in countries over the world. The increase of the LNG industry is making the gas market more global and a future with Henry Hub as a similar world reference price for gas as Brent is for crude oil is imaginable.

1.1.3.3 Oil and gas prices

Because oil products and gas are substitutes for a large number of applications (mainly in power generation, industrial and residential demand) the LOOP suggests there should be a relation between the two prices. The utility value of a Btu of energy creates a powerful long-term linkage between oil and gas prices (Foss, 2007) finds a correlation of 0.84 between crude oil and natural gas price). Fuel substitution, short term or long term, can occur if one fuel is priced much lower than its substitute. In general, gas at Henry Hub (HH) trades at a discount to Brent, although it also sometimes (a lot) higher, in extreme winters when gas supply is short of demand. While HH and Brent have moved together for most of the last decade, there have also been periods of ‘disconnects’ especially since 2005. The reasons why natural gas traditionally trades at a discount are among others: the premium of oil products in the transport sector; the higher transport cost of natural gas to end-users (where the real competition is, not at some reference location) and strategic considerations of gas suppliers, who want to guarantee demand.

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Shell Gas & Power - Public 40 0 2 4 6 8 10 12 14 16 18 20 11/1/ 93 11/1 /94 11/1 /95 11/1/ 96 11/1 /97 11/1/ 98 11/1 /99 11/1 /00 11/1/ 01 11/1 /02 11/1/ 03 11/1 /04 11/1 /05 11/1/ 06 $/ mmb tu Brent Henry Hub

Figure 16. Historic Henry Hub and Brent prices

Even Henry Hub gas prices are thus linked to oil prices; which is caused by a number of factors on the supply and demand side:

Demand

- The potential to switch between natural gas and petroleum fuels is present at the margin, creating a band of resistance.

-

Conversions of oil-fired plants to be able to burn gas or oil/gas, often are inexpensive and can be done within a relatively short time period (Farina and Palmer, 2006).

- Oil indexation of gas contracts. Supply

- When natural gas is priced below residual fuel oil, gas producers will earn insufficient returns resulting in shuts in wellhead production (Foss 2007).

- Oil and gas are complements in production (Villar and Joutz, 2006).

- Higher oil prices increase the cost of natural gas production and development, which puts upward pressure on the gas price.

Because of gas market liberalization, increased LNG trade and declining switchable capacity in the power sector (USA: Farina and Palmer, 2006; Europe: Söderholm, 2000) and oil supply shortages there is speculation in the literature of a possible decoupling of Henry Hub and Brent prices (e.g. Panagiotidis and Rutledge, 2007). While empirical evidence for this hypothesis is so far lacking, it is definitely a possibility for the future and one that could have profound impacts on the gas and LNG industry and oil-gas competition.

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1.1.4 End-user fuel prices

End-user prices determine the choices of end-users and therefore aggregate demand. Hence, they are important for the forecasting of LNG demand, even though LNG itself is always traded at international fuel prices

The price final consumers have to pay for their fuel usage differs from the quoted international prices because of transport costs, taxes and margins of distribution companies. Again it is important to what extent the LOOP holds and whether competition and arbitrage are possible. Since oil products are easy to transport, oil products markets can be assumed to be competitive, and oil product prices to be trading at some price difference to Brent that accounts for taxes and distribution costs.

Gas is not a liquid market and hard to transport. Furthermore, not all gas markets are liberalized and therefore end-users might only have one option to buy their gas from. In liberalized gas markets such as the USA, the UK and some other European countries end-user gas prices are determined through gas-to-gas competition and prices should trade at some price difference to either HH, NBP or Brent. In regulated markets (Asian countries, as well as, some European countries) the gas companies can in principle decide themselves what to charge end-users, although they might be restricted by government regulations. Even in those markets the end-user price is often linked to some oil index, in order to guarantee demand. But this does not necessarily mean that end-user gas prices will also be at a discount to a certain oil product, when the international fuel price of gas is at a discount to the price of the particular oil product.

1.2 Energy system

Now that the relevant demand sectors and fuels of the energy market have been discussed, a short note on the system that is needed to allow this market to function. The process of getting crude oil out of the ground towards the fuelling of your car with gasoline at a petrol station, or from a natural gas field to the gas being available in your kitchen at home, is complex and requires a lot of infrastructure. This infrastructure (refineries, pipelines, gas-grid, petrol stations, and harbours) needs to be developed and this requires large investments by the government. Earlier the following three questions were stated, which determine the extent of demand, which is restrained by the equipment in place.

- Is the right equipment installed? - Is the equipment switched on?

- How much of the fuel will be consumed? Infrastructure

A second constraining factor, which has already been discussed a couple of times, is the infrastructure. Crude oil and oil products require harbours that are suitable for tankers, refineries and/or pipelines to supplies in the domestic country, or neighbouring countries. For the end-user markets petrol stations, a retail network and ships and/or tank wagons to transport the fuel. This requires substantial investment, but these will be made almost in any case because oil is so important for the transport sector. Once refineries/supply routes are in place to fuel the wagon park, other oil products can profit from the same infrastructure.

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Shell Gas & Power - Public 42 Natural gas requires a lot of investments as well. While it does not rely on refineries, it does require a gas-grid in order to transport gas to end-users. Without this infrastructure gas demand is simply not a possibility for end-users. Because the overlap between infrastructure for oil products and natural gas is small, the development of a gas market requires a lot of additional investments. Sometimes gas can use infrastructure used by oil products, for example when a gas-grid was first used to transport gasses based on some mixture of LPG.

Source of supply

The third factor in the energy system is the source of supply: are crude oil and natural gas available and how? Crude can either be supplied by domestic sources, pipelines or tankers. Natural gas can similarly be supplied by domestic supply, pipelines, or LNG tankers. When a country has abundant supplies of certain fuels this can have a big influence on the choices it makes in the development of its energy system. Sources of supply compete with one another to be able to fulfil certain demand. LNG does therefore not only compete with oil products but also with pipeline gas and domestic supply. Sources of supply may be limited or restricted because of geographic, political or economic reasons.

A number of factors have an impact on the choices a country makes for its energy system, which have consequences for the energy market in that country, such as the available technology, fuel prices, regulations and political considerations. One factor that has a very profound impact is discussed in more detail and this is the stage of development of a country.

1.2.1 Stages of development

In the media there is a lot of talking about developed and undeveloped countries and everyone can see there is a difference in energy system and market between an undeveloped tribe, whose members burn wood for heating, and a society which is able to construct a nuclear plant. Moving beyond such stereotypes there are two effects of the stage of development of a country:

- Size effect

- Composition effect

1.2.1.1 The size effect: the S-curve

As countries become more developed they start to use more energy, for one because their national production (GDP) increases, and second because with higher income levels people are living more luxury lives. This is not a linear relationship however, but follows an S-shaped pattern as depicted in figure . As countries undergo a gradual switch from agriculture to industry, each unit of extra income produced requires more energy, as it is the result of more energy intensive processes. However, energy demand eventually slows down as countries diversify their economy into non-industrial sectors, and as technology allows them to find more efficient equipment.

Oil – gas competition

Oil – gas competition

Understanding of inter-fuel substitution in key LNG markets

Groningen, August 2007

Oil – gas competition

Understanding of inter-fuel substitution in key LNG markets

Groningen, August 2007

This study has been carried out for Shell Gas & Power and its contents are confidential.

The author is responsible for the contents of this report and holds the copyright.

Executive summary

Preface

Contents

Table of contents

Introduction

Overview of the report

Part I: Background

1. The energy market

1.1 Energy market

1.1.1

Fuels

1.1.1.1 Crude oil & oil products

1.1.1.2 Natural gas

1.1.1.3 Oil products compared to natural gas

1.1.2

Demand sectors

1.1.2.1 Power

1.1.2.2 Industry

1.1.2.3 Residential

1.1.2.4 Non-energy use

1.1.2.5 Transport

1.1.3

International fuel prices

1.1.3.1 Crude oil & oil products

1.1.3.2 Gas

1.1.3.3 Oil and gas prices

-

1.1.4

End-user fuel prices

1.2 Energy system

1.2.1

Stages of development

1.2.1.1 The size effect: the S-curve