Business as usual for UK gas despite Rough?
November 2017 | Abhinav Charan, Giovanni Bruni, Peter Lambert
The announcement of the permanent cessation of storage operations at Rough by Centrica (June 2017) comes at a time marked by declining gas production in the UK continental shelf, a global LNG market that is becoming long, and Brexit Britain reassessing its trading equation with Europe.
The decision to close down Rough will wipe out nearly 70% of the United Kingdom’s natural gas storage capacity, which has played a critical role in ensuring the security of supply particularly since the UK became a net gas importer in 2004. Rough’s closure further challenges the UK gas market, which has historically maintained one of the lowest levels of storage capacity (as % of total demand) in NW Europe.
Given this situation, a few broad implications emerge:
1. Storage has played a decreasing role in recent years
According to the National Grid, storage supplied only 6% of the gas demand in the most recent winter (2016-17) and, in particular, Rough contributed an average of 5 mcm/day, with a maximum of 23 mcm/day, approximately half of what it had contributed in previous years (see Exhibit 1). Overall, storage has played a limited role in terms of supply but has certainly provided flexibility to the market.
The closure of Rough will eliminate the only seasonal or long-range supply available to the UK. The slack will be taken by other flexible sources including LNG or interconnectors with mainland Europe.
Exhibit 1: On average, storage has contributed less than a tenth of the UK gas supply over the last five winters
2. Going forward, a tightening market balance and increased volatility
Reduced supply capacity and an increase in peak demand are expected to tighten the market balance and increase volatility. Based on the National Grid’s ‘No progression’ case, the UK would face a reduction in supply driven by declining production from the UK continental shelf (see Exhibit 2). Layering on the loss of Rough would further cut down deliverability and eliminate more than two thirds of the UK’s gas storage working capacity.
In line with the McKinsey Energy Insights’ Global Gas Model, overall gas demand in the UK is set to gradually decline over the next decade. However, the UK is likely to experience increased peak gas demand, driven by the change in energy mix as gas compensates for the phasing-out of coal-fired generation and for supporting intermittency inherent to renewables. The need for gas could get more pronounced on non-windy, gloomy days, leading to peaking gas demand.
Exhibit 2: Without Rough, the UK’s peak supply/demand balance could tighten over the next decade
Without Rough, the UK stands to lose 3.3 bcm of working capacity (~70% of UK storage capacity) and ~41 mcm/day of deliverability (25% of UK storage deliverability). Peak gas supply capacity utilization could rise from ~50% today to over 80%, increasing reliance on import facilities (LNG terminals and interconnectors). This could prove problematic as LNG markets are expected to retighten in the mid-2020s and usage rules for the Interconnector (IUK) and Balgzand Bacton Line (BBL) pipelines could face renegotiation from the EU to meet future energy needs.
3. No investment in new long-range storage while fast cycle assets may benefit from volatility
Despite the expected market tightening, investment in new long-range storage is not viable in the near to medium term. As evidenced by past data at Centrica Storage (Rough) (see Exhibit 3), higher profits have been recorded at higher spreads. The recent decline in profitability is directly linked to spreads lower than or equal to $1 per MMBtu in 2015 and 2016. The outlook for the next two cycles (2017/18, 2o18/19) remains bleak with forward spreads of $1.1-1.2 per MMBtu.
Based on a hypothetical 500 mcm long-range storage facility, a spread in the range of at least $2.0-$2.6 per MMBtu would be required to break even. For an investor seeking returns over a 20-year horizon, the actual spread would need to be consistently high at least in the next few years to quickly pay for the upfront capex. However, the likelihood of lower spreads in the near future and the uncertainty associated with long-term energy markets serve to weaken the case for an investment at this stage.
Exhibit 3: Spreads and profitability of storage assets show strong correlation
If anything, the remaining UK storage assets should profit from Rough’s closure. While the slower cycle assets will seek to provide seasonal flexibility, the faster cycle assets could leverage intraday volatility and flexible deliverability to their advantage. According to Ofgem (Britain’s electricity and downstream gas regulator), the price volatility of gas by month (for day-ahead contracts) has been in decline over the last decade, but had already restarted increasing at the end of Q3 2016 (see Exhibit 4). Without Rough, further structural volatility could be expected, particularly in the winter months. Flexible and fast cycle storage assets could emerge as the winners of the Rough story.
Exhibit 4: Volatility of day-ahead gas price has been generally decreasing in recent years
 About 6% of total UK gas demand. Storage covers more than 20% of demand in Germany, France, and Italy.
About the authors
Abhinav Charan is a Specialist in McKinsey Energy Insights' Kuala Lumpur office, Giovanni Bruni is an Associate Partner in McKinsey Energy Insights' Singapore office and Peter Lambert is a Practice Senior Expert in McKinsey's Sydney office.