Slide in gas storage margins set to continue

July 2017 | Pietro Dalpane


Narrowing seasonal price spreads have been putting gas storage holders exposed to spot prices across Western Europe under considerable pressure, and there appears to be little sign of improvement anytime soon.

Both European seasonal and daily gas price spreads have been shrinking significantly in recent years. The summer-winter differential at the NBP sank from $8.6/mmbtu in 2005 to $0.9/mmbtu in 2015, while daily price volatility dropped from $0.6/mmbtu to $0.1/mmbtu (exhibit 1).

If there is an insufficient price differential between summer and winter, then there may not be enough incentive to store gas. Similarly, if a day’s peak power is not much more expensive than off-peak, then there is not much point in drawing on gas stocks to generate gas-fired power during peak hours.

This has led the average price of storage to fall sharply, as illustrated by prices obtained in the Netherlands’ capacity auctions, which fell from EUR7/MWh in 2012 to less than EUR3/MWh in 2016. Similar auctions in the Czech Republic also saw sharp falls. These capacity prices represent the market’s willingness to pay for standard flexible capacity but, for some storage operators, they are well below long-run marginal breakeven costs - as depicted by the average published and regulated tariffs. Despite varying by type of storage, location, and regulatory regime, these tariffs offer a good benchmark for what the ‘typical’ market price should be to cover investment costs.


Exhibit 1: In line with auction prices, both seasonal and daily price spreads have been shrinking significantly in recent years


Source: Timera Energy, Bloomberg, McKinsey Energy Insights

The depressed market environment is creating challenging times for the industry, and storage operators not covered by long-term agreements or regulated tariffs are reacting by taking action on three main fronts.

  • Firstly, there has been an increased push for a regulatory framework to cater for gas storage tariffs. Such a framework would still enable the auctioning of storage capacity at the start of the year, but storage holders would receive additional payments from governments if the auction payments did not cover their costs.
  • Secondly, companies have been closing down capacity. Such closures have included unprofitable capacity owned by major utilities in the UK and the Netherlands, and some further sales and closures are expected in the upcoming years.
  • Finally, storage holders have been stressing their strategic value with proposals that storage volumes could be allocated to a collective EU strategic reserve with regulated prices for its use. This would mean some financial recognition for the role storage plays in the security of energy supply.

It is important to highlight that while the prime function of gas storage has historically been to provide a strategic reserve, in recent years this role has partially shifted. Through its unrivaled response time, improved over time by an increasingly larger share of salt cavities as opposed to a traditional oil- and gas-depleted field, gas storage has increasingly supplied the market with short-term responsiveness to supply and demand fluctuations, providing considerable liquidity. Should the challenging environment persist - forcing operators to close their assets - the enhanced market liquidity might, in turn, deteriorate. This ability to provide liquidity, if adequately recognized by the market, could infuse hope in the challenging environment storage operators are currently facing.

Past and future drivers

Many of the drivers that will affect the European gas storage market are expected to have a neutral or negative impact in the short- to medium term, making a market upturn unlikely.

1. Gas demand

The first of these drivers is European seasonal gas consumption, which is expected to remain relatively stable over the next few years - in contrast to the decline in demand of ~20-25% since 2010. This contraction in demand took place largely among residential power consumers and was a major driver in the shrinking price spreads. The anticipated demand stability going forward – overall across Western Europe, even though some countries are expected to experience different trends - could provide some relief to the margins of storage operators.

2. Groningen’s critical role

The Netherlands’ giant Groningen gas field has been highly beneficial to Dutch storage operators over the last few years as its output has been severely cut. Productions caps are expected to remain and overall Dutch gas production is generally forecast to decline between 2% and 4% p.a. over the next 10 years.


Exhibit 2: Groningen’s flexible capacity had remained steady before reduction measures were implemented in 2014/15


Source: Bloomberg, NAM, ICIS, McKinsey Energy Insights

Beginning in 2014/15, Groningen - which is Europe’s biggest gas field and a significant swing producer - had its output constrained dramatically in an attempt to address rising extraction-related earth tremors in the more mature areas of the field, which began producing in 1952. Up until then, the field had acted to absorb surges in winter demand, but this is no longer possible with output now capped at 24 bcm – less than half the level it was in 2013 (Figure 2).

This output cap has been advantageous for seasonal spreads and storage rates but has so far been outweighed by other factors. Up until now, the lower output has not been tested by any lengthy extreme cold, although this last winter did provide a reasonably tough challenge – leading to a welcome, if temporary, respite for storage margins.

After being lowered to 26 bcm, the limit was confirmed at 24 bcm until 2021 in January this year and then further curtailed in April to 21.6 bcm for 12 months, starting October 2017.

3. LNG link to global market

LNG provides Europe with a connection to the global gas market, which is growing in size and liquidity. The LNG market tightness at the beginning of the decade was partly favorable to European storage margins. Significant volumes were re-directed east away from Europe during the winters of the years following the Fukushima disaster, which helped widen seasonal spreads between the European and Asia basins, putting moderate upward pressure on storage rates . However, this has now disappeared.

Over the next 6-8 years, the LNG market will experience a supply overhang, recently deepened by Qatar’s decision to add 23 mtpa of export capacity from its North Field. Such abundance of LNG is expected to reduce the likelihood of a wide price spread between the two basins. Ample supply to the Asian market means the arbitrage from Europe is not expected to open again for some time, keeping cargoes in the Atlantic basin.

Europe has large volumes of surplus LNG import and regasification capacity, which could be used to both import and store gas for the peak winter demand periods, so the continent will have little trouble accommodating any additional arrivals.

This new supply of LNG may add downward pressure on seasonal spreads and storage margins over the next few years, as storage holders are forced to compete with LNG landed prices for market share.

4. Piped import developments

There has also been some downward pressure on storage margins as buyers have gained greater contract flexibility from Russia over the last two or three years, including a move away from crude-based pricing and toward European gas benchmark links, and, in some cases, a reduction of take-or-pay levels. Further downward pressure on storage margins will depend on the degree of contract flexibility achieved by buyers and the availability of spare winter pipeline capacity from Russia to Europe – which will be strongly impacted by the expiry of transit contracts through Ukraine in 2019, as well as the timing of the Nord Stream II and Turkish Stream I developments.

5. Infrastructure developments

Additional storage capacity over recent years has been growing by about 2% per year between 2011 and 2015. Under-construction and planned projects show potential for a similar growth over the next years, slowed down by the recent closure of the Rough storage facility in the UK. Rough, which accounts for 70% of UK storage capacity, is an aging asset which has outlasted its original design life of 25 years. Safety concerns about the integrity of wells prompted Centrica to impose limits last year on working gas volume as well as injection rates. The company subsequently announced in February that because of well testing the site would not be available for gas injection until July 1st at the earliest. This has finally led, in June 2017, to the decision to permanently close the facility, deemed too unsafe and uneconomic to reopen.

Storage margins’ worst enemy is interconnectivity, as shortages are more easily covered given a wider range of options. Infrastructure interconnectivity grew by 3% between 2010 and 2015, partly fueled by the EU initiative to incentivize a selected list of Projects of Common Interest (PCI). About 70 projects are expected to be commissioned over the next 7 years mainly in Central and South-East Europe, propelled by a lasting effort toward security of supply (Exhibit 3).


Exhibit 3: The EU is committed to bring ~70 interconnection projects online by 2023 and is expected to keep enhancing security of supply


Source: EU website, Press, McKinsey Energy Insights

Conclusion

In summary, gas storage remains a fundamental element to the gas market. Despite partially shifting its function from strategic reserve to enabler of short-term market liquidity, it has played a crucial role to the stability and efficiency of the gas market. However, the economics of existing storage assets not shielded by regulation or long-term contracts has significantly deteriorated in recent years, driven by severe margin erosion. Over the upcoming years, there are many uncertainties about the drivers that will shape the impact on storage economics, with the likelihood that asset holders might need to prepare for potentially further tough times ahead. Continued efforts to increase security of supply (if not targeted to strategic storage) will likely work against margins – unless public money is allocated to shield commercial storage returns. Some relief is expected to stem from a recovery of gas penetration in the power sector and a decline in Groningen’s gas production (in particular in its swing capacity). However, at the same time, storage capacity has the potential to continue its growth at a steady pace and so imports via LNG, which, alongside their corresponding impact on storage economics, will continue to depend on the uncertainty surrounding the EU-Asia gas price arbitrage.

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About the authors

Pietro Dalpane is a senior analyst in McKinsey's London office.

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