In the second and final article in this two-part series on global trends that are set to shape the future of energy, we examine 3) Crude Oil’s Shale Revolution, 4) Global Natural Gas and, finally, 5) Global Power Trends. Analysis of these trends will provide useful information and guidance to consider as you try to navigate your way through the decision-making process related to energy demand, supply, and sustainability. 3) CRUDE OIL'S SHALE REVOLUTION Why the US oil shale revolution is a big deal...except for the consumer In 2005 the US was importing 60% of its oil needs. US oil production had been in structural decline since the late 1980s, leaving the country not only highly reliant upon supplies from neighbours Canada and Mexico, but also from countries such as Venezuela, Nigeria, Russia, and Saudi Arabia. But the US has experienced a remarkable turnaround in its energy fortunes in the past few years. Hydraulic fracturing and onshore shale plays have turned the domestic natural gas market on its head, and now a similar scenario is underway in the domestic oil market. The most recent statistics are startling. US crude production grew 14.6% in 2012, achieving the highest year-on-year increase since 1995. The start of 2013 has seen production break above seven million barrels per day to reach a 20-year high. Even more remarkably, exponential growth is being seen from just a few shale plays, with a number more yet to reveal their full potential. [login type="readmore"] Of the shale plays currently ramping up, production is surpassing even the most bullish of expectations. The original US shale play is the Bakken shale in North Dakota, which saw production increase 58% in 2012 versus the prior year to average 769,000 barrels per day. Meanwhile, the ramp-up of output in the Permian and Western Gulf Basins has led oil production for the state of Texas to double in the last three years, reversing a downward trend which had been in place for the past 23 years. According to the International Energy Agency (IEA), this trend of increasing domestic output is only set to continue. The agency predicts imports will drop to about four million barrels per day in a decade from the current average of 10 million barrels per day. This drop will not only be due to increasing production in the US, but also due to higher fuel-efficiency standards for vehicles. In fact, the IEA projects total US liquids production (includes crude and natural gas liquids) will surpass that of Saudi Arabia by 2020 to reach 11.1 million barrels per day. This will mean that the world’s largest fuel consumer will become the world’s largest producer. Given this domestic backdrop, there is a presumption that growing domestic production will lead to lower fuel costs in the US, as has been the case with natural gas. Unfortunately, this is unlikely to be the case. Whereas natural gas is priced domestically given the lack of ability to export, gasoline and diesel prices are much more dictated by the input price of crude oil, which is driven to a large part by global, not domestic, fundamentals. If the global dynamics reflected the dynamics of the US domestic market, this presumption might hold true. The reality is that demand in developed countries such as the US is currently declining, and is set to flat-line over the coming years and decades due to increasing efficiencies and declining energy intensity as the economy shows less of a focus on manufacturing. Meanwhile, global oil demand growth is set to rise at a rapid clip, driven on by emerging market demand. So while the US will see distinct benefits from rising domestic production in the form of greater energy independence, benefits at the pump seem a much less likely scenario. What does it mean to you? Global oil markets will still dictate the prices, even as production of oil from shale grows in the US. The challenge of understanding global crude markets fundamentals combined with global crude products markets fundamentals is immense. Throw in the influence of complicated geopolitics, and the challenge of keeping up with and understanding how crude and product prices will evolve, becomes time and cost-prohibitive for companies whose core business is not forecasting energy markets. The common presumption that the US shale oil boom should reduce gasoline and diesel prices in the US is a great example of how counterintuitive these markets can be without in-depth research to drive conclusions and actions. 4) GLOBAL NATURAL GAS How price divergences are bringing the world together It is almost incredulous to consider that US natural gas prices were seven times higher in the summer of 2008 than they were in the spring of 2012. A lot has happened in recent years, but there is only one main reason for such a sea change in the dynamics of the US natural gas market – shale. After achieving a high of $13.60/MMbtu in the summer of 2008, prices experienced a cataclysmic fall for the rest of the year as the global recession took hold. But even as other commodities such as oil started to rebound from their lows in 2009 as demand - and hence a sense of balance - returned to these markets, US natural gas prices were unable to halt the bleeding. This was because the market fundamentals for US natural gas had been turned on their head, as domestic production continued to ramp up even as prices fell, causing a massive supply glut. The game-changer was shale, as emerging unconventional plays required much lower breakeven prices than those seen by their conventional counterparts. This was largely due to increased efficiencies involved such as horizontal drilling combined with hydraulic fracturing. The supply glut was then further exacerbated by the emergence of oil-bearing shale plays in the past few years. Despite focus on the much more profitable commodity of oil, associated natural gas was still produced in sizeable volume, and essentially produced for free because oil was the primary focus. US domestic production has relentlessly ramped up in recent years, and remains near record levels. Given this backdrop of cheap and abundant supply, it is no surprise that US natural gas prices have averaged below $4/MMbtu since the beginning of 2009. On the other side of the world, just as stark a shift in market dynamics can be seen in Asian natural gas prices, but in an opposing manner to that of the US. Prior to the Fukushima Daiichi nuclear disaster of March 2011, Japan relied upon nuclear reactors to meet 30% of its electricity needs. However, in the aftermath of the tragedy the country took all 54 nuclear reactors offline. This left a gaping hole in Japan’s energy requirements, and one which natural gas was immediately relied upon to help fill. Just a glance at the chart on the page below highlights the divergence in Japanese prices from their global counterparts due to the immediate demand response following the Fukushima disaster, with prices accordingly propelled higher. Although the first few nuclear reactors are starting to return to service, increased reliance on natural gas will be an ongoing trend for the foreseeable future. Finally, the European natural gas market has continued to see prices moving broadly in sympathy with oil, as a good deal of Europe’s natural gas contracts are still tied to oil-indexed pricing. So while US prices continued to be suppressed by increasing supply in 2009, European natural gas prices rose in tandem with oil. We are starting to see a material shift in this purchasing behaviour, however, as an increasing number of buyers are making purchases on liberalised hubs, which are dictated by gas-specific fundamentals (though still influenced by oil price movements). Given the backdrop of falling supply from the North Sea, an increasing reliance on imports, and elevated oil prices, UK and European natural gas prices have remained far more elevated in recent times than the weaker demand-side fundamentals would lead us to expect. Despite the fact that Asia, the US, and Europe are seeing distinctly different pricing environments given their contrasting regional fundamentals, it is these price divergences which are accelerating the natural gas market to become more global. And these markets are set to be inextricably more closely linked in the coming years due to the expansion of the global LNG market. The US is set to have an increasing impact on the global market in coming years, as LNG exports will be a viable option from the US by 2016. Arguably the largest interest in long- term contracts with potential US LNG exporters has come from Japan, as the country seeks long-term stability and diversification in its energy flows. The UK, and ergo European prices, meanwhile, will likely not only benefit from having a new prospective supplier, but also from having additional supply available in the global market. Ultimately, the development of LNG exports will help to lower the cost of natural gas on a global scale, though could push domestic prices higher for newer exporting nations such as the US. What does it mean to you? As the global LNG market grows in the coming years, price environments can shift dramatically, contract structures may change, and new opportunities may arise. Indeed, the increasingly interdepending natural gas markets will introduce new complexities to natural gas markets everywhere. Thinking several years ahead of the curve as to how the global arbitrage may bring global prices and markets together may prevent missed opportunities for end-users. 5) GLOBAL POWER TRENDS The inherent volatile nature of power markets will remain, despite the changing generation mix Energy prices have a long tradition of being more volatile than most other commodities or traded financial products. Near-term prices are more volatile than forward contracts, while day ahead electric power prices are among the most volatile of all energy prices. Indeed, day-ahead Germany power prices are more than three times more volatile than day-ahead UK gas prices. When markets experience real-time supply shortfalls, inventories of a commodity are called upon to make up the difference. For example, in many natural gas markets around the world, winter consumption cannot be met by daily production and imports, so supplies are drawn from storage facilities to meet demand. This helps to stabilise prices by effectively eliminating the shortfall. The same philosophy can be applied for shorter-term, rather than seasonal, spikes in demand – inventories are a supply cushion and can mitigate some of the price volatility. Unlike coal, natural gas, oil products, and many agricultural commodities, electric power cannot be stored in commercial quantities. This provides a distinct market differentiation for power relative to other commodities. If supply is to meet the demand in a power market, generation (supply) capacity must be at least as great as the volume of demand at its peak. Given the extreme volatility exhibited in electricity consumption, generation capacity needs to be much greater than the average demand load across a year. This is much different to a market such as natural gas, where a supply cushion is provided by the ability to store gas for times of higher demand. Supply capacity for natural gas, excluding storage, can therefore fall short of peak demand. This, in turn, means electricity grids need to manage the level of demand, which plays into how physical supply contracts can be structured for industrial and commercial users. Interruptible supply contracts may provide price advantages to industrial and commercial users that can reduce or even eliminate electricity consumption on short notice. This also creates additional regulatory involvement regarding supply and demand relative to other commodities; one form of additional regulation is that of the required capacity margin – a mandated cushion of generation capacity beyond the expected peak demand. But perhaps most strikingly, this lack of storage capability creates extreme fluctuations in price, as real-time supply shortages are directly reflected in the market price. This price volatility can wreak havoc on a financial budget. As demand for electric power grows, it becomes essential for generation capacity to increase. In 2010, the year for which the most recent data is available, world generation capacity had grown 23% in the preceding five years. Of these capacity additions, 34% were renewable sources of electric power (wind, solar, et cetera). A recent study by Schneider Electric Professional Services’ Global Research & Analytics team analysed the positive relationship in power markets with higher proportions of the generation mix coming from renewables and the greater volatility in those markets. As renewable generation capacity and utilisation grows in global power markets, we are likely to see increasing volatility in electric power prices, with Germany – as a leader in renewable generation – providing an example now of how the future will look. What does it mean to you? These market characteristics create risks and opportunities for end-users, which can be managed actively. By sourcing strategically, physical supply contracts can be chosen based on key factors such as pricing, contract terms, product structures, credit conditions, all of which can contribute to the ability to reduce the price risk and volatility. In markets where possible, employing a dynamic hedging strategy can also mitigate exposure to price spikes and help to ensure financial plans are met. Gathering stakeholders to put a strategy in place, guided by research and forecasts for market dynamics is key to managing the exposure to extremely volatile power prices. To read Schneider Electric Professional Services’ White Paper predicting the energy dilemmas of the future, click here.