INSIGHT

MARCH, 2020

What does the Oil Price fall

mean for the Gas Market?
What does the Oil Price fall mean for the Gas Market?

On 9th March, Brent fell 30% and has seen continued volatility in the following 24 hours sending a shockwave through the
global energy markets. With the gas market already depressed and underutilization of supply projects a reality, what impact will
this oil price fall have on the gas market? Our LNG short term trade & price outlook will be published on 12 March and will
address how the global gas market will balance through the remainder of this year. But what can we learn from previous oil price
shocks on longer term implications and what is different this time for the gas market?

Following on destructive impacts from the coronavirus, this oil price fall has created a lot of bearish sentiment across markets
globally. However, the impact on the gas market is a bit more mixed. In the short term, with European prices already at
$3/mmbtu and US LNG already on the margin, it feels as if gas prices have already reached a floor.

In a case where the oil price remains low, the full impact will not be felt in the gas market until 2021 when reduced US oil drilling
impacts gas associated with oil production and the lagged impact of the oil price drop feeds through into gas contract pricing in
Asia and Europe. Low oil prices have a mixed impact on regional markets, depending on market structure and competing fuels.
In some places lower contract prices are needed to compete with coal, but in others, gas competes directly with oil.

The price drop will result in developers postponing major new investments with long term implications. Expectations between
buyers and suppliers will need to be reset – ultimately delaying new supply currently scheduled for the middle of the next
decade.

Downside risk to associated US gas supply…

In the short term, the biggest downside risk for gas supply is to associated gas production – largely from unconventionals in the
US. However, it’s not an instantaneous effect as prices are still generally above variable wellhead operating costs. Wood
Mackenzie’s Genscape estimates US gas production would be down by almost 0.9 bcfd by end of 2020 compared to estimates
based on prices from Friday, before the oil price fell. This is exacerbated though in 2021 though, with more flexibility in drilling
reductions, and Genscape estimates end of 2021 production could be 3.1 bcfd lower than pre-crash forecasts at 90.5 bcfd.
Associated gas production from the Permian would account for less than 0.2 bcfd and 0.8 bcfd of the reductions for the end of
2020 and 2021, respectively. Ironically, low oil prices are bullish for US gas prices and US gas producer equity valuations. On 9
March, prompt April NYMEX Henry Hub was initially priced down to its prior March 2016 low of $1.61/mmbtu before rallying. By
market close it was up nearly 6% and many gas-focused corporates, already facing financial challenges, actually saw their stock
rebound as much as 20% on the day.

…but the supply impact elsewhere will be more muted

The majority of global LNG projects are mainly supplied from non associated gas and we are expecting little direct impact on
LNG supply in the short to medium term. Some medium-term decisions to continue drilling new wells at lower prices may come
under more scrutiny, for example Australian coal seam gas (CSG) producers that sell LNG on an oil-indexed basis may look to
postpone drilling at lower prices, as wells become marginal and developers like Santos and Origin look to conserve capex.

Elsewhere, low oil prices present risk for deferred investments. In Brazil, this could be deferred sanctions to pre-salt oil fields
that would bring associated gas into the domestic market. Nigeria and Algeria, both major gas exporters, are reliant on high oil
prices to fund government expenditure, and will come under fiscal pressure.They will need to weather the storm which could
delay investment.

Investments in new supply will be subject to more scrutiny

The greater risk to supply is on pre-FID investments. Record LNG supply investments last year and plunging LNG spot prices
this year were already testing the appetite of LNG project developers to sanction new LNG projects in 2020. But the drop in oil
price will make these decisions more complicated. While the oil price today is not relevant to the economic viability of pre-FID
projects, lower oil prices will have several consequences:

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What does the Oil Price fall mean for the Gas Market?

• Capital investment will be restricted by companies that have exposure to oil prices – either via oil production or via LNG
contracts linked to oil.

• Shareholders and financers will be more nervous about LNG investments linked to oil prices

• US LNG will become less competitive versus oil indexed LNG

• Projects where sponsors are planning asset sales ahead of FID will be hesitant to proceed with a sale in this environment.

As a result, there will be fewer LNG projects taking FID in 2020 and 2021. Projects in Mozambique, Mauritania/Senegal and
Australasia will come under pressure. This is likely to translate into lower global supply between 2024 and 2027. We will focus
more on exactly which LNG projects get pushed back in our pre-FID LNG supply tracker which we will release next week.
However, we see limited scope for post-FID projects to change their investment plans in this environment and we expect these
projects to continue to push hard to meet construction timelines to ensure positive cashflow as soon as possible.

The biggest uncertainty for long term LNG supply is how Qatar will react. Qatar is planning to sanction its six mega-train North
Field expansion project this year. With low cash flow breakevens and an ambition to grow LNG market share long term, it is
likely to see little reason to change its plans in this environment. It may also be eyeing the opportunity for lower costs. But
despite lower oil prices we see limited scope for LNG projects to decrease LNG plant costs in this environment due to ongoing
pressure on the LNG EPC sector.

Regional gas markets will respond differently

Global gas demand is already under severe pressure in 2020 as the coronavirus outbreak initially curtailed gas consumption in
China, and continued downside is expected in Asia Pacific and elsewhere as the world looks to contain the spread of the virus.

Low oil prices have a mixed impact on regional markets, depending on market structure and competing fuels. The fall in oil
prices this week will start to impact long term contract pricing from 2021. A sustained lower oil price brings lower LNG contract
prices in Asia, which have been at a premium to hub priced gas in recent times.

In markets where the price is set by the weighted average cost of gas (WACOG), such as Japan and South Korea, lower prices
for oil-indexed purchases should support coal-to-gas switching economics in the power sector. The South Korean market has
already seen some coal-to-gas switching in recent months due to escalation of seasonal coal curtailment power policy and
amongst independent, non-KOGAS buyers who have benefited from tumbling LNG spot prices.

For most power generators however, coal-to-gas switching economics remained challenged due a sustained high WACOG price
– the price at which most of the utilities must procure their gas from KOGAS. Legacy, long-term contract volumes indexed at
14% of JCC or higher currently dominate the KOGAS supply mix. As a result, WACOG sat around $10-12/mmbtu for much of
2019, above market spot prices and significantly above coal. With the dramatic fall in oil price to $35 however, WACOG prices
are set to fall by around half over the next 3 to 6 months, given contract lags. This should bolster coal-to-gas switching
economics and the case for further pro-gas environmental policy decisions, but competition from coal will remain intense.

For China, at an oil price of $35/bbl, contracted LNG arrives at a cost lower than domestic wholesale price benchmarks. While
there is strong incentive for NOCs to retain the benefits to compensate for years of import losses, the import cost reduction will
be partially passed through to downstream, and will allow the government to push through its policy of lowering gas prices to
end users. This will help coronavirus-affected business to resume operations, but stimulating new coal-to-gas switching will
require further policy support even under a low oil price environment.

But in other markets, gas demand will come under pressure from oil as a competing fuel. Notably in India, a lower oil price could
slow the shift from oil to gas in the industrial sector, as both long and spot LNG prices will compete with fuels like heating oil,

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What does the Oil Price fall mean for the Gas Market?

LPG and naphtha. In addition, the current slowdown in refined products demand is leading to stockpile. Oil marketing
companies are beginning to reduce their marketing margins and selling products at heavy discounts – leading to a downside risk
on the overall utilization of recently procured spot LNG cargoes in the short term. With huge competition from other fuels, either
strong policy push or ban on liquid fuels can safeguard LNG demand growth. More broadly, we also expect to see a slower pace
of fuel switching (from oil to gas) in LNG frontier areas such as the Caribbean and Central America.

European gas demand and flows will face little impact from even a sustained oil price collapse. Oil-indexed Russian pipeline
contracts now account for less than 25% of Gazprom’s portfolio and, regardless, the current market share strategy is unlikely to
change. Algerian pipeline contracts into Spain remain fully oil-indexed and have been sitting at take-or-pay levels. If oil prices
remain low, Spanish buyers would take more Algerian piped volumes. This would not become a possibility until October 2020
due to the lag on the contract but in 2021 it would reduce the space for LNG into Spain by 2 bcm, placing even more pressure
on the oversupplied LNG market.

In the US, we expect to see downside to industrial demand, the sector with the most domestic demand growth in the long term.
Much of this growth has been underpinned by petrochemical plants, and as margins shrink from the downstream polyethylene
market, we are watching for delay to the start-up of these new plants.

A contraction in contracting?
As in Europe, changes to oil price will impact how buyers in Asia think about short and long term LNG procurement. In previous
extreme price events, we have seen changes in LNG contracting behavior. After 2014/15 when oil prices last dipped buyer
preferences changed from Henry Hub indexation and back to oil-indexation, but with shorter contract terms.

Prolonged low oil prices will bring oil indexed contract prices more in line with spot prices. Although at $35/bbl, a traditional
Asian oil indexed contract price is $5.6/mmbtu (at 14.5% + a constant of 0.5/mmbtu) still significantly higher than current Asian
LNG spot prices at $3.1/mmbtu. Greater alignment between spot and contract prices will reduce pressure on existing contract
price re-openers. It may also encourage some buyers to refocus on oil-indexed LNG deals again, although given current market
uncertainty and coronavirus travel restrictions, the more likely outcome is prolonged negotiations on new LNG contracts.

What does this mean for gas’s role in the fuel mix?
More of the same in Europe and North America?
The energy transition is underway and this shock in the oil market will no doubt have policy makers reviewing how future energy
needs should be met. On a very simplistic basis, fossil fuels compete with renewables and this oil price drop will make fossil
fuels more cost competitive. But volatility in the commodity markets may encourage some regulators to diversify away from oil
and gas more rapidly. The reality is different markets will respond in different ways, with each considering how to get the right
balance of clean, low cost and secure energy supplies. Europe is already pushing forward with the ‘European Green Deal’ and
we do not see that being derailed by changes in commodity price outlooks. Similarly, in the US, the energy transition is led more
by economics and a lower oil price will curtail both oil and gas production.

An opportunity for governments to clean up their air?

In Asia, however, a lower oil price is expected to benefit Asia gas demand. While in general coal will remain cheaper than gas,
lower oil price-indexed gas will support coal-to-gas switching. Although price alone is not sufficient to guarantee gas demand
creation, lower gas/LNG prices will cement the existing pro-gas policies and favors further pro-gas decisions. A sustained lower
gas price environment will potentially facilitate gas sector reforms that many Asian markets planned but have been hindered by
affordability concerns. Effective reforms would in turn incentivise gas infrastructure investment and long-term gas demand
creation. Oil-to-gas switching is part of the story, but it is really coal-to-gas switching and overall energy demand that set the
trajectory of Asian gas demand. Having said that, the volatility in oil prices, and concerns around geopolitical stability from fossil

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What does the Oil Price fall mean for the Gas Market?

fuel supply sources may prompt Asian policymakers to re-assess energy security, leading to adopt a faster and more dramatic
shift away from fossil fuels.

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