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Gas pricing - an incentive to oil companies.

Oil E&P companies live with the risks and rewards of their business. With our industry forecast through the decade of High Sulphur Fuel Oil there is a real prospect that a well-head gas price with a 66 per cent HSFO base price and HSFO indexation will be at best utility and quite probably loss making for producers. The effect of this will be to exacerbate the problems that now face Pakistan in developing its natural gas industry and increase its dependency on imported petroleum supplies. Natural gas development depends on the government policy.

World proven reserves of oil, at 1990, are quoted as 1,009 billion barrels and proven world gas reserves of 120 trillion cubic metres (798 billion barrels equivalent). The equivalence in energy terms of these two fossil fuels reserves is only recently being redressed in terms of the new significance placed on international gas exploration. The Gulf War highlighted for Pakistan, not for the first time, the strategic value of developing its primary, indigenous sources of energy of which natural gas has been the poor relative.

Now the worth of natural gas as the optimum primary energy form of the 21st century promotes natural gas to the top position of any nation's energy portfolio; a position not perceived for gas until recently. This need has been tracked by exploration companies who seek to respond to this changed perception through the correct level of incentive to find and produce natural gas. How can this perception be changed to realization in Pakistan? I would like to address the four following questions in answering that today:- (i) Why should Pakistan change (ii) What is currently wrong with well-head

gas pricing? (iii) What has evolved and promoted

natural gas? (iv) How can well-head gas pricing be put

right to stimulate natural gas


Why should Pakistan change?

Firstly the economic benefits could be very significant. A recent World Bank report' quoting energy import data for various countries in 1987 attributed the worth of energy imports to Pakistan as US $1.78 billion, of which the majority were oil, in energy terms this equates to a 400 BCF gas field consumed each year. Sceptics would say this substitution was not feasible but as a target to aim at this is a worthwhile objective.

The growth in demand for energy in Pakistan is substantial; natural gas alone in its traditional uses has a potential demand growth of 7 per cent per annum. If advantage is taken of the enhanced performance available from natural gas burnt efficiently in Combined Cycle Gas Turbine (CCGT) to generate new supplies of electricity, in what has been identified internationally as lowest cost power generation, then that growth in gas demand could more than double. Fifteen per cent over current demand of 1500 mmscfd in the year 2000 could approach an additional 1.6 TCF per annum of natural gas above current consumption levels.

The efficient use of energy concerns us all. In real terms what we want to produce, how much we will waste, how much that energy production and its by products will change, even damage, our environment. I will bring out further aspects concerning new applications for natural gas later but if I identify one flagship piece of technology for natural gas it is CCGT plant which if ordered today could achieve thermal efficiencies of 54 per cent compared to steam cycle power generation plant operating with thermal efficiencies in the mid 30 per cents. Typically this is a phenomenal 70 per cent improvement in thermal performance of the power generation process.

Pakistan is concerned about its environment. Further since the environment of Pakistan has no ring fence around it Pakistan's environmental concerns become international environmental concerns. I am sure in seeking international financing for energy projects increasingly the major international financial institutions will want to be assured that the more environmentally friendly energy options, such as natural gas, are pursued.

What is Currently Wrong

With Well-head Gas pricing?

Wrong is a word that is associated with blame in this case though the wrong has evolved through distortions in the closed economy of Pakistan. There is no real (free) market for energy hence the pricing is artificial and unresponsive no demand. The net effect is that the existing Pakistan gas market is demanded led, has a shortfall in gas and the premium application for natural gas in CCGT power generation, which could benefit the whole gas to electricity chain as well as the economy, can't really get started.

The exploration and production activity of the international oil companies in Pakistan is typically directed to look for oil and only by mishap have they found hydrocarbons that they gloomily announce to be gas! This E&P strategy gives an underestimate of total gas reserves and understimate of replacement rate. The comparative incentive from the base price 66 per cent HSFO formula is clear to see in comparing the ratio of a recent crude price to a calculated gas value in the same time frame Diagram 1. Observers may say this ratio is affected by a number of other variables such as: Wells required, Processing facilities, Transportation costs, Time delay to production costs. These will vary significantly from project to project but it is considered that the weighting of these variables, when accumulated, is neutral on the mineral value ratio.

The value calculated of $ 1.2 mmBtu based on the 66 per cent HSFO formula, but without the traditional volume discounts may look to observers to provide a marginal project for a medium sized onshore field. However the reality is that oil prices in general are now at reasonable price levels and any analysis of revenue performance from a long term gas contract tied to this commodity should also take into account the low levels of pricing which have historically affected this commodity, unless a substantial floor value is worked into this form of pricing.

More worrying for the producer, and it questions the whole basis of linking gas prices to the heavy, high sulphur end of the barrel is an industry forecast for this commodity which is demonstrated in Diagram 2. Against a normalised price for a barrel of crude two distinctive factors are anticipated to take the price of HSFO down during this decade. Firstly the demand across the barrel for commodities is changing with a greater demand for the light end products such as kerosine, jet fuels, and high speed diesel (HSD). Already there is insufficient appropriate refining capacity in the World to match this trend the remifications of which are already being presently observed in a growing surplus of HSFO supplies available in the Asia/Pacific Basin. In turn this surplus is causing downward pressure on the market price. A quite separate affect is attributable to the additional costs to reduce the emissions of predominantly SO from HSFO either by flue gas desulphurisation after combustion or by stripping out the sulphur during refining in which case it would be classified as the more expensive LSFO. Either way the commodity which by specification is HSFO is expected to receive a permanent drop in its real value down to a price where the economics of this low quality product, with enhanced emissions control technology, is again competitive with "greener" fuels.

The distortion of energy prices, their subsequent relativity and inability to be responsive to changes is highlighted by a hypothetical example of a CGT plant in Pakistan as follows. If say a 350 MW plant was privately developed it could have available to it under model power purchasing contract terms, a price for power generated of approximately US $ 0.0525/kWh. With an internal rate of return to the power project of 18 per cent it has been calculated that for the industry standard CCGT scheme, ($1 million/MW capital cost, 50 per cent thermal efficiency) a natural gas price of $3 mmBtu could be supported. Currently this is not available to gas producers in Pakistan. Indeed if any additional price premium is achieved over and above the price achievable under a 66 per cent HSFO formula then currently it would be returned to the Government by means of a gas surcharge. This example in my view is a classic case where the economic rent available under this fuel/utilization technology should be shared along the chain and subsequently benefit producers and the economy of Pakistan.

There may have been some strategic energy conservation view of pricing well-head gas at such a low level that its development would be restricted. If that was so in Pakistan then here, as in a number of other countries, the realisation has been that artificially low consumer prices defeat any attempts at efficient utilisation and again the constrained well-head prices act as a disincentive to find gas to conserve in the first place. So the natural gas stays locked unlocated unquantified in the ground.

What has Evolved and

Promoted Natural Gas?

If we first focus on the biggest concentration of energy use, power generation, and look at the five primary energy forms to generate electricity then the league table of their desirability as recently as 1985 would have been as shown in column 1 of Table 1. The comment in column 2 is, I think, sufficient to rearrange that league table to where it is perceived now in 1991.
 League Table of Preferred Primary Energy
 for Power Generation
1985 Cause of Change 1991
Hydro Electric Environmental impact Natural Gas
Nuclear Chernobyl, real Costs Hydro Electric
Coal Acid rain Coal
Oil Gulf Crisis Oil
Natural Gas CCGT Nuclear

In the analysis of this re-order natural gas has gone to the top of the league not just because of its startling thermal performance with CCGT plant but also because in every other aspect of the power generation debate be that; cash flow, impact on the environment or operation risk the other primary energy forms have been relegated through the table-1.

A number of virtues that promote natural gas in power generation have promoted it in other fields. I note some reborn and new areas of market growth for natural gas and its associated fields stimulated by more efficient use and environmental concerns: Compressed Natural Gas For Motor Vehicles, Methanol Production, MTBE (an oxygenating fuel ingredient to gasoline). New market applications for natural gas do not stop on the ground Tupolev have successfully operated experimental LNG fuelled passenger aircraft!

The green factor of natural gas should not be passed over lightly 2. Sulphur oxides are perhaps the most significant polluting by-products of burning fossil fuels. They contribute acid rain, and can be toxic and corrosive. Natural gas supplied through the Pakistan gas grid contains little or no sulphur. Where hydrogen sulphide is found as part of the gas produced it is removed before the gas enters the gas grid. Diagram 3 shows typical values for SO2 emissions from power stations. To produce the same amount of energy, burning HSFO produces over 1,000 times more sulphur dioxide than burning natural gas. Even with the addition of the fuel gas desulphurization plant a power station burning HSFO still produces 100 times as much sulphur dioxide as natural gas.

Burning fossil fuels produces oxides of nitrogen. Emissions standards in Europe now require that plant conforms to the levels identified in Diagram 3. Using gas generally produces less nitrogen oxides than using coal or oil for the same heat content.

There is a growing consensus that there is a connection between an increase in the so called "greenhouse gases" and the overall warming of the earths surface. Carbon dioxide produced by burning fossil fuels is a major contribution to these gases but some fuels produce more than others: for the same amount of energy input, natural gas produces only 60 per cent of the carbon dioxide produced from burning coal, and 80 per cent of that from oil. When the higher efficiency of using gas is taken into account natural gas's relative position is still further improved. Methane itself is a contributor to greenhouse gases and because natural gas is primarily methane, the fuel is singled out for attention. To put the current views before you, methane from the natural gas industry around the world averages around 8 per cent of total global emissions. Since methane is thought to be responsible for 15 per cent of the greenhouse effect, emissions from the gas industry currently contribute 1-2 per cent of the overall greenhouse effect! In global terms, the increasing availability of natural gas, combined with its high efficiency in use, can contribute to the goal of sustainable development with the minimum environmental impact.

How can well-head gas pricing be put right to stimulate natural gas exploration and use?

From the points put earlier in this paper it is apparent that Pakistan is not taking best advantage of its current opportunities and the future, more importantly, will exacerbate current misalignment of gas pricing, Pakistan's economy and energy needs. In an open economy marketeers of natural gas will be found matching its burner tip price against other alternative, competing forms of energy. Where there are other gas supplies a further dynamic refinement to pricing will be gas on gas competition. The alternative fuels will vary from process to process and size of the application, which to a certain extent may grouped by business sectors. For example water heating may be carried out by an electric water heater for domestic use whilst in industry a fuel oil fired boiler would be used. In Diagram 4a the use of gas by sector is identified then in 4b the alternatives energy forms are identified. With this information a gas marketeer (by legislation in Pakistan not an E&P company) can compute his bulk competitive cost for gas, with due allowance for this operating costs. Also he can be comfortable that indicative indexation basket that he would agree to in his purchasing was a back match for his customers alternative energy forms.

By systematically reviewing this algebra by forecast revisions of his customer portfolio the gas marketeer is able to anticipate any revision required in his base price to customers, against his gas provisions for the future. The next wholesale purchase the marketeer makes of gas has again to project forward his future needs in competitive base gas price and revised were appropriate in the indexation basket. I have covered the principle of market relating in its simplest form, more sophistication can be incorporated in this highly adaptive technique. How would this system react to a large new premium market such as the CCGT power generation market?

Firstly the premium potential can be ascertained by the marketeer through negotiation with his customer the power generator. In turn views of price and other requirements would be indicated to the producer/explorationist who given a share of the enhanced value, hence the correct incentive, would increase his activity accordingly. Pakistan may be moving towards privatization in some sectors but is not an open economy. Energy prices are subsidised in instances for good social or strategic reasons. To my view what is required in terms of future gas pricing policy is a marriage between this market related pricing concept and the strategic objectives of Pakistan's economic and energy policies.

Concluding Remarks

The premium applications for natural gas continually develop as its virtues become apparent. Natural gas is no longer the Btu substitute for other fuels. It is clear that flexible well-head pricing for gas must be developed so that the right level of incentive is posted to bring forward supplies. The pre 1986 vision of continually spiralling oil prices, to make an oil index linked gas contract eventually make positive cash flows, is no longer true.

Oil E&P companies live with the risks and rewards of their business. With our industry forecast through the decade for High Sulphur Fuel Oil there is a real prospect that a well-head gas price with a 66 per cent HSFO base price and HSFO indexation will be at best utility and quite probably loss making for producers. The effect of this will be to exacerbate the problems that now face Pakistan and increase its dependency on imported petroleum supplies. Natural gas development depends on the government policy. The producers are already converted.


[1.] World Development Report, The World Bank (Washington, D.C.: World Bank, 1990). [2.] Gas and the Environment, British Gas, 1990.
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Author:White, M.
Publication:Economic Review
Date:Feb 1, 1992
Previous Article:Measures for early development of oil and gas discoveries.
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