We read stories about a coming “US gas glut”. There is something in that, but it will mostly be a local phenomenon. Here is why..

The point is, natural gas can only be transported over long distances in two ways, both quite expensive, which is why distance matters in the natural gas market:

1. Via pipeline
2. Via tankers

Needless to say, pipelines are expensive to build and are mostly a national or regional phenomenon. They also have a habit of being situated in awkward places, giving small states potentially enormous leverage. Witness what happens almost yearly to Russian gas that has to travel to Europe via Ukraine…

The second method to transport natural gas is to convert it in liquid form (LNG, or liquid natural gas). One has to build LNG facilities, which are multi-billion dollar investments. On top of that, the LNG is transported in big purpose made tankers, which cost upwards of another billion or so, plus operating cost and plus infrastructure (import and export terminals) that can handle these tankers. There are only 16 countries exporting LNG.

These two basic facts produce a situation that natural gas/LNG is not a commodity, it’s simply too expensive to be transported over large distances. The evidence of this is that large price differences between regions stubbornly persist.

When gas is traded, it’s mostly a regional phenomenon, which needs the following ingredients:

• A source with sufficient supplies to warrant billions of investments (whether piplelines or LNG facilities)
• End markets nearby with guaranteed demand for large amounts of gas.

These regional markets exist for instance within the old Soviet Union, which has been extended to Europe, The Middle East and Europe, and in Asia where there is a large producer (Indonesia) and large import markets (Japan and South Korea) and on the American continent.

Between these markets large price differentials remain, with gas usually the cheapest in America, more expensive in Europe, and most expensive in Asia. Here is one indication of these price differentials:

• Taiwan purchased two LNG cargoes for immediate delivery from Nigeria in December, paying $920 a ton, equivalent to about $17.5 per million British thermal units, compared with about three cargoes a year earlier at an average price of about $12, the data from the energy bureau showed. Benchmark gas futures in New York were at $4.6 per million Btu. [Chinapost]

A further complicating factor is that not all gas sources are equal. The most important difference is perhaps that between conventional and non-conventional gas. The latter are gas which is contained in coal (which used to be considered a nuisance as it increased the risk of coal mining considerably) or shale.

The point is, these unconventional gas sources have production cost way in excess of conventional sources. For instance, there is (at least before the crash of the energy markets with the global economy) a real hype about US and Canadian shale gas, but look at a source that produces average production cost for Canada (you have to go to page 15) and you’ll notice that ALL of it lies above the current US spot price (aproximately $4.5 per Mcf).

Almost all of the big new US gas finds are shale gas, like the big Barnett shale, and these production costs are similar to those in Canada. The cheapest (probably Chesapeake; CHK) would be at least $5 per Mcf.

Unlike conventional gas, unconventional wells have to be treated (which in the case of coal seam gas implies a host of environmental risks as well, to the extent that Canada has not given permissions in quite a number of cases).

Unconventional wells, even after (expensive) treatment, flow a lot less, on average, than conventional sources, and exhaust way earlier. The simple fact is that unconventional sources have way lower permeability and porosity, on average.

So, to export unconventional gas sources, producers have to deal not only with the necessary infrastructure cost, but also compete against conventional sources which might be a lot closer to the end markets, and therefore doubly advantaged. Which is the main reason it’s not going to happen anytime soon.

Let us give an example. It has become clear that Papua New Guinea (PNG) has lots of natural gas, which is conventional gas, and therefore cheap. It is also close to big end markets, like Japan, South Korea, and increasingly China.

It’s only real competitor in the region is Indonesia, but that country, still the region’s biggest exporter, is using more and more gas for domestic use (as it’s relatively clean), while demand in the region is rising structurally much faster than the demand for energy in general (because, well, it’s relatively clean).

Australia is emerging as another potential big exporter, but compared to PNG, it has several big disadvantages:

• It’s unconventional gas (coal seam gas), production cost are way higher because thousands of wells have to be produced, treated, and manned to supply enough gas to be able to go ahead with the construction of an LNG facility. To put that into perspective InterOil could supply the same gas with just three or four wells, it has two wells which flow at 100Mmcf/d, which is way beyond anything that any Australian coal seam gas can match.
• Australia is further away to the end markets, and these tankers are expensive to build and operate
• Australia has labour and regulatory cost a multiple of those in PNG, further disadvantaging it’s cost base.

Now, there are some who argue that the US, with it’s newfound shale gas resources, might be able to flood European or even Asian markets. However, if Australia already has large cost disadvantages, this will hold more true for the US.

If these plans materialize, it will be because demand for gas develops to such an extent that the market cannot be supplied by much cheaper local conventional gas sources, but this implies prices sufficiently high to make up for all the cost disadvantages of further away, high-cost based unconentional gas.

Which implies a true bonanza for the cheaper local suppliers..

One of which will be InterOil. We are bullish on that stock for some time, and with good reasons.