The perils of gas pricing

Arriving at a price that is viable for both the buyer and the seller is tricky business

Recently, when veteran Communist Party of India leader Gurudas Dasgupta claimed that the government's move to raise domestic natural gas prices will result in an additional subsidy burden of Rs 76,000 crore for the Centre, he not only tore apart the government's proposal but also brought to light the complexities of gas pricing in this country.

What makes things particularly difficult is the purported "windfall" gain to a company that is hard to measure in a policy regime straddling the two worlds between private exploration of oil and gas and public control over the produce. Another tricky part of the exercise is to arrive at a price where both the buyer and the producer are able to do viable business without raising the government's subsidy bill.

If natural gas was to be used for the power sector alone (it is also used for fertiliser and filling LPG cylinders) then perhaps things could have been a little different. The government could have easily looked at the price of coal and gas, weigh their viability option for power plants, and then, theoretically speaking, it could have arrived at a formula linked to coal after providing for the equivalent heating value.

In the American market, for instance, coal and gas price became inter-related last year, when the NYMEX gas price fell below $2/mmBtu and could effectively compete with coal for market share in power generation. "In April 2012, for the first time ever, coal and gas tied for market share for power generation. We saw power plants switch over to gas from coal, most especially in the Southeast. Effectively, coal became the ceiling for gas prices because of this dynamic," says Samantha Santa Maria, managing editor, North American Natural Gas, Platts, an energy reporting agency.

Banking on coal
According to the US Energy Information Administration, after an equal share (32 per cent) of power was generated from coal and natural gas in April 2012, a combination of higher prices for natural gas and increased demand for electricity during the summer months led electric systems across the US to increase their use of coal-fired units again. Coal generated 40 per cent or more of the nation's electricity each month since November 2012, with natural gas fuelling about 25 per cent of generation during the same period.

In March 2013, coal-fired units generated a little over 130,000 Mwh of electricity, while natural gas units produced nearly 85,000 Mwh. Higher prices for natural gas reduced the fuel's share of total generation below the record levels of April 2012. Nonetheless, coal's share in total generation remained below its typical range prior to 2009. Between 2001 and 2008, the coal share (on an annual basis) ranged from 48 per cent to 51 per cent. Coal last achieved a 50 per cent share in 2005 and is expected to be 40 per cent in 2013, according to the most recent US Energy Information Administration's Short-Term Energy Outlook.

Since 2011, natural gas prices in the US have fallen drastically, leaving many to question the rationale of giving a price increase to Reliance Industries back home. However, there are signs the prices are on an uptick again. Maria says since the beginning of this year gas prices in the US have been on the rise.

According to Platts assessment of May 31, natural gas traded in the Japan Korea market at $14.45. The NW European marker was $10.90; the southwest European marker was $11.60. In contrast, the Nymex Henry Hub in the US market was trading at $3.991 early today. This discount of over $10 in the US market is largely due to continued rampant shale production there and the ongoing coal-gas dynamic.

In India, where the total gas-based installed capacity is 18,713 mw and the gas required is 72 million standard cubic metre a day, if gas price is increased by $1, the power sector will see an impact of Rs 10,040 crore at 70 per cent plant load factor for 28,000 mw. When it comes to fertiliser, every dollar increase in gas price for 32 million tonne urea production from 2017-18 would translate into an additional Rs 4,144 crore annually in input costs.

But globally, governments do not set the price for natural gas. Even in India, the government had not initially envisaged such a situation. It was only in 2007 when Reliance Industries sought approval for the KG-D6 gas fields that the government decided to set the price.

Imported coal vs domestic gas
Imported coal prices range between $100 and $90 a tonne but the landed cost comes to $123 a tonne after adding freight cost ($12 a tonne), customs duty (5 per cent) and handling charges ($6 a tonne). Taking into account an inward freight of about Rs 110 a tonne for every 50 km and a landed destination which is 500 km away from the ports, the landed cost would easily come to $143 a tonne. Assuming a gross calorific value of 5500 kcals/kg and considering that gas-fired plants have higher efficiencies than coal-fired plants and capital costs saving are Rs 1/Kwh, the equivalent gas price would be $11.50/mmbtu, says PMS Prasad, executive director, Reliance Industries.

Even though domestic gas effectively competes with imported coal, Prasad says coal cannot be linked with gas prices in the Indian market. "World over gas-based power never competes with coal for base load. They are meant for meeting peaking demand," he adds. He cites a Goldman Sachs report of March 2013, which shows 240 mmscmd (66 mmscmd for power) demand for gas is available at a price of $8 mmbtu or more.

However, while more than 50 per cent of the 63 million standard cubic metre a day of Reliance Industries' KG-D6 production was allocated to the power sector by an empowered group of ministers, not a single unit from the KG-D6 fields has gone to the power sector from April this year. Falling production saw the entire 15 mmscmd available being consumed by fertiliser companies and the rest was used for LPG production.

With regard to gas versus liquid fuel, prasad says gas offers the convenience of usage as a clean fuel and is highly efficient. It has high value as a chemical used for producing ammonia in fertiliser plants where it competes with naphtha and furnace oil. It can be an ideal fuel for usage in ceramics, glass shells, sponge iron plants and in refineries and petrochemical plants as a fuel where it competes with naphtha and fuel oil, he says.

The Rangarajan Committee on production sharing contract has arrived at a price of $8.20/mmBtu for gas. Furnace oil is much more expensive at a price of Rs 39,643 ($720) a tonne or $17 per mmBtu, assuming a calorific value of 10500 kcals/kg. "Gas based on the committee's formula is nearly 50 per cent cheaper than furnace oil. Hence, gas has to be priced with liquid fuels which are less environment-friendly and to encourage competition, it has to be priced competitively with imported gas," he says.

The ministry of petroleum and natural gas is going by the Rangarajan formula where the simple average of netback price of Indian gas imports and that of North American, Europe and Japanese market is adopted. This will mean a uniform pricing for buyers and sellers irrespective of the cost of production and the bidding norms under which the right to explore and produce were leased out.

Prasad says when in the exploration and production business, inputs are determinable but output is only probable. "Therefore, it carries a different risk premium and investors will only be comfortable if prices are allowed to be determined by the market price." Clearly, the government is not looking at this option at all. In contrast to $6.7, suggested by the ministries of petroleum, finance and fertiliser, market price would mean gas producers get $10 something-which will be unaffordable for the fertiliser and power plants.