Up to the moment of Enron’s demise, the world’s gas markets flourished
with manageable volatility, providing good price discovery into the forward
market. Gas held an enviable position between the highly mature oil markets
and the infant power markets – it had excellent liquidity, good ability
to be stored, and with the aid of a hyperactive spark spread, seemingly ever-increasing
demand.

The backlash post-Enron has been severe and far-reaching. Investors, banks,
and even company boards have lost faith in the activities of merchant trading
units. This loss of confidence created a downward spiral of massive proportions,
reducing the mighty to junk. Trading, once the poster child of energy companies
around the world, is now the monster locked in the attic. While it is still
there, still breathing, it is not something to be talked about or touted as
exemplary.

Ironically this is exactly the opposite of what was needed. One of the major
concerns about trading units before the crash was the black box nature of reporting
of their activities. What the analysts wanted and the market needed was to
provide greater transparency, not less. However, many organizations feared
both the public perception and what might be uncovered by being open. As a
result, organizations were only willing to provide transparency once they themselves
were convinced that all the controls were in place, were functioning, and that
their numbers could be relied upon.

Many also learned another invaluable lesson: credit risk cannot be overlooked.
Credit events such as Enron happen very fast, and controls need to exist to
prevent domino events causing complete market meltdown. Credit risk transcends
commodities, asset infrastructures, and geographic boundaries such that a transaction
in Australia or London can impact a position in Houston or Calgary.

In North America, the fabric of participants in the market is changing. Financial
firms own a significant amount of independent power generation capacity. Many
interstate pipelines are under new ownership. The major oil companies have
greater presence in merchant energy markets.

Dwindling gas production has reignited interest in liquefied natural gas (LNG)
facilities and infrastructure. With only four functioning US LNG terminals
and demand for LNG outstripping the existing terminal capacity, 20 LNG projects
have been announced in the last year. While many of these projects won’t
reach full maturation because of local opposition, regulatory hurdles, or changes
in economics, the terminals that do get built will change the geography of
the gas markets.

In Europe, the market-making US companies have retreated to their domestic
market in an attempt to save their organizations. Now, the market is dominated
by French and German companies that pursued M&A activities when values
slumped from their peak. As Europe expands east, so do these new giants of
the energy business, buying asset-backed operations and local distribution
companies. The portfolio of supply is also changing with North Sea output.
There is increasing demand for pipeline deliveries from Russia and North Africa.
The UK is now reinvesting in LNG facilities both as receipt points in the UK
and in LNG production in the Middle East and Africa.

Europe is not the only market where demand for LNG is growing. In the Asia-Pacific
(AP) region, there has been a substantial LNG market that is continuing to
grow, and the major oil companies such as Shell are investing heavily in major
projects such as the island of Sakhalin. Many would like to see LNG facilitate
traded markets and believe that the best way to achieve this is through the
removal of destination clauses from LNG contracts. This would allow cargoes
to be easily rerouted based on market conditions.

Another factor changing the game in AP is the emergence of deregulated markets
in multiple locations such as Japan and Korea. As these markets are created,
these countries are going through the same challenges as their predecessors
as to rules of engagement, limits, and structure, but with the benefit of first-
and second-generation lessons learned. As these markets mature, traders around
the world will have the opportunity to create and participate in cross-theater
transactions. For example, gas produced in Russia could be liquefied for export
to the United States and delivery to California. The day could be close at
hand where one could execute such a transaction on a single exchange.

Combined heat and power (CHP) facilities may also change the energy game by
allowing gas companies to compete with power companies. Until now, CHP facilities
were confined to large businesses, government buildings, and hospitals, but
advances in technology have made it possible to install micro-CHP in private
homes, replacing the traditional heat and hot water system. These new systems
still provide heat and hot water, but also 1 kilowatt (1,000 watts) of constant
power, in the same footprint as the traditional household heating units.

This is a boon for the gas companies since essentially they get to grow their
demand volumes for marginal additional investment. But it gets better, as in
most liberalized power markets, there has long been a rule designed to encourage
the take-up of CHP and local generation. This rule generally states that all
generators with production below a given threshold have the right to export
all excess production onto the grid. Therefore, the power companies have to
account for these volumes, which, in turn, increases their costs. As the unit
price of these devices comes down over the next few years, the ROI may improve.
From the consumer’s perspective, these units are more ecologically sound,
provide cheaper power, and in the event of a power outage will keep the lights
and TV on. In the event of major grid failure, or drop in transmission deliveries,
a local grid could isolate itself and provide power generated by even the smallest
domestic devices. The autonomic self-healing infrastructure is not far away.

Another technology set to have an impact on the world stage is gas to liquid
(GTL) fuel; GTL diesel substitute can be burned in most modern engines, but
has the benefit of being significantly more environmentally friendly at the
point of use due to its very low sulfur output. There is significant pressure
on the oil majors to cease gas flaring, and GTL offers an environmental alternative
to this waste of resource. The downside is the cost to build GTL processing
facilities, but this expense is being cut and may soon reach reasonable levels.
When GTL becomes economic, the gas industry will have a new market and demand
for gas will grow further.

Examining these factors in the marketplace helps to compose a picture of where
the gas markets and their participants will be headed:

Geography. With production in substantial decline in or near most of the industrialized
nations, gas must be delivered from a greater distance either via pipeline
or LNG. A single deal could cross several national boundaries and international
waters. Markets will need to evolve to handle multinational, multistate commodity
deals.

Risk. As if the basket of risks were not large enough – credit, operational,
price, commodity – the globalization of gas will add investment, transportation,
geopolitical, and other complexities to risk managers’ portfolios. Just
understanding the US storage position or a siloed view of industrial production
will be inadequate. Management of risk will need to continue to advance in
sophistication and control to keep apace.

Participants. One view of this evolving market would indicate that only the
large multinational companies will be positioned to operate and be profitable
over the long term. Some are of the opinion that the market will be dominated
and potentially controlled by the oil majors and the banks. In the interim,
however, the less mature markets will attract many new entrants, and the alternative
technologies may even put the consumer in the game. Markets that handle global
deals may have many more possible participants than they have had historically.

Regulation. Given the dramatic failure of Enron and the following collapse
in confidence, the industry is becoming subject to more and more regulation.
Some countries have now placed energy trading under the auspices of their financial
regulators, and energy merchants are required to hold banking licenses. Finance
regulatory frameworks were always more proscriptive than those in energy and
have been significantly tightened over recent years. Compliance issues are
going to place even greater demands on systems and resources over the coming
years, with organizations having to be fully conversant and compliant in every
jurisdiction in which they operate.

Demand. Demand is a dicey part of the picture. In a vacuum, not only would
it seem that demand will continue to incrementally rise in the industrialized
nations, but many developing nations such as India and China are hurtling at
light speed into conspicuous consumption. On the reverse side of the equation
is that some consumption is part of a zero sum game. If an industry such as
smelting leaves a high-cost country to move to AP, the consumption is not a
gain or loss. Understanding the drivers behind demand trends globally will
be key for market participants and all investors in gas infrastructure projects.

Reserves. Reserves continue to be an enigma. They are a key factor in market
and investment decisions, but for all of the industry’s technological
advances in estimating reserves, predicting reserves with a high degree of
accuracy is elusive. Current estimates show the former Soviet Union to have
the greatest reserves, which given the instabilities, inefficiencies, and commercial
difficulties in that environment may produce less than perfect supply conditions.
The US National Petroleum Council’s report to Secretary of Energy Spencer
Abraham indicates that production from traditional US and Canadian sources
of supply is projected to be 22 percent less over the next decade than what
the same group had projected in its 1999 report.
Substitutes. Natural gas consumption has traditionally been affected by coal
or fuel oil as electricity generation substitutes that become economical under
different price scenarios. CHP and fuel cell technology, among others, also
have the potential to affect the gas markets.

Technology. The larger organizations will also have the ability to buy competitive
advantage through investment in information and communication technology infrastructure.
Integration has passed the enterprise application phase, which in many cases
failed to deliver against it promises. Today companies are integrating their
asset infrastructures (supervisory control and data acquisition [SCADA] to
automated meter reading [AMR]) into their commercial departments, to provide
data on demand throughout the enterprise. Traders have real-time data on production
and demand values that allow them to reduce imbalances and associated penalties.
Integration, however, no longer stops at the company firewall; it extends throughout
the value net with open outcry trading being replaced not only by electronic
exchanges but by trading networks and automated deal execution. Information
is said to be power, but having that information and acting on it before the
competition is profit.

Natural gas in the new world order is not what it used to be – pump gas
out of the well, transport it to a generation plant, and our stoves will light.
It is vastly more complex, challenging, and intimidating. For those who see
the entire landscape and incorporate that into their strategy, there will be
high financial reward. The opposite is true for those without the vision or
resources to prosper on the evolving natural gas stage. To all of us in the
industry, it will continue to provide high drama in the years to come.