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Need of the hour: gas pricing reform

by Yasmin Helal on Dec 6, 2016

The cost of new gas production is set to rise significantly in the future.
The cost of new gas production is set to rise significantly in the future.

Maintaining the GCC’s low gas prices, which are set considerably below international prices, is unsustainable and will create significant problems for the region in the future, according to a recent study by management consultancy Strategy&, formerly Booz & Company, part of the PwC network.

While keeping GCC gas prices low has supported local economies in the past, the cost of new gas production is set to rise significantly in the future. According to Strategy&, the average weighted costs of new gas production across the GCC could rise by a factor of one-third to two-thirds by 2030 as technology requirements necessary for accessing and successfully extracting gas becomes greater — from $1.50 to $4.50 per thousand cubic feet in 2015, to $2 to $7 per thousand cubic feet in 2030.

Developing new sources of gas production is therefore not sustainable at current prices which are typically significantly below this level and, if not addressed, will lead to a potential gas supply gap of over 300bn cubic meters by 2030.

On the argument of the need of GCC countries to adopt gas pricing reforms, George Sarraf, a partner at Strategy&, says “If the cost of gas does not start to reflect its true market value and appropriate investment in the oil and gas sector is not allocated soon, the GCC will be unable to meet demand for gas in the future. Reforms should define a mechanism that prices natural gas closer to its true value and that in some manner reflects the global and regional dynamics of supply and demand. While abundant and cheap gas has played a critical role in the development and diversification of GCC economies, the current system is not sustainable.”

“Gas – like any other commodity – should be priced in line with its true market value. That is a price set by supply and demand forces. The market decides where best to use the gas given alternative fuels and feed stocks. While this approach is the norm in liberalised economies, countries in the region will have to move gradually towards that goal. That is the path towards sustainability [in the LNG market],” Sarraf told Oil & Gas Middle East.

The best approach to setting gas prices is to use market mechanisms such as ‘oil indexation’ and ‘gas hub pricing’. Oil indexation requires gas prices to be linked to a basket of commodities including crude oil and oil products. Gas hub pricing, also known as ‘gas-to-gas competition’, is when gas is traded based on spot prices set by the market in a liquid trading hub to better reflect the true price of gas to consumers.

“Gas prices in the GCC are usually fixed and at levels that do not necessarily reflect the actual value that the market sees,” Sarraf says. “In other words, gas prices today are the result of state policy rather than what the market values. A mismatch (usually lower than market) between these two result in subsidy and therefore in wastage behaviour with negative impact on long-term sustainability.”

According to David Branson, an executive advisor with Strategy& in Dubai and a member of the energy, chemicals and utilities practice in the Middle East, “Many markets around the world are becoming increasingly liberalised and are gradually moving from oil indexation to gas hub pricing as the preferred pricing method. In 2014, 43% of all gas sold was subject to gas hub pricing and 17% was indexed to oil. However, the Middle East is yet to adopt market-based gas pricing with almost all prices regulated by national governments.”

For the GCC market specifically, Strategy& suggests four possible effective gas pricing regimes for countries to implement: 1) increase wholesale prices to match – at a minimum - the increasing production costs and encourage investments in new supply sources, 2) index gas prices to oil prices, 3) link domestic gas prices to prices in existing hubs in other geographies or 4) establish a dedicated GCC gas hub price.

“The time to act is now and some countries have already taken steps in this direction but more is needed to advance this vital reform across the region. Although a new regime will result in higher gas prices, carefully crafted mitigation measures can help with the transition.

These will allow the economy as a whole to benefit from increased diversification, private investments, true competition and a greater sense of energy security,” added Dr Yahya Anouti, principal with Strategy& in Dubai and a member of the energy, chemicals and utilities practice in the Middle East.

Building on that argument, Sarraf adds, “All GCC countries have recognised the need to increase gas prices and many have already done that (e.g., Saudi Arabia, Oman). But this is not enough. Gas prices are not fixed because they fluctuate depending on market forces. Some sort of mechanism needs to be put in place to acknowledge that.”

As a consequence of a new pricing regime however, gas prices will inevitably increase and may have an adverse socio-economic impact on consumers unless managed carefully. The impact of a new potential gas-pricing mechanism therefore requires proactive and targeted risk mitigation measures to ensure that the benefits of the new pricing model are captured.

According to Strategy&, GCC countries need to proactively communicate with all key stakeholders to evaluate potential risks of higher gas prices and offer appropriate solutions. “Indeed, the cost of supplying new gas will increase due to the more challenging nature of non-associated gas fields. To develop such fields cost-effectively, partnerships with international oil companies with advanced technologies are needed (e.g., development of the Shah sour gas field in the UAE). But that would not remove the burden from increasing market prices as well,” Sarraf says.

For example, mitigation measures might include offering incentive packages to industrial customers and instituting targeted compensation mechanisms for the poorest households. Accompanying a move to market-based gas pricing, a regulator for gas should also be established to govern the new gas pricing regime and monitor its application.

“There are a few examples to mitigate the impact of higher gas prices. Usually, they all point out towards targeted subsidies. In other words, subsidise a specific user as opposed to the inputs for the entire sector,” Sarraf states. “Also, the decision needs to differentiate between industries that can absorb the hike by being leaner with others that may need real state support. There are a few examples of targeted subsidies in the viewpoint.”


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