LNG and the US Natural Gas Market American Gas Association ThirtyFirst Annual Legal Forum

1
LNG and the US Natural Gas MarketAmerican Gas
Association Thirty-First Annual Legal Forum

• July 22, 2008

Mark EllisDirector, Corporate Economics
2
LNG and the US Natural Gas Market

• What we thought would happen
• What happened
• What now?

3
LNG and the US Natural Gas Market

• What we thought would happen
• What happened
• What now?

4
What we thought would happenDeclining domestic
production
Source EIA
5
What we thought would happenRobust demand growth
Electric power
Industrial
Commercial
Residential
Source EIA
6
What we thought would happenRapidly growing LNG
imports
EIA US LNG import forecast Bcfd

• The outlook changed dramatically in just three
  years
• Expected 2010 LNG imports tripled to nearly 7
  Bcfd
• What we need to do is get in place, as soon as
  we can, the capability of fairly substantial
  imports that enable our manufacturers who use
  natural gas to compete internationally Alan
  Greenspan, April 21, 2004

YE 2004
YE 2001
Source EIA
7
What we thought would happenHigher price
expectations
NYMEX natural gas forward prices /MMBtu
12/31/2004
12/31/2001
Source NYMEX
8
LNG and the US Natural Gas Market

• What we thought would happen
• What happened
• What now?

9
What happenedDomestic production resurgence
Source EIA
10
What happenedDelayed LNG supply
Wood Mackenzie Global LNG supply forecasts
2004/2005/2006/2008
10/2005
12/2006
1/2004
5/2008
Liquefaction projects were delayed in the face of
economic, environmental and technical challenges
Source Wood Mackenzie
11
What happenedStagnant US demand growth
US natural gas consumption Bcfd
2004 forecast

• Growth in power generation (driven by
  gas-for-coal substitution) was offset by declines
  elsewhere
• Industrial demand destruction, triggered by high
  prices
• Residential/commercial mild winters
• Expected 2010 demand is now 9 lower than the
  2004 forecast and roughly equal to 2000 demand

Electric power
Industrial
Commercial
Residential
Source EIA
12
What happenedHigher prices
NYMEX natural gas forward prices /MMBtu
6/30/2008
12/31/2007
12/31/2004
12/31/2001
Source NYMEX
13
What happenedbut not high enough
Source PIRA
14
What happenedUncommitted cargoes bid away
Source PIRA Sempra analysis
15
What happenedReduced LNG import forecasts
EIA US LNG import forecast Bcfd

• The outlook changed dramatically in just three
  yearsagain
• The LNG import forecast was cut in half

YE 2004
YE 2007
YE 2001
Source EIA
16
LNG and the US Natural Gas Market

• What we thought would happen
• What happened
• What now?

17
What now?LNG option value

• Key changes in LNG since 2004
• Globalization multiple supply and demand points
• Higher prices
• But local gas market dynamics havent changed
• Demand highly weather-dependent
• High transport and storage costs
• Low infrastructure reserve margins
• Prices sensitive to inventory levels and other
  infrastructure constraints
• High volatility and substantial locational price
  differentials (i.e., low inter-regional
  correlation)
• High price volatility low correlation
  diversion capability high LNG option value
• Physical
• Financial

18
What now?Physical arbitrage example
1 Fixed variable (including losses at
7/MMBtu) costs for Incremental shipping (0.62
0.16 2.6x7 (0.33 0.11 1.1x7) 0.44,
US regas (0.35) and US pipeline (0.04)
19
What now?Financial arbitrage example
September 2006 forward prices /MMBtu

• Each time forward prices flip, spreads are
  captured
• If prices dont flip before expiry, value lower
  of two prices last hedged spread
• Difference between hedged and closing spread
  opportunity loss
• Physical financial arbitrage value
• Last open position 1.13
• Prior unwound hedge 1.36
• Total 2.49
• Physical only
• 6.82 6.23 0.59
• Difference (financial only) 1.90

Hedge unwound, spreadscaptured (1.36)
0.72
Last openposition
0.64
1.13
0.59
20
What now?Drivers of US regas option value

• The option value of US regas will be driven by
• The amount of LNG available to arbitrage
  cross-basin spreads
• The relative tightness of North America and
  Europe currently, North America is well-supplied
  relative to European markets

21
What now?Shifting of the LNG swing point

• The Middle East is generally viewed as the global
  LNG markets swing point
• Until 2007, the Middle East was the marginal
  supplier to the Pacific basin, with leftover
  cargoes serving the Atlantic
• In 2007 and 2008, unexpected Pacific basin demand
  growth soaked up all available Middle East
  supplyand then some, pulling in cargoes from as
  far away as Nigeria and Trinidad
• New Middle Eastern supply entering service in
  2009 should shift the swing point back to the
  Middle East, freeing more cargoes to arbitrage
  Atlantic basin price differences

Global LNG supply and demand Bcfd
Atlanticbasin
DevelopedAtlantic basin
MiddleEast
DevelopingAtlanticbasin
Pacific basin demand pullscargoes from the
Atlantic
Developing Asia
Pacificbasin
Developed Asia
Source Wood Mackenzie Sempra analysis
22
What now?US and European price convergence?
Natural gas spot prices /MMBtu
UK NBP
3.38

• The UK-US gap has closed since the start of the
  year
• US storage inventories have returned to more
  normal levels
• UK storage has filled-up

US Henry Hub
Source Bloomberg
23
What now?Players with regas positions on both
sides of the Atlantic
Source Wood Mackenzie
24
LNG and the US Natural Gas MarketConclusion

• Predicting natural gas markets is tricky,
  especially US LNG
• Marginal source of supply
• Global competition
• Rapidly-changing fundamentals (supply and
  demand)
• Value of, and demand for, optionality is
  increasing
• Roughly correlated to prices
• Cost to provide optionality (regas, storage,
  ships) hasnt risen as fast
• Natural gas market participants are building more
  optionality including US LNG market access
  into their portfolios