Moneycontrol
Sep 13, 2017 05:53 PM IST | Source: Moneycontrol.com

Will GAIL take a beating from its US natural gas contracts?

Foreseeing increased energy demand in years to come, GAIL had entered into long-term contracts for importing US shale gas, which is scheduled for delivery from the beginning of next year.

 
 
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Petronet LNG successfully renegotiated the terms of its LNG import deals with Exxon Mobil from the Gorgon facility in Australia recently, thereby reducing the effective price of the LNG contract. This move stands to benefit the downstream gas marketing companies like GAIL, BPCL and IOCL (as LNG is generally priced at a margin above cost in the downstream market).

While GAIL stands to benefit from this renegotiation, it has made GAIL’s own US shale gas import contracts look relatively expensive. Although changing market dynamics from being a supply empowered market towards a demand-driven one might help GAIL in renegotiating its terms with US companies, chances of success are slim. Offloading the entire contracted supply will be a major challenge for GAIL in times to come and this could impact margins.

Background

During 2011-13, when crude was crossing the USD 100 mark there was a definite incentive to switch to cheaper fuels. A sudden increase in US shale gas exploration led to a fall in gas prices and made it an attractive cheaper alternative.

Foreseeing increased energy demand in years to come, GAIL had entered into long-term contracts for importing US shale gas, which is scheduled for delivery from the beginning of next year.

The company also entered into gas import contracts with Russia’s Gazprom. Over the years, market dynamics has altered drastically. Given the steep fall in crude prices over the last years, these contracts, which were once cheap and attractive, are now looking expensive. Not only have the contracts become expensive, GAIL is also facing lower-than-expected demand from the industrial sector as companies are switching to renewable energy sources.

Contracts

GAIL had entered into a 20-year contract with Cheniere Energy for the supply of 3.5 million tonnes of LNG per year and with Dominion Energy’s Cove Point liquefaction plant for the supply of another 2.3 million tonnes per year. They also signed a deal whereby Royal Dutch Shell would buy 0.5 million tonnes of this LNG. This leaves GAIL with a potential of 5.3 million tonnes of the expensive LNG.

Impact

These contracts have put GAIL in a position where it has more upcoming supply than demand. Moreover, owing to the changed industry landscape over the last few years and recent renegotiations, GAIL’s US LNG has become very expensive and less competitive. Hence, offloading the upcoming inventory will not be easy. In order to offload this expensive LNG, GAIL will have to compromise on margins or else its volume will take a hit.

Steps to overcome the issue

In an attempt to offload the expensive inventory, GAIL has entered into time, destination and physical swap deals for more than 60 percent of the contract. The company has entered into three time swap deals where it will take deliveries in order to cater to the current demand and sell later in 2019 when it receives the supplies from US.

Destination Swap Agreements - GAIL is actively looking at destination swaps that would enable the company to save on the freight charges. These contracts, if they come through will provide significant savings and be positive news for the company.

Building Supply - The management is actively pitching to enter into supply contracts with domestic firms and is already in advanced stages for supply of the US LNG to domestic fertilizer and refining companies (PSUs).

Will it work?

Although the management recognises this risk and has been working to remove/reduce this, the old contracts nevertheless stand to impact profitability.

Time swap agreements might provide a breather in the short-term, but the impact of expensive contracts would only be deferred to a later year. Sale to a PSU might provide some relief but there would be limited volume. Cushion from the renegotiated terms of Petronet contract would provide some relief but supply from Petronet is very small as compared to US contracts (0.43 MT vs 5.8MT). Renegotiating the terms of the US contracts would be the only solution. With markets turning in favour of the buyers, is there a silver lining amid the dark clouds?

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