Thursday, March 30, 2006

Brian Fallow: Importing gas no small issue

Contact Energy and Genesis Power are at pains to reassure us that they will not start importing liquefied natural gas to fuel their power stations unless they really, really have to.

In any case, they say, the potential impacts on the economy are not nearly as bad as they are sometimes painted.

To that rhetorical end, they have commissioned a report from Bryce Wilkinson, of Capital Economics, and Kieran Murray, of LECG, on the "macro-economic consequences of importing gas".

Alas, it does not live up to its title.

It does not consider at all what the effects on economic output, employment and households' discretionary spending power would be of having LNG-fuelled power stations setting the wholesale price of electricity.

In the absence of a big model of the economy like the Treasury's, that would be hard to do.

But it would be more to the point than just giving soothing assurances which boil down to saying that the trade and current account deficits are already so bad that importing LNG wouldn't make them much worse.

With oil at US$60 ($100) a barrel and the exchange rate at US60c, the same amount of oil that we imported last year would cost about $5.5 billion a year. Compared with that, the report argues, an extra $400 million worth of LNG is neither here nor there.

We might as well be hung for a sheep and a lamb as for a sheep alone.

But that view invites a response along the lines that if you find yourself in a hole, first stop digging.

The problem arises from the way prices are set on the wholesale electricity market.

The spot price in any half-hour period is the price of the marginal generator. In other words, it is the most expensive power needed to satisfy demand in that period.

Other generators who have offered electricity at lower prices get the spot price all the same.

Much of the time that marginal generator is one of the gas-burning plants. It is especially likely to be so when demand is relatively heavy.

So the cost of LNG would heavily influence average wholesale electricity prices and, with a lag, retail ones as well.

The report assumes the two companies import 60PJ of natural gas to supply existing combined cycle gas turbine plants, including the one under construction at Huntly.

They do not consider the implications of any further gas-fired generation being built, though that would become more likely once the LNG infrastructure was in place.

And they take as given, the companies' estimated price range for the gas.

The problem is that in the Asia-Pacific region, LNG prices are linked to oil prices. The relationship is not one to one; a US$1 increase in the price of a barrel of oil does not necessarily result in a US$1 increase in the equivalent quantity of LNG.

But the most perfunctory googling throws up lots of reports of LNG prices rising as oil prices have climbed and of LNG supply contracts being renegotiated as as their oil price cap provisions are breached.

And, of course, we have just seen a 12 per cent drop in value of the kiwi dollar in a matter of weeks.

So the question remains: Why would we want domestic electricity prices to be hostage to world oil prices and the exchange rate?

Former Shell chairman Lord Oxburgh, in Wellington for a climate change conference this week, warned that the days of cheap oil are over.

"The earth is getting pretty well explored," he said. "The chance to find very much more [oil], especially in the concentrations which make it easy to get out, is very small. I'm not saying it is running out but it is getting scarcer and more expensive."

He said it was hard to see any pressures that would push oil prices down again, short of a major world recession. Oil prices would continue to oscillate but around a rising trend.

The report's authors admit that: "Experience has shown that a major change in relative prices globally, or in resource availabilities locally, can necessitate potentially painful and costly adjustments to the structure of the domestic economy."

A sharp rise in imported oil prices could send the dollar lower. "This could aggravate the pain to importers and consumers while benefiting exporters and some domestic producers of energy."

Even a major oil strike would be a mixed blessing. "A large domestic oil find could appreciate the currency, creating major losses and unemployment in traditional export industries."

In their opinion, the proposed LNG project "is too small statistically and economically to justify any material concerns of an economy-wide nature".

But, there is another problem.

Comalco has made it clear that the sort of electricity prices needed to make LNG viable would be too rich for its blood.

But if the aluminium smelter were to close, say in 2012 when its present power supply expires, that would suddenly free up about 5000GWh of electricity a year, about a seventh of national production.

What would that do to the economics of LNG-based power? It would certainly reduce the net present value of those generators' revenue streams in a big way compared with a scenario in which the smelter is still there. Would a billion dollar LNG terminal and re-gasification plant turn into an instant white elephant?

It looks like a Mexican stand-off: LNG means no smelter (with the loss of 1000 jobs and $1 billion a year in export receipts) but no smelter means no need for LNG, at least for another six years or so.

Comalco and Meridian Energy are in the throes of re-negotiating the power contract, a process not expected to be concluded until next year. They really need to know if Genesis and Contact will go ahead with LNG.

But Genesis and Contact really need to know if the smelter will still be in the picture post 2012. It's a mess.

Appearing before the commerce select committee last week, Electricity Commission chairman Roy Hemmingway aired his concerns about the possibility of a three-year generation crunch, if Comalco decided to close the smelter.

There is probably enough new generation due to come on stream to see us through to 2009.

But if the smelter is to close, the electricity it uses could take care of about six years' worth of normal growth in demand. Instead, investment would be needed in transmission to upgrade the equivalent of a dirt track connecting Manapouri power station to the national grid.

Generation investment plans would go on hold.

But what about the 2009 to 2012 period when the smelter would still be operating but no new generation was economic?

Hemmingway said some kind of intervention would be needed.

Intervention? In a market-based system?

The present industry structure is the handiwork of policymakers convinced that whatever the problem, the solution is a market. You want security of supply? You want efficient investment? Just build a market and they will come.

But what we have ended up with is the risk of the third winter power crisis in six years, and the prospect of electricity prices driven by the world oil market and the exchange rate.

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