The United Kingdom’s rising dependence on imported natural gas was thrown into stark relief last winter when falling North Sea production, icy temperatures, and underused import and storage capacity sent spot prices soaring.

Although some 40Bcm of new import and storage capacity will be online by end-2006 (Table1), the United Kingdom is still facing low flexibility in its gas system with questions remaining over whether the country has sufficient supplies to meet demand.
The tight supply-demand position was highlighted in winter 2005/06 that began with speculation from the UK Meteorology Office (Met Office) that a very cold winter was forecast and rising concern that the country did not have the required gas import capacity in place to cope with such temperatures.

This resulted in very high forward prices over the winter, ranging from a minimum of £0.53pertherm (US$1.01/therm) to a maximum of £1.18/therm, and record spot price spikes towards the tail-end of winter as the country’s largest gas-storage facility Rough went offline following a fire. The shortfalls forced energy regulator Ofgem to ask power station operators and industry to switch to alternative fuels, and led to an investigation into low capacity usage on the United Kingdom–Belgium Interconnector (IUK) and an European Union (EU)-probe into reserve mechanisms in continental Europe.

At first glance, prospects for winter 2006/07 look much improved with the Met Office issuing a conservative forecast on temperatures over the coming months and new import infrastructure in place, thus easing concerns over tightness in gas supply. However, should we really be less concerned about the gas supply and demand situation this winter than last?

In this Special Report, we assess the reasons behind last winter’s price spikes and look ahead to the coming few seasons to ascertain the likelihood of a repeat situation. In summarising the results of Global Insight’s Flexibility Study for the United Kingdom, we ask specifically whether the United Kingdom could still face price spikes driven by an ongoing supply-demand gap if temperatures fall below seasonal norms for a prolonged period this winter.
The weather factor

In examining the winter gas supply-demand position, it is essential to identify the main parameters classifying winter and how they affect demand. Global Insight’s flexibility model has two principal criteria: ‘normal’ weather, defined as average winter conditions; and the magnitude of a 1-in-50 winter, which is the criterion used by some companies for planning purposes. The data used for the weather analysis is heating degree days (hdd), defined as the daily average temperature below 18°C. The UK winter is defined as lasting from November to March.

The suggestion that normal winters are getting warmer calls into doubt whether we can assume a normal or 1-in-50 winter today is the same as over the past 50 years. We know that weather is normally distributed. Hence, we first check the data for a significant change in the mean and variance over time using econometric tests. Where there is a significance, we can then calculate the change in mean (or normal weather) for each year by taking the average change in means of two data sets.
The following key factors can be noted when undertaking weather analysis:

o All EU7 countries ( examined have had a significant change in normal winters, but not the variances.

o When looking at the coldest peak temperature – in our case the average of the three coldest consecutive days –there has been no change in trends.

o There is high correlation in weather between countries in continental Europe.

o The United Kingdom has high weather correlation, but not as high as countries in continental Europe.

In conclusion, the United Kingdom could sometimes have a slight advantage when obtaining spot supplies from Europe if the weather is not so highly correlated between the United Kingdom and the north-western continent: ie, a lag in weather change could ease the tightness of supplies from Europe when required in the United Kingdom. However, the high correlation also indicates that a cold winter in continental Europe will mean a cold winter in the United Kingdom.

Winter 2005/06 saw different weather severities across Europe. All countries experienced a colder than normal winter, with the coldest weather occurring in January 2006. However, the severity of Germany’s winter was greater than in the United Kingdom as shown in Table 2.

The United Kingdom had a cold winter (probability of less than 50percent is considered ‘normal’), but it was close to 50percent unlike that of Germany, which was close to a 1-in-50 winter (which has a 2percent probability of occurring).
Having determined the weather parameters for the United Kingdom as shown in Fig.1, the relationship between historical weather data and demand data allows the model to project the supply and demand position that the United Kingdom could face under different weather conditions.

The events of winter 2005/06 can help in assessing the situation the United Kingdom could face in winter 2006/07. Every month except March in winter 2005/06 was marginally colder than normal; the coldest month being January. However, in winter 2005/06 total gas demand in the United Kingdom reached 55.3Bcm, compared with ‘normal’ demand of 57.3Bcm.

Demand could have reached 58Bcm over the period had high gas prices not caused a 2.7-Bcm drop in demand. In particular, there was significant demand-side response from the power-generation sector as well as industry following regulatory requests to switch to alternative fuels to ensure continued gas supply to the domestic sector.
Over the period, 77percent of gas supply was met by indigenous production in the United Kingdom, with 19percent imported and 4percent provided from storage shown in Fig.2. Concern grew when IUK did not run at full capacity despite high prices. This situation occurred because of constraints into Belgium as well as cold weather in continental Europe, which caused bottlenecks in continental Europe and led to physical congestion. Such problems occurred on the pipeline route to Zeebrugge running from Eynatten on the Belgian border and affected Dutch export points into Belgium, routes used for transiting gas to the United Kingdom from Russia, German storage, Norway via the Zeepipe or the Netherlands.

That said, in winter 2005/06 there was virtually no Russian gas shipped to the United Kingdom because of the Russia-Ukraine price dispute in early January, which resulted in reduced supplies to all of Europe. This was followed by very cold weather in Siberia, which caused Russian gas pipelines to freeze and led to many European countries not receiving the full requested Russian gas supply until after February.

In addition, continental European utilities displayed more of a public service rather than
short-term ‘commercial’ approach to reserves than in the United Kingdom, choosing to keep gas in storage at the start of the winter rather than export it to the higher-priced UK market, despite arbitrage opportunities. During winter 2005/06, only 64percent of IUK and 42percent of LNG capacity at the UK sole facility Isle of Grain was used, a factor that UK energy regulator Ofgem estimated cost U.K. consumers up to £1.5billion over the winter.

If the United Kingdom faced a normal winter for 2006/07, gas demand would be 58Bcm rising to 62Bcm in a 1-in-50 winter, assuming growth in the UK gas market of 0.6percent. If demand is +1 standard deviation away from the mean, demand swing would be 2.3Bcm. This is a colder winter than experienced in winter 2005/06, as shown in Fig.3.

The supply position for the United Kingdom in winter 2006/07 is, for two reasons, slightly more optimistic than the last one: first, because of the potential to import the required supplies; and, second, because of a new gas contract that is expected to start supplying.

We forecast that indigenous gas production will decline from 42.8Bcm in 2005/06 to 41.8Bcm this winter, which places the country in a worse supply position than last winter. This is despite the completion of IUK’s expansion, which increases the supply potential into the United Kingdom by 7Bcm. Unfortunately, Belgian grid operator Fluxys’ transit capacity to service the increased expansion will not be ready until 2009 at the earliest. Hence, some of the previous winter’s issues regarding European bottlenecks will remain this winter’s issues too. We expect supplies via IUK to come mainly from Russia and European gas storage; another potential source is Norway through the Zeepipe.

The inauguration of new pipelines from Norway and continental Europe will provide additional supply security, but this may still not be enough to mitigate shortfalls if temperatures dive.

Dutch gas will now arrive via the Balgzand-Bacton Line (BBL), linking the United Kingdom with the Netherlands from December 2006, providing a second link with continental Europe. The BBL will boost the United Kingdom’s potential gas supply by 16Bcm/year. One-half of this capacity will carry gas under a signed gas contract between Dutch operator Gasunie and the United Kingdom’s Centrica for the supply of 5Bcm in the winter months and 3Bcm over the summer.

The southern section of the Langeled pipeline, which came online in October 2006 and provides Norwegian gas to the United Kingdom, also increases potential sources of supply. However, the Ormen Lange field, which will provide supplies to the United Kingdom when the northern part of the Langeled is in operation, will not be available until winter 2007/08. Nevertheless, supplies have and will continue to be imported, although recent reports suggest that Norway will not be able to increase supplies to the United Kingdom because of other export commitments. Even with Langeled in place, Global Insight does not believe that Norway will export more than 5.7Bcm, which includes contract flexibility, during the coming winter.

This means that the only contribution since last winter to firm gas supplies will be Dutch supplies contracted via the BBL. All other supplies are expected to arrive in the form of spot gas via IUK or the Grain LNG terminal.

There is no new additional storage capacity for this winter; however, the Humbly Grove storage facility will be operational this winter and the country’s largest storage unit Rough is expected to be fully operational (unlike last winter when a fire took it offline in February 2006). As a result, Global Insight expects the United Kingdom’s 3.8Bcm of full working storage to be available.

If the United Kingdom faces a normal winter this year then storage flexibility will not be sufficient, with the country likely to require contracted interruptions depending on the level of spot gas availability. Fig.4 shows that spot gas will be key to meeting demand. Unfortunately, spot gas in the form of LNG may be diverted to other markets, particularly the United States, if arbitrage opportunities emerge. IUK spot gas may also not arrive because of bottlenecks in Europe and/or limited potential suppliers.
Global Insight has developed two different scenarios to provide a picture of how much difference spot gas availability could make to the winter balance (Fig.4).
The result is under +1 standard deviation when demand is at 60Bcm – storage would be sufficient to balance demand if LNG utilisation was 30 per cent and IUK utilisation 50percent. However, contracted or voluntary contracted interruptions would be required if no LNG is imported and only 30percent of IUK is utilised.
The experiences in winter 2005/06 when IUK spot gas did not arrive despite high prices represent substantial supply risk. Gas supplies in winter 2006/07 face the same risk, leaving considerable uncertainty for UK balances.

The parameters in which the United Kingdom could cope without any spot gas are shown in Fig.5. The United Kingdom could cope with demand of 56.3Bcm without any additional spot gas, assuming all indigenous production of 41.8Bcm, contracted imports of 10.7Bcm, and storage of 3.8Bcm are used. We have estimated that this demand would be associated with a winter as cold as 1667 hdd, which has a cumulative probability of 27percent: or a probability of 73percent that spot gas would be required. Under a normal winter, the United Kingdom would require approximately 2Bcm of spot gas.

Outlook and Implications

Spot gas will remain the crucial factor in meeting UK gas demand for the coming few years until adequate import and storage capacity comes online. With the amount of spot gas available varying year by year, the key question is whether it will be sufficient to meet 2006/07 winter demand.

A liquid market such as the United Kingdom should attract the gas required; however, as seen in winter 2005/06 this may not always be the case despite high wholesale prices. This means that the United Kingdom’s dependence on spot gas will continue to pose a risk to supplies as indigenous production declines.

The shortage of piped gas suppliers also heightens the United Kingdom’s exposure to imports and increases the risk of future shortfalls. Much of the gas via IUK will come from Russian sources as Dutch gas is likely to transit via the BBL. The reduction in transport constraints from the Netherlands with the BBL in operation, as well as a signed gas-supply contract in place, helps strengthen the gas-supply situation.

IUK supply sources may also come from Norway via the Zeepipe or gas from European storage or LNG terminals, although the Belgian terminal at Zeebrugge presently has no capacity available for spot gas to the United Kingdom. Such reliance on continental supplies means that bottlenecks will pose the same risks to supply this winter as they did last winter until and unless they are addressed.

Spot gas via continental storage is unlikely to arrive during the early part of the winter because of the public-sector approach usually taken by industry operators in continental Europe. This means that gas supplies will be less responsive to prices in the early part of the winter. Dependence on LNG spot gas poses some risk to UK supply this winter based on arbitrage opportunities that could see cargoes diverted to other countries.

The high correlation in weather between the United Kingdom and continental Europe, as well as any supply problems on route, could decrease the potential supplies available to the United Kingdom. Russian supply interruptions could also cause significant supply problems to countries in Europe, which would have a knock-on effect for UK spot supplies.

Gas transiting several countries can also add to the risk of reduced supply, especially when experiencing a similar situation in weather and supply reduction as was seen in Italy in winter 2005/06.

Overall, the United Kingdom’s supply position for 2006/07 is slightly more comfortable than in winter 2005/06 because of the potential to import the required supplies.
However, the United Kingdom is not yet as well-placed as it should be for supply to match demand. With lower restrictions on import capacity, winter 2006/07 will be interesting to watch. In particular, a close eye should be kept on how the market deals with its growing reliance on spot gas.

Regardless of whether it is a warmer than normal or colder than normal winter, the key question is whether there will be sufficient spot supplies available when they are required, given the United Kingdom’s high dependence on this type of supply.

Ammi Thomas is with Global Insight. Article Extracted from Global Insight’s Gas Flexibility Service. For more information, visit www.globalinsight.com