What would it take to maximize returns from the ongoing deregulation and run the overall gas sector on a sustainable basis?
In order to maximize returns from private sector involvement and ensure sustainability of the overall natural gas sector, it is important to first adopt a holistic approach to resolve the deep-rooted structural and operational challenges. Underpricing of the fuel is a major challenge, and unless the subsidy structure is rationalized and ultimately done away with, the financial viability of the natural gas sector would be difficult. As observed in the previous sections, the global LNG market has been evolving rapidly, with new economies becoming a part of the value chain and the nature of purchase agreements and pricing dynamics changing over time. Pakistan is one of the countries that has made a late entry to this market. As such, it has the advantage of first analyzing and learning from the ongoing transformations across more mature markets – such as greater private sector involvement, emergence of flexible term contracts, and increasing share of spot purchases – and accordingly framing its medium- to long-term policy direction.
In this light, the regulatory and structural challenges would need to be addressed to smoothen the supply chain subtleties and satisfy the unmet demand. Furthermore, given the duration of the existing term contracts and the concurrent growing interest of new players to set up terminals and distribution networks, the existing government-controlled import operations would continue to run in parallel with the upcoming private sector involvement in the domestic LNG market. For such a hybrid market to function effectively, however, reorganizations would be required, along the lines of international best practices, to maximize returns from the ongoing developments. In particular, reforms in the following areas could potentially make the domestic LNG operations smoother and more efficient:
1) Introducing some form of price pooling mechanism to ensure that sufficient demand is generated and the public distribution network remains financially viable once private players enter the market
As noted above, the pricing of natural gas in the country is based on the provision of cross-subsidies: the household and fertilizer (feedstock) sectors are subsidized heavily, at the cost of commercial and transport sectors. 124
After the entry of private sector terminal operators and importers in Pakistan, who would be free to sell the imported fuel at competitive rates (with no government intervention), it is likely that the high-priced transport and industrial sectors, and other commercial units, may eventually move out of the public piped gas network – especially as new pipeline capacities come online and the virtual LNG distribution expands.
In this case, the two public utilities will be left with heavily subsidized and low-revenue sectors, since they will be bound to sell both the LNG as well as natural gas at prices negotiated or fixed by the government.
These gas utilities will also be bound by the LNG import prices negotiated by the federal government on a long-term basis under the term contracts. In contrast, the private companies could procure spot cargoes at the timing of their choice and as per suitability.
In this regard, a shift towards price-pooling would go a long way towards addressing this challenge. To a large extent, the uniform rate applicable on all the end-users would reduce the incentive to switch suppliers.
Furthermore, the potential revenue gains from switching household consumers to the weighted average LNG price, as opposed to the current slab-wise structure, would be significant. As of FY21, Pakistan’s indigenous supply of natural gas is unable to meet 29 percent of the total demand for gas by all sectors. This supply gap is estimated to increase to 78 percent by FY30. Assuming that this entire increase in unmet demand is met by imported LNG, then at current rates, the average foregone revenue in case of slab pricing for household consumers would be 55.6 percent of the realized revenue in FY30.
Price pooling may also help generate additional LNG demand in the country. This is important because in the short- to medium-term, where the take-or-pay contract agreements would stay in place for imports as well as terminal operations, additional demand generation can be one way to make prices favorable. It is important that this prospective LNG demand be generated from buyers who currently pay higher gas tariffs (almost at par to LNG rates), such as residential consumers using above 10.64 M ft3, transport and general industries, ice factories, commercial sector, and captive power plants.
This pooling mechanism has gained traction lately in the countries that are utilizing parallel gas supplies from indigenous sources and imports. For example, India introduced price pooling between natural gas and LNG for one of its largest gas consumers i.e., urea plants, in May 2015 to provide a level-playing field to all fertilizer companies and ensure better management of demand-supply gaps. In Pakistan, the adoption of a similar pricing mechanism may ensure smoother availability of gas to more productive sectors. Figure S1.14 illustrates the average natural gas tariff for different sectors. The red bars show current averages, whereas the yellow bars suggest the average tariffs, if the LNG tariff rates are pooled with the prevailing rates in different sectors.
2) Supply reliability would also be helpful in generation of additional demand
While price-pooling would help generate additional demand, provisions under the distribution agreements and in the sectoral allocation and management policies add a further layer of uncertainty to gas supplies.
During winter seasons, there is a heightened overall demand for natural gas. In these months, household and commercial gas consumers get prioritized access to both the indigenously sourced and the more expensive imported gas, according to the Natural Gas Allocation and Management Policy 2005. Furthermore, the consumer LNG contracts with gas distribution companies clearly postulate the right of distributing companies in terms of curtailing or discontinuing the deliveries of LNG to industrial and commercial consumers.
In such a scenario, other sectors, such as general industry and power, remain hesitant to increase their reliance on LNG and prefer to meet their energy needs through the indigenous natural gas (because of cheaper cost) or alternative fuels (to avoid supply uncertainties). Therefore, the government needs to review the allocation and management mechanism of natural gas supplies to incentivize sectors to switch to LNG, which would help utilize the excess terminal capacities and lower the end-user gas prices.
3) There is a need to discover the optimal balance between spot and term purchases
Over the long-term, sustainable demand can only be generated when end-consumers are certain of receiving smooth supplies at competitive rates. To a certain extent, private sector participation in LNG trade would fill the additional demand-supply gap while ensuring market efficiency. However, the authorities would have to appropriately weigh the pros and cons before deciding on importing the fuel via long-term contracts or short-term spot purchases.
There exists a trade-off between flexibility and stability when it comes to term and spot imports, with the applicable slope of the former staying relatively unchanged for the duration of the contract and that of the latter varying according to the overall global supply and demand dynamics.
As stated earlier, most of the LNG importing countries arrange their initial supplies through long-term contracts on G2G basis.
These contracts assure volume security, which is a primary consideration in building up the capital-intensive LNG infrastructure in the importing countries.
While the average duration of term contracts has still not changed considerably between 2015 and 2020 (Figure S1.15), excess supply in global LNG market in recent years has offered buyers relatively favorable conditions for both new contracts and renegotiation of existing ones. In comparison to the falling trend in international spot prices and the lower slopes contracted in the newer agreements, the older contracts appear to be expensive in terms of flexibility and pricing. From 2015 onwards, the newer global contracts began exhibiting more flexibility in terms of pricing mechanism, with increasing adoption of hub- based pricing instead of oil-linked pricing, and inclusion of more flexible price review clauses.
For instance, India’s state-owned Petronet had successfully negotiated with Qatar’s exporting company RasGas over non-lifting of LNG during 2015, and got a waiver of a take-or-pay payment. The deal also reduced the contract price by nearly half, with the flexibility to lift the 2015 take-or-pay quantity over the remaining term of the 25-year contract; the company also renegotiated the contract price with ExxonMobil. Similarly, in 2019, Japan’s utility company Osaka Gas initiated arbitration over its contract with ExxonMobil over the LNG pricing issue.
However, as mentioned before, the volume of spot trade has also substantially increased globally during the last few years, with its share in overall trade rising to 35 percent, from 5.0 percent in 2000.
