Gas bills are rising - but there's light at the end of the tunnel

Gas and electricity prices have been in the media spotlight once more, with Centrica's British Gas announcing tariff increases for the second time this year and most of its competitors seem likely to follow its lead. Energy costs are difficult to avoid and have been putting increasing demands on household income. At the same time, the Monetary Policy Committee has just increased base rates by another 25 basis points to quell inflation, partly stoked by higher energy costs, resulting in higher mortgage and debt repayments. Consumers are therefore being squeezed on both sides.

The price of gas: nearing its peak

In amongst all the gloom, there is a chink of light at the end of the tunnel. This comes in the form of increasing gas supplies, which are being brought on stream in order to offset the UK's depleting North Sea gas resources. British Gas is so confident that gas prices are nearing their peak that it has just launched its Fix and Fall' product which allows dual fuel customers to fix their energy tariffs for the next 12 months and then see a 5% fall in tariffs at the end of 2007.

Oil and gas production from the UK continental shelf currently supplies three quarters of domestic energy needs. This is expected to rise in 2007 in response to increased capital expenditure stimulated by higher oil and gas prices and the Buzzard oil field reaching full production. Output is then expected to fall at an annual rate of between 9%, the trend rate over the last 3 years, and 4%, assuming that the current high levels of capital expenditure are maintained.

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Gas supplies: ensuring security of supply

The UK Government's Energy Review estimates that up to 40% of the UK's total gas demand could be reliant on imports by 2010 versus the current position of around 10% and that this percentage will rise to 80%-90% by 2020. The UK is already a net importer of coal and is expected to become a net importer of oil by 2010. Norway is already a significant supplier of gas to the UK, while Algeria and Qatar will become more important suppliers in the medium term. Longer-term, Russia, the Caspian (especially Iran) and Nigeria are likely to become increasingly important given that they jointly account for 79% of the world's proven reserves of natural gas.

This could increase the UK's exposure to geo-political risks in these regions. This necessitates a reliant and flexible energy system to ensure security of supply, which in turn is seen as being dependent on "a mix of fuel types, a variety of supply routes, international markets that efficiently allocate resources, back-up facilities such as gas storage, and a robust infrastructure to transport energy supplies to centres of demand". £10bn of private sector investment is planned over the next few years, which includes new gas pipelines, new liquefied natural gas (LNG) import terminals and new gas storage facilities.

Gas supplies: investing in infrastructure

The Langeled gas pipeline, which runs between Norway and Easington in Yorkshire is expected to begin pumping gas from the beginning of October 2006. This will be supplemented a year later by gas from the huge Ormen Lange gas field, at which point Langeled could supply up to 25% of the UK's gas demands. Furthermore, the Balgzand Bacton Line (BBL) interconnector which runs between the Netherlands and Norfolk is expected to become operational on 1 December 2006 with a capacity of 15% of peak UK gas demand. The existing gas Interconnector between the UK and Belgium is also being upgraded so that it will be able to supply a further 15% of peak demand from December 2006. The Rough gas storage facility, which declared a force majeure after a fire, is also back to full

injection capacity so should be able to fulfil its obligations to customers this winter.

In addition, the worldwide capacity of LNG shipping, import and export facilities is expected to almost double by 2010. In the UK, there are plans to add more than 100m cubic metres per day of LNG capacity over the next five years. Phase One of the Isle of Grain LNG terminal in Kent was commissioned in July 2005 and a £500m investment in Phase Two should be completed by late 2008, supplying 13% of the UK's gas demand. A Phase Three expansion is also under review. New LNG import terminals are also being built at Milford Haven in Wales, which could handle 20% of Britain's gas demand when operational in 2007. However, while LNG supplies

increase the flexibility of the gas market, long-term contracts, limited liquidity and shipping distances mean that the gas is largely supplied into regional markets.

Gas, unlike oil, is not currently traded in a global market. Assuming that all of these investments are delivered, they will not only address the need for diversity of gas supply but could increase gas import capacity by around

100bn cubic meters by 2015. This is not only sufficient to meet forecast

gas import needs but should also ensure a comfortable margin of spare capacity over the peak winter demand period. Consultants have assessed the risk of a significant involuntary supply interruption as "minimal" between 2008-14, only rising to 1%-2% after 2014 as the level of spare capacity becomes tighter.

Of course, the rollout of major infrastructure projects can be held up or even abandoned as a result of costly delays in obtaining planning consents. This could result in higher and more volatile gas prices impacting on both consumers and industry, particularly during periods of peak demand. To avoid this, the Government is holding consultations this autumn with a view to simplifying and streamlining the planning process.

Gas supplies: the issue of supply from Europe

However, even if the pipelines are open for business on time, it does not guarantee that gas will be pumped into them. Last winter saw UK gas prices rise well above those on the Continent and yet gas flows through the UK-Belgium gas interconnector averaged only 60% of its total capacity, implying that European gas companies were not responding to price signals as they would be expected to do in a competitive market. Instead, they seemingly chose to supply their own domestic consumers in preference to exporting gas to the UK. This has attracted scrutiny from OFGEM and

corresponding competition authorities within the European Union, so this issue should receive attention going forward.

The European Commission has identified a number of weaknesses in the EU's energy market, namely "the high degree of market concentration; vertical integration being used as a barrier to entrants; the lack of market integration; the lack of transparency; and the lack of well functioning and transparent market mechanisms for setting prices". It hopes to address these issues by promoting competition through liberalisation and making full use of regulation to tackle anti-competitive practices. If effective, UK gas prices should start to fall more closely in line with those on the Continent, bringing the additional benefit of less price volatility.

We conclude that as the supply of gas import infrastructure grows, there is scope for optimism that recent hikes in gas prices will at least flatten off in 2007 and could realistically start to fall in 2008. This will take some of the heat out of the inflation rate and could provide some scope for interest rates to start coming down. This would help to take the pressure off consumers and householders, as well as reducing the cost base of British industry, which has positive ramifications for the UK economy and equity market.

By Jeremy Batstone, Director of Private Client Research at Charles Stanley