PLAYERS LINE UP IN SCRAMBLE FOR U.K. NATURAL GAS MARKETS

David Knott
Senior Editor

Britain's gas supply industry is part way through an enforced change from a state owned monopoly to an open market. The next 3 years will see completion of the most dramatic part of the change.

Britain's industrial and commercial gas markets have already been opened. British Gas plc competes with other gas producers that have moved downstream, companies formed to buy gas for resale, and electrical power companies seeking to broaden their array of services.

Starting next year, the large domestic market will be liberalized, completing a government led process of change begun 10 years earlier.

This last stage of liberalization is likely to be by far the most complex, with potential players lining up to seize their share. But behind every opportunity there is a problem, and a big market shakeout is likely before too long.

BRITAIN'S GAS

Long before gas was discovered off the U.K. in 1965, Britain had built up a national gas grid to transport "town gas" manufactured from coal by state owned British Gas.

After first gas came ashore from West Sole field in 1967, the U.K. market converted to using natural gas from fields mainly in the southern U.K. North Sea. Britain has maintained a relatively secure future in gas production.

Britain's Department of Trade & Industry (DTI) calculates that 982 billion cu m of natural gas had been produced in the U.K. from 1967 to the end of 1994. Remaining gas reserves were estimated at 660 billion cu m at the end of 1994, while probable reserves reckoned at a further 855 billion cu m and possible reserves at 400 billion cu m. The U.K. produced 70 billion cu m of gas last year.

In 1986, Britain's government privatized the state gas production and distribution company, setting up British Gas as a public limited company, a monopolist with secure markets only for the medium term.

Government's aim was to introduce competition to the market in three main stages: industrial sector first, then commercial, and finally the residential sector.

At privatization, British Gas lost its legal monopoly of the contract market, made up of industrial users buying more than 2,500 MMBTU/year of gas. In 1989, the first competition for large contract customers in industry and power generation appeared.

COMPETITION

In March 1992, government demanded that British Gas open at least 60% of the contract market to competition. By December 1993, new gas suppliers had claimed about 50% of the contract market.

In August 1992, the commercial market, for users of 250-2,500 MMBTU/year, opened to competition. By December 1993, British Gas held 70% of the commercial market.

Now Britain's industrial and commercial gas market, defined as customers receiving more than 250 MMBTU/year, is fiercely competitive. British Gas said there are 60 authorized gas suppliers, of which 30 are active shippers,

"Half of Britain's gas market is open to competition," said British Gas Chief Executive Cedric Brown, in his 1994 report to shareholders. "By the end of 1994, our share of the total market above 250 MMBTU, including power stations, had fallen to around 40% from more than 50% at the start of the year."

Government's gas industry regulator, Office of Gas Supply (Ofgas), ordered British Gas to reduce its industrial and commercial market share, excluding power stations, to less than 55% by 1995. The company said its share of the sector was 47% by the end of 1994.

Ofgas data for the end of June 1995 show independent suppliers with 72.6% of the industrial and commercial market and British Gas with 27.4%. Ofgas estimates the U.K. industrial and commercial market at 800 million MMBTU/year.

GAS LEGISLATION

Legislation for liberalization of the residential gas market is to be set out in government's new gas bill, published in draft form in March. It was scheduled to be approved by parliament this summer.

The legislation aims to provide the legal framework for a new gas network operating code required for opening the residential market to competition in April 1996.

Wood Mackenzie Consultants Ltd., Edinburgh, said most of the gas bill consists of setting up a new gas code detailing conditions for operating and using the network and a licensing framework setting conditions for three types of system users.

One user will be the public gas transporter and operator of the pipeline system, a British Gas unit it designates "Transco." This unit is not related to Transco Energy Co., Houston.

The bill recognizes that distribution remains, in effect, a monopoly. So British Gas' prices for transportation services will remain closely regulated.

Gas suppliers will be responsible for delivering gas to customers and licensed to cover a specific area or customer category. Suppliers will have an equal obligation to supply all customers within the license. These include unattractive (less profitable) consumers, such as those likely to default on payment.

Shippers will arrange with transporters for gas to be sent from the beach through the grid to customers' premises. Supplier and shipper functions may be handled by the same legal entity.

LEGISLATION DELAYED

A DTI official said prospective gas suppliers must wait until the legislation is passed by parliament before they can apply to Ofgas for gas supply licenses.

Conditions for residential supply licenses to be written into the gas measure are expected to include an obligation to supply all prospective residential customers within an area, publish charges, and ensure continuity of supply.

Transportation licenses are expected to require licensees to keep separate accounts for transportation and storage, set standards of performance, and compensate customers if these are not met.

However, government announced July 13 it had decided to delay the final parliamentary stage of the gas bill until autumn, giving rise to concerns that opening of the residential gas market would be delayed.

DTI said July 14 remaining stages of the gas bill debate had been carried over until October. It hopes parliament will approve the remaining stages in November.

`DTI is still aiming to start the pilot scheme for competitive gas supply in Southwest England Apr. 1, 1996," DTI said. "Any gas supplier which assumes there will be delays risks putting itself at a disadvantage to competitors."

Clare Spottiswoode, director general of Ofgas, reportedly said delaying the gas bill until November would make it "...extremely difficult to bring in competition on the timetable envisaged by government."

Ofgas was reported to have been told by Treasury that funding for a licensing branch will not be released until the bill has become law.

A DTI official said it will be working on the draft license conditions in the meantime, after receiving advice from a consultative document earlier this year. Another consultation draft of license terms is to be issued in August.

John Alstrop, commercial director of Kinetica Ltd., a joint venture between Conoco (U.K.) Ltd. and power generator Powergen plc, said there was always known to be a possibility that the gas bill timing would slip.

"Dec. 1 was the appointed day for domestic (residential) market supply license applications," Alstrop said, "and in practice a couple of months delay might be good in allowing time for debugging of network operating systems.

"But finalization of license conditions can go ahead in parallel with final stage of the gas bill, so applications should be able to go ahead Dec. 1. We do not envisage any delays."

COUNTDOWN

Two main pieces of legislation will affect British Gas as it prepares for acceptance of competition throughout the U.K. gas market.

First is price formulas, decided by Ofgas. They set prices for transportation of gas through the existing pipeline network and storage of gas in British Gas facilities.

Brown said Britain's Transco will argue for formulas that recognize capital investment in the network "while ensuring a realistic return for shareholders and allowing our continued investment in a world class infrastructure."

Tariff formulas are constantly under review, an Ofgas official said, and the agency is taking first steps toward setting out proposals for 1997 tariffs reviews.

Then there is the network code, which will be a legally binding code of operation. It will set out rights and responsibilities of Britain's Transco and gas shippers using the existing grid for transportation and storage.

DTI said the schedule to introduce the network code has slipped several months, and changeover to operation under the code has had to be phased.

Under the revised schedule, and before the news of the gas bill's delay, all Transco's information technology systems, used to monitor and control gas flows in the grid, have to be in place and ready for trials Oct. 1.

By Dec. 1 Transco must be ready to begin operations of the network under special conditions. This will be a "soft landing" approach, whereby shippers will not at first be charged for imbalances at the end of every day.

NETWORK CODE

On Apr. 1, 1996, the U.K. grid is to be fully operational under the network code, with shippers liable to pay for imbalance in their daily shipments and so given a financial incentive to balance shipments.

Once the network code is in operation, tariff formulas for gas supplies will no longer apply. Gas prices will be left to market forces.

Ofgas sees its role as general policing of the network after 1998. This will include control of formulas for prices of gas transportation through the grid and for storage.

Current and potential gas shippers view the network code as a complicated arrangement. One source said it is not for the faint-hearted and will be tough for companies to work with and manage. The code's requirement to balance shipments every day or pay a penalty is the big danger.

Ultimately, Transco must ensure that there is enough gas passing through the grid each day to meet demand. If there are imbalances, Transco must put them right.

Every shipper will pay for Transco's readiness to intervene because the cost is spread in network charges, but individual penalties will be levied against companies that do not balance their shipments each day.

Texaco Ltd.'s Texaco Gas Marketing unit said what has been a difficult year for gas suppliers will become even more difficult when the network code goes into force.

Texaco said, "In place of balancing supply inputs with customer usage on a monthly basis, supplies must soon be balanced on a daily basis. Since weather can have a dramatic effect on customer usage-10 C. colder can mean 10% more gas--compliance with the new code will be a major challenge for the industry."

BRITISH GAS VIEW

In preparation for the new regime, British Gas has split into five business groups and is laying off a large number of workers. From 65,500 employees in August 1993, the company expects to cut back to 40,500 by the end of 1998 (OGJ, Dec. 27, 1993, p. 28).

In the countdown to residential sector competition, British Gas is shy of releasing details of its plans for operating under a liberalized market, saying it does not want to show its hand too soon.

The company's price is dictated by the Ofgas tariff formula, which will continue to operate as it is until 1997, when it will be reviewed.

A British Gas official said the company will be surprised if it is released from price regulation even then. But it will be negotiating for favorable terms as the market is opened.

The official said, "The bottom line for British Gas is that competitors will be able to undercut us on price terms because they are fresh to the market and without overheads like ours in the early stages.

"Also, British Gas is tied to long term gas supply contracts, unlike competitors that will be in a position to negotiate lower cost supplies."

Some rivals have said they can undercut British Gas prices by 10%, said the official, but this is speculation: "They know our upper price limit, but they don't know what price we will actually charge."

British Gas last year unveiled a new strategy to maintain revenues and profits after its monopoly market opened to competition. The game plan is to drastically cut staff and investments in Britain, while stepping up exploration, development, and downstream gas projects overseas.

Richard Giordano, British Gas chairman, said at the time the strategy required a change in attitude by British Gas: "We will be more dynamic and commercially astute" (OGJ, Oct. 17, 1994, p. 42).

Since then, the main statement of British Gas' intentions under a liberalized market has appeared in the company's 1994 annual report.

Brown reported that British Gas' Transco shipped an average 170 million cu m/day of gas in 1994. Transco is to be fully separated from gas trading units of British Gas by December 1995.

Brown said, "While for practical reasons the national pipeline system will remain a monopoly, it is now a separate business whose purpose is to enable a range of different suppliers, including the trading units of British Gas, to distribute gas to their customers safely and efficiently.

"Competition is being phased in to all gas supply markets, with some 30 companies already shipping gas via the British Gas system to industrial and commercial customers."

PILOT PROGRAMS

Britain has about 18.4 million residential customers, defined as those using less than 250 MMBTU/year.

Last March, DTI announced that Britain's gas industry had chosen an area farthest from North Sea gas terminals to test operation of residential supplies under a liberalized market.

Southwest England is regarded as the area that will be hardest hit by higher distance-related transportation charges under government's forthcoming gas legislation. Hence, it is a good test case.

About 500,000 consumers in Cornwall, Devon, and Somerset will be able to choose who supplies their gas from April 1996, when the British Gas monopoly on household gas ends in the region.

U.K. gas companies were asked last January by Tim Eggar, minister of industry and energy, to propose an area to test new market conditions (OGJ, Feb. 6, p. 32).

"The Southwest received by far the most support," Eggar said. "Nearly a third of all responses to our consultation document suggested the Southwest as the most suitable area."

DTI plans a phased introduction of competition in gas supply. After the test begins in April 1996, another 1.5 million homes are to be offered a choice of suppliers in 1997, with competition across the U.K. due in 1998.

Eggar this month disclosed details of the second area of Britain to be opened to competition for gas supply under market liberalization. One and a half million homes in the Avon, Dorset, Sussex, and Kent regions of southern England will be able to choose their gas supplier starting in 1997.

U.K. MARKET

Table (53582 bytes) Vicky Pryce, strategy partner and chief economist at management consultant KPMG, London, said the U.K. has the world's fifth largest gas market, and this is expected to grow 2.53.5%/year during the next 15 years.

Deregulation provides opportunities for market entrants, she said, with two million customers to be given choice of gas supplier starting in 1997 and Britain's 18 million homes free to choose starting in 1998.

Low overheads of independent gas suppliers in comparison with British Gas are said to yield a competitive advantage, although Pryce warned that competition among independents in the industrial and commercial markets has already narrowed margins.

Low potential returns are key to the future makeup of the domestic supply market, Pryce said. Only large utilities are likely to be able to bear the cost of market entry. That leaves financially weak companies to merge or seek niche markets to survive.

Among the financially strong companies is Alliance Gas Ltd., created in 1992 out of the BP Gas Marketing division. British Petroleum Co. plc is a 50% partner in Alliance, with Norway's Den norske stats oljeselskap AS holding 40% and Norsk Hydro AS 10%.

An Alliance official said the company claims to be the U.K. independent gas supplier with the largest number of customers, currently selling gas to 30,000 business premises.

The official said, "We have diversified from selling only to large customers, where there is intense market competition, to supplying smaller businesses as well."

Alliance is not yet committed to supplying the residential market as it becomes liberalized, but only because the regulatory regime has not been fixed.

"Alliance is reserving its position until legislation is in place," said the official. "If we do enter the domestic (residential) market we would not intend to be niche players. Alliance would look for a significant market share."

LIKELY PLAYERS

Peter Ind, director of gas services for analyst John Hall Associates, Horsham, U.K., said all 30 active independents in gas supply operations are reserving their options over residential market entry because of the frightening amount of legislation concerning supply guarantees.

"Assessing the potential market is difficult," Ind said. "All the Players have more gas than they need, and they see the domestic (residential) market as an opportunity to get rid of some.

"Big oil and gas companies want to spread their influence from gasoline stations into the housing estates. The majors and the electricity companies will most certainly be in the domestic (residential) gas market."

Ind is not sure how long the market will need to take shape: "All the companies are sitting on the fence over the pilot schemes, but I guess they will all want to be in there.

"They are all saying they would like to enter the market in principle, and they are gearing up to market their gas but, regional electricity companies apart, they have no experience in selling in this market."

Kinetica's Alstrop said his company, like other independents, is evaluating opportunities in residential gas supply.

He said, "Kinetica's decision on entering the domestic (residential) market depends on whether government and regulatory authorities are prepared to monitor and control British Gas to ensure that third party shippers are not disadvantaged by British Gas' actions."

Alstrop also said there has been much debate about whether the regulator needs powers in addition to existing competition laws. Independents are continuing discussions with government and Ofgas over the matter.

"There is a feeling among independents that current competition laws grind slow and small," Alstrop said. "By the time any investigation is completed the damage will have been done."

SHAKEOUT AHEAD

One adviser to U.K.'s independent gas suppliers said there is some fear that regional power companies are likely to become the dominant players in the residential gas market.

Power companies have well established positions in regional utility markets, unlike independents with origins in the oil and gas sector.

The adviser said residential market dynamics favor large companies. Buyouts of small companies are expected, similar to the Quadrant Gas acquisition of Gas-Direct Ltd. last May.

Quadrant, the U.K. gas marketing unit of Shell U.K. Ltd. and Esso U.K. plc, bought Gas-Direct but intends initially that the company will continue trading under its own name.

Quadrant said Gas-Direct's portfolio of large, multisite public sector and single site commercial and retail customers is a good fit with Quadrant's industrial and commercial customer base.

The adviser said some smaller gas shippers undoubtedly are set up with such a sale or with stock flotation in mind in the first place.

Gareth Howarth, gas market analy for Arthur Andersen & Co., London, said there is a great deal of uncertainty among gas suppliers as to how the market will shake down.

"Companies are thinking about the domestic (residential) market quite seriously and are preparing to jump in with both feet," Howarth said. "It would take a brave company at this point to say it won't enter the domestic market. Lots will jump in, but eventually the market will thin out."

KPMG's Pryce said potential profit margins in the residential sector are not great. She reckons only a handful of players, in particular majors and independents offering electrical power and gas, are likely to find the economics attractive long term.

The residential sector will become an oligopoly, Pryce predicted.

"We are going to find companies merging and small companies being taken over," Pryce said. "Economies of scale are the only way anybody will make any money in the domestic market.

"The domestic market will become a superutilities' sector after a while. Not all the independents have yet realized that they will have to merge to survive. Expectations among gas shippers about the costs of simply remaining in the market have changed for the worse."

Chris Bourke, market development manager for Total Gas Marketing, said recently the competitive nature of the gas market means that marketing is initially focused on price.

"With the competition intensifying, however," Bourke said, "we realized that we had to offer more than low prices to keep our existing customers and acquire new ones. It all boils down to service."

PRICE FALL

Gas shippers have set up a busy spot market in industrial and commercial gas supply It operates informally through deals made by telephone.

The Alliance official said many gas suppliers are interested in establishing a formal market, perhaps along the line of crude oil trading on London's International Petroleum Exchange.

Any formal trading center is likely to be established only after the network code is in operation, the official said.

"There is money to be made in trading on top of the benefit of being able to balance gas supply and demand," he said.

Trading has been one contributor to a recent massive reduction in the beach price of natural gas, with a ripple effect of improving the economic viability of the U.K.-Continent Interconnector gas export trunk line project (OGJ, Dec. 19, 1994, p. 26).

"Prices have fallen recently," said the Alliance official, "and the gas market is expected to be soft for a few years, although the price may still be volatile."

He said gas recently fell to less than 0.90 ($1.44)/MMBTU from 1.80 ($2.88)/MMBTU because of surplus supply on Britain's isolated gas market.

"Now U.K. gas prices are below those on the continent," said the official. "That means one of the problems attributed to the Interconnector no longer applies. Interconnector interest holders committed to the project when the price was 1.50 ($2.40)/MMBTU."

Wood Mackenzie said the gas surplus developed because:

Uncertainty over opening of the residential market to competition led British Gas to continue to contract for gas purchases in the belief that it might be forced to supply 100% of the residential market until 2002. That was suggested in the Monopolies & Mergers Commission report of 1992.

British Gas' forecast of lost market share, particularly in the interruptible supply contract market, has been exceeded by competitor penetration.

The requirement for British Gas to shed market share created opportunities for suppliers to secure customers with considerable ease. Suppliers offered simple discounts to British Gas published schedules. Competition drives down prices.

Wood Mackenzie said, "Uncertainty in the gas market caused by the impending changes in opening the domestic (residential) sector to competition may have long term repercussions for the industry as a whole.

"Market conditions and gas to gas competition in the industrial, commercial, and soon the domestic (residential) sectors will result in a lower gas price outlook for consumers and producers.

"The government has a balancing act to perform to ensure that an appropriate level of reward and incentive, for consumers and producers alike, is present in the gas chain."

Texaco said it has been a traumatic year for the natural gas market, with gas that traded at 2.20 ($3.52)/MMBTU a year ago now selling at less than half that price.

Texaco Natural Gas Manager John Perrett said recently that, while the price downturn acted to the detriment of most gas companies, for Texaco it had been a benefit.

"Unlike a number of our competitors," Perrett said, "we do not have long term purchasing agreements to buy at much higher prices. Each month Texaco can be much more competitive because we buy on the open market."

KPMG's Pryce expects gas prices to residential consumers to drop 10% after liberalization and the beach price to slide by as much as 40%. But she believes most potential residential market entrants will not be deterred.

Despite the residential market offering low margins and a strict regulatory regime and costs to market entrants still unknown, almost 30 companies have expressed interest in the Southwest England pilot programs.