Henry Hub in Europe – Gazproms magic kingdom of sunk cost simulations

The mother of all battles is on in the gas industry. Haven’t seen it yet? Then you must be living on Mars. Gazprom certainly sees it and is rushing out to warn everyone who wants to listen – and those who don’t – that there will be no price war for gas in Europe and that the US LNG bubble is just that – a bubble that is why there is not going to be a price war.

Let’s see how much substance Medvedev’s claims have.

So far, Gazprom has not had a lucky finger in predicting the future of European gas. They have clung on to oil links in their gas sales contracts like it was holy water on the way to hell when it was already clear to even the most mule-headed of all gas professionals that those clauses go the way of everything – they will be part of Europe’s energy history. No more.

They – Gazprom – also believed that they could control a market that had already liberalized – as if it was still a bunch of monopolies that did not care for economics – when they could see what had happened in North America and the UK after liberalization.

Well, they are in for some more nasty surprises as what they call liberalization (oh yes, we call it that way too and we also have not seen anything yet) is just a pale copy of what a free market can do.

Let’s get into the mind of a Russian (or European or indeed other oil and gas sellers) energy strategist for a while. They still believe that the world is a zero-sum game and that markets can be controlled not knowing that the very notion of control would kill anything deserving the term “real market”. A market for them is a bunch of willing subjects that will buy whatever they have at whatever price. “Want some?” was a valid marketing gig in the high-price market. Gone.

They also believe, that humans usually behave rationally and that past behavior of consumers or societies is a good guide for future behavior. radical change makes them blush.

The inherent chaos of a truly free market gives them jitters because – in the end, they have decided to go into energy. After all, this world still seemed insulated from this free market fickleness. It all boils down to reserve numbers and plant-metrics and capacity-values and pipe dimensions and …

Do you get the picture? It’s like a general, moving troops and counting that figures will win him the day – eventually. If there is a shortfall in something, just put the numbers in and that’s it and if you do it alright – you can plan it all many years in advance.

The last couple of years should have taught us that hogwash never really works except of course if you kill the market and install those sweet monopolies again. However, even then it does not work but the monopoly has many ways to cover those malfunctions up. Consumers must always pay, regardless of what happens – they have no choice. And producers don’t have to worry about the wishes of those consumers anymore.

That’s different now. We have a choice and some of us use it.

Back to LNG from the US. Those plants have been built at a very high cost and in the current market environment, they won’t be able to recover them right now. In a sense, common wisdom should dictate that as they cannot possibly produce at prices the market will be willing to pay, they should mothball the facilities and wait for better times. Except that …

Part of the cost they suffer is the money they sunk to build the plant in the first place. This sunk money – or sunk cost if you like it that way – is gone, as no matter what you do, you have disbursed it regardless. This is also true if you have not yet paid but you have an obligation that is so firm that you cannot possibly think of wiggling out of it.

And this is also true if the very stuff you bought could potentially be used otherwise – but not really. A theoretical possibility is like a wet dream. It’s nice but you don’t get the satisfaction you can expect out of a real encounter with life, breathing person that craves this as much as you do. You know what you could do in theory if only …

Someone, who has engaged in regasification capacity which he cannot use otherwise (for whatever reason) but he does not consider it as sunk cost is having a wet dream. Someone having engaged in a time charter without an alternative cheaper LNG supply (cheaper than the expensive one) is having a wet dream if he treats it as a value-bearing item on the balance sheet.

Investopedia defines sunk cost as follows:

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DEFINITION of 'Sunk Cost'
A cost that has already been incurred and thus cannot be recovered. A sunk cost differs from other, future costs that a business may face, such as inventory costs or R&D expenses, because it has already happened. Sunk costs are independent of any event that may occur in the future.

BREAKING DOWN 'Sunk Cost'
When making business or investment decisions, individuals and organizations typically look at the future costs that they may incur, by following a certain strategy. A company that has spent $5 million building a factory that is not yet complete, has to consider the $5 million sunk, since it cannot get the money back. It must decide whether continuing construction to complete the project will help the company regain the sunk cost, or whether it should walk away from the incomplete project.

Unquote

If you are a utility buyer from Europe and you have bought US liquefaction capacity, then your tolling fee is sunk. CAPEX and OPEX are confounded as no matter what, you will pay this terminal fee to the operator who needs it to cover his obligations. If you are the owner of the terminal and you sell LNG, the OPEX is still future cost and potentially does not enter the sunk cost but then again, mothballing the plant is not free either.

Back to our buyer of liquefaction capacity – this company very likely also engaged in Time Charters for the vessels as you don’t do those things two weeks before the startup of the plant. Those costs cannot be avoided anymore as well so except if you can reuse the vessels otherwise, you may consider them sunk. But then, if your vessels are considered sunk, and your liquefaction fee as well, what is the regasification fee that you will have to lash out on?

You are right. It’s sunk as well. As your vessels are busy scooping up the LNG from the plant, you cannot reuse the regasification capacity otherwise than either subletting it or using it for other supplies but for that, you would need other vessels and …

That’s cocks and bulls as Africans like to call them. Let’s face it. Pretty much anything except the price of the feed gas you buy is sunk for you so those nice calculations at what price US LNG will stop coming, are bull. Because in reality, everyone will scramble to find an excuse for keeping things moving and the plants producing as everyone needs to make every dollar that can be made to save the balance sheet.

This means that Gazprom will have to compete with LNG at the price of Henry Hub in Europe for the foreseeable future. And that’s far below anything they are comfortable with. But they might want to look at their cost stack to find what parts of that are sunk cost.

To them at least.