NATURAL GAS TRADING IN INDIA

Gas Market in India

Natural gas industry in India is under government control today due to its strategic importance.
Till few years back, the production of natural gas in the country was totally under the control of
two PSUs viz. Oil and Natural Gas Corporation (ONGC) and Oil India Ltd. (OIL). However,
with the New Exploration and Licensing Policy (NELP), private players have been allowed to
participate in exploration and production of natural gas. Currently, the two PSUs still account for
83 percent of domestic gas production. Marketing of gas and pipeline infrastructure is
undertaken by GAIL India Ltd. Companies such as Gujarat Gas Company Ltd.

(GGCL), Mahanagar Gas Ltd. (MGL) and Indraprastha Gas Ltd. (IGL) are engaged in
distribution of gas and are regional players. Power and fertilizers are the two primary sectors
which together account for close to 80 percent of the gas consumption. Besides, other sectors
such as petrochemicals, sponge iron and transportation also consume natural gas. Demand for
natural gas in India for 2003-04 was estimated at 98 mmscmd (million standard cubic meters per
day). Against this demand, allocations made by Ministry of Petroleum and Natural Gas
(MoPNG) stood at around 120 mmscmd. Currently, in India, natural gas forms 8 percent of the
primary energy consumption as compared to 24 percent worldwide. According to India
Hydrocarbon Vision 2025 report, demand for natural gas is expected to show a sharp rise in the
future with the demand reaching to 391 mmscmd by 2024-25.

The report also expects that the share of natural gas in total energy mix to go upto 20 percent.
The demand for natural gas is expected to grow at a CAGR of more than 7 percent by 2007-08.
The major force behind this demand growth will be investments in power sector. Government is
planning to add power generation capacity of 41,110 MW under the Tenth Plan and over 60,000
MW in the Eleventh Plan. Fertilizer sector will fuel this demand further as major players switch
from naphtha to gas as feedstock.

Indian market is looking for LNG from suppliers with softer terms and conditions some of which
are mentioned below:

(1) Shorter duration contracts

(2) Pricing formula
(3) Fixed price
(4) Quasi fixed Price by setting a formula
(5) Price with Floor and Ceiling Negotiated ratio of fixed elements while lowering the ratio of
the crude oil-linked portion.
(6) Flexible Terms and conditions

Indian importers shall endeavor to create an optimal portfolio of LNG contracts by negotiating
different pricing formula with different contractual terms. This will enable them to match
demand patterns, customer needs and lower generating costs.

Natural Gas Trade

(1) Natural gas can be transported in pipelines or as LNG. As natural gas is inherently bulky, it
cannot be economically transported in its gaseous form by pipeline across deep oceans over long
distances (over 2,500 km), even where long distance transportation is technically feasible. Once
liquefied, however, natural gas is much more compact, occupying 1/600th of its gaseous volume.
This makes LNG convenient and safe to

handle, transport and store in large amounts as energy in liquid form. With steady growth in
demand, world trade in natural gas has also increased at a CAGR of about 8% over the past 28
years. Between 2001 and 2002, both pipeline exports and LNG exports grew by 4.9%. Projected
increases in consumption will require bringing new gas resources to the market. Numerous
international pipelines are either planned or are already under construction.

(2) The development of liquefaction technology, the need to transport natural gas over long
distances across oceans, coupled with cost decreases throughout the LNG chain, has made LNG
more economical, and led to expectations of strong growth in international LNG trade. The
economics of transporting natural gas to demand centers currently depend on the market price,
and the pricing of natural gas is not as straightforward as the pricing of oil. More than 50% of the
world's oil consumption is traded internationally, whereas natural gas markets tend to be more
regional in nature, and prices can vary considerably from country to country. In Asia and Europe,

(3) LNG markets are strongly influenced by oil and oil product markets rather than by natural
gas prices. As the use and trade of natural gas continues to grow, it is expected that pricing
mechanisms will continue to evolve, facilitating international trade and paving the way for a
natural gas market

LNG International Trade

(1) International trade in LNG, which began in 1954, has grown to 150 bcm in 2002.
(2) This accounts for around 26% of the total trade of natural gas internationally; the balance
natural gas is traded via pipelines.
(3) Asia Pacific accounted for about 70% of total LNG imports in 2002 followed by Europe and
North America.
(4) Japan and South Korea are the key markets for LNG, where natural gas cannot be supplied
through pipelines.
(5) Japan is the largest importer of LNG in the world, and accounted for 48.5% of total LNG
imports in 2002.

(6) LNG imports in most countries are backed by the Government or state-owned entities, like
Kogas in South Korea, China Petroleum Corp in Taiwan, and Gaz de France in France.
(7) In Japan, the importing agencies are power utilities for captive use of natural gas, and gas
utilities for distribution.
(8) The major exporters of LNG currently are Indonesia, Algeria, Malaysia and Qatar. LNG
project developers typically seek a long term contract (20-25 years) for their product at a price
that is sufficient to cover their capital costs, which includes take-or-pay and floor price
arrangements to ensure that the project can service its debts even in a lower than- anticipated
price scenario.
(9) It is also common for consumers to take an equity stake in LNG projects, so as to have a
community of interest between the buyer and the seller.
(10) A successful LNG Project must have large and sufficient proven at the end of the project.

Indian Scenario

(1) India is the third largest consumer of natural gas in Asia, relying until now on domestic
production, gas still accounts for less than 10% of primary energy consumption, and the
economy is increasingly starved for natural gas and power.
(2) For a number of reasons, ranging from environmental concerns to competitiveness in power
generation, natural gas remains a sought-after power generation based on imported naphtha and
condensates will not be able to compete with natural gas, although increased domestic
production could affect demand for gas imports.
(3) For now, gas imports via pipeline and increased domestic naphtha production remain more
distant possibilities; meanwhile both the government and private industry are pursuing LNG
imports. Like Asia, India's primary energy mix is dominated by coal, owing to coal's availability
in abundance at a lower cost, relative to the other energy sources.
(4) While primary energy consumption grew by 3.5% in 2002, coal marginally increased its
share in the energy mix from 54.9% in 2001 to 55.6% in 2002, and oil lost share marginally from
30.8% to 30%.
(5) Natural gas maintained its share at 7.8%. Going forward, as per estimates, the total share of
oil and gas in the primary energy mix is not expected to change substantially.

(6) However, gas, owing to its non-polluting nature and ease of use as compared to oil, is
expected to gain significance and have a greater share in the primary energy mix.

Demand of Gas
(1) The increasing importance of natural gas, as a fuel and as a feedstock, is expected to drive the
demand for natural gas in India.
(2) With gas' share in the primary energy mix projected to increase to 15% by 2007 according to
the Hydrocarbons Vision 2025 report, the demand for natural gas is projected to increase from
151 mmscmd in 2002 to 231 mmscmd in 2007 and 391 mmscmd in 2025.
(3) In 1991, GoI established the Gas Linkage Committee to re-assess the potential of gas
production and establish the priority of gas availability of gas.

(4) Based on the recommendation of the Committee, MoPNG makes the gas allocations.
(5) Natural gas is used in India as a fuel in power plants using combined-cycle technology, and
as a feedstock in the fertilizer and petrochemical industries.
(6) It is also used as a fuel in several other industries, such as glass, ceramics, sponge iron and
tea.

Supply of Gas

(1) It increased more than ten-fold (from 2.4 bcm in FY1981 to 31.4 bcm in FY2003) after the
Bombay High field commenced production.
(2) Initially, the demand for gas was low, but with commissioning of the HBJ pipeline and
projects, demand rapidly increased.
(3) Currently, there is a shortage of gas, and this demand-supply gap is projected to increase with
strong growth in demand vis-à-vis plans to bridge this gap by resorting to alternate sources of
gas.
(4) This strategic importance of natural gas for the Indian economy coupled with a shortage of
supply and its recognition by the GoI has had an impact on the evolution of the fiscal and
regulatory environment for natural gas.

Analysis of Natural Gas Demand & Availability from Various Sources

Currently most of India’s gas is produced from the western offshore fields which include South
Bassein fields, Joint Venture fields of Tapti & Panna-Mukta and production of Associated
Natural Gas from Mumbai High. The gas supplies from South Bassein fields and JV fields are
fed into HBJ system for gas supply to Northern and North-western part of India including
Gujarat. The other onshore gas producing regions within the country are as follows:
(1) Cambay Basin, Gujarat
(2) Cauvery Basin
(3) Krishna-Godavari Basin
(4) North-Eastern region including Assam & Tripura
(5) Rajasthan

Gas Demand

(1) The power and fertilizer sectors have been core consumers of natural gas.
(2) These two sectors together consume about 70% of the gas today.
(3) The balance goes to industrial units where it replaces mostly liquid fuels.
(4) Gas is also supplied to the residential and the commercial sectors in Mumbai, Delhi and a few
towns of Gujarat, Assam and Tripura.
(5) Over the past many years a number of gas demand projections have been made by various
agencies.

Projections

(1) A number of attempts have been made so far to estimate the future demand for gas.
(2) Although the figures do change every time the exercise is taken up, a trend of increasing
demand far exceeding the supplies available from indigenous sources seems to have been well
established.
(3) In a meeting taken by Secretary (P&NG) on 29.04.2005 regarding projected demand of
natural gas in medium to long term.
(4) The meeting was attended by officials from Ministries of respective consumer industries viz.
Power, Fertilizer, Steel, etc. and experts from other companies/agencies involved in gas business.

Gas Trading

(1) Natural gas trading refers to the resale of natural gas in the wholesale market, and supply to
resale in the retail market. (In the United States gas trading and independent gas supply are
considered part of marketing.) Because these two operations are closely related, they are often
performed by the same firm.
(2) The gas trading and supply business is a very competitive segment because of the limited
scale economies.
(3) Traders and suppliers need little up-front investment to start operations— a trader needs only
a desk, a computer, and a telephone to contact customers and make deals.
(4) As a result, the optimal size of a gas trader or supplier is small relative to the gas market.
(5) This optimal size increases with deregulation of the industry— because markets become
more complex, with increasing use of short-term and financial transactions— but not enough to
pose a threat to competition in the segment.

Role of Gas Trading Supply Demand Matching

The uncertainty of demand

(1) Long-term contracts will only be signed if there is a secure potential for an outlet.
(2) The fact that the national markets are immature with weak internal infrastructures, means that
most potential outlets in the new markets (about 85%) are in the fields of electricity production,
chemical usage and some other big consuming sectors.
(3) This fact alone restricts the potential for development, and as a result the import projects are
mostly linked to electricity production projects; this is a well-known pattern already encountered
in previous market developments in Japan and South Korea.
(4) It will be favored in future because of the liberalization of the electricity industry and the
advent of independent power producers using combined cycle gas turbine equipment. In future,
however, it will also be severely restricted by the level of networks and urban distribution
networks, as will be the case in China and India.

Expanding spot trading contributes to increasing flexibility of supply

(1) Spot trading of LNG, which is a yardstick of flexibility, is increasing at a rapid rate.
(2) Transactions under short-term contracts (less than a year and inclusive of spot trading) in
2001 recorded a tenfold increase over 1992 levels and reached a hefty 8% of total trade (IEA,
“Flexibility in Natural Gas Supply and Demand”).
(3) Above all, conspicuous rises were noted in spot - traded LNG destined for the US.
(4) In order to expand their LNG sales, the oil majors, among others, are no longer remaining
idle in the position of investors, interest holders and/or suppliers of LNG in the upstream sector.
(5) They are adopting the strategy of becoming LNG buyers themselves and are collecting the
surplus capacities of many projects, while tapping new demand.

(6) The colossal U.S. market (consuming ten times more natural gas than Japan) can
easily digest such moves.
(7) This is why the US-bound LNG spot trading is ballooning so rapidly.
(8) This concept is becoming real in the Atlantic market, as demonstrated by
expanding spot transactions.

Price Discovery

Lack of transparent pricing mechanism

(1) The factor behind under-utilization of natural gas in Asia is the lack of
transparent and competitive gas pricing mechanisms.
(2) Though Asia dominates the growing world LNG trade, LNG accounts for only a
quarter of international gas trade, and involves only a few countries in Asia. For
most Asian countries, natural gas is locally produced and consumed.
(3) These four factors, combined, have contributed to a low level of gas
consumption in Asia. Promoting gas consumption did not become a priority for Asian
governments until the economic boom of the 1980s generated the skyrocketing
energy needs of the 1990s.

Prices Fluctuation

(1) Changes in gas cost – major factor

(2) Seasonality in demand
(3) Product supply/demand imbalances
(4) Proximity of supply/supply disruptions
(5) Competition in local market
(6) Environmental regulatory programs
(7) Costs to produce cleaner products

Consideration of pricing -formula options

(1) Options of future “pricing formula” are summarized below.
(2) Fixed pricing (stated by a PETRONAS vice president for gas at SPEC 2002;
(3) Oriented toward a? crude oil price-free mechanism) Quasi- fixed pricing by
setting a small figure for “a” in the formula, P = aX + b (adopted by China/India;
(4) Oriented toward lower price and stability) Raising the ratio of fixed elements
while lowering the ratio of the crude oil-linked?portion (proposed by a Japanese
importer at the World Gas Congress 2000;
(5) Oriented toward lower price and stability) The retail price of coal/coal- heavy fuel
oil-crude oil/electricity, etc. taken as price indicators (prevailing on the European
Continent; to help LNG-fired power retain/stabilize its competitiveness against rival
power sources).
(6) Petroleum products such as heavy fuel oil and kerosene taken as price
indicators?(prevailing on the European Continent; to help LNG-derived city gas
retain/stabilize its competitiveness against rival fuels) LNG pricing linked to
NYMEX/IPE futures (in order to reflect on-going market conditions) Making the
contract two-tiered, with a flexible delivery portion (to better meet seasonal
demand) and a?fixed delivery portion (separation of price and flexibility) Many
options of pricing formula will be available in the future. It is also possible to
arrange a wide variety of LNG contracts by pairing different pricing formulas with
various trading patterns, each having flexibility of its own (e.g. long, medium and
short contract terms, varying TOP coverage, non-uniform deliveries).

Trading Models in the Deregulated Natural Gas Industry

(1) Trading mechanisms guide transactions in natural gas and transportation markets.
(2) They facilitate interactions among market participants with the objective of achieving
simultaneous clearing of natural gas and transportation markets at minimum cost to the gas
industry.
(3) Deregulation of the natural gas industry leads to separate trading of natural gas and
transportation services, which increases the complexity of markets and imposes substantial
requirements on market participants if they are to complete all their transactions at the minimum
cost.
(4) While a vertically integrated gas company optimizes all transactions internally, participants
in a deregulated gas industry must coordinate their natural gas and transportation transactions in
an open market.
(5) The process of minimizing the total cost of natural gas and transportation to the industry must
take place across thousands of decentralized transactions.

(6) Unless these transactions are guided by a trading model, they can result in sub optimal
allocation of resources.

Bilateral Trading Model

(1) The bilateral trading model is based on decentralized bilateral transactions.
(2) The model relies on competitive gas and transportation markets to generate efficient prices
and minimize the cost of natural gas to the end users.

Decentralized Spot Markets

(1) In the bilateral trading model market participants conclude all deals in bilateral negotiations
and write contracts that address all issues relevant to a transaction.
(2) Demand for ways to minimize of transaction costs leads to the emergence of traders who
complete transactions on behalf of other market participants.
(3) Spot markets develop as market participants require efficient pricing of natural gas at every
moment.
(4) Spot markets are thus developed through the decentralized action of market forces.
(5) Competitive spot markets generate signals about the market value of natural gas and give
market participants the right incentives to complete transactions efficiently.

(6) As a result, decentralized bilateral trading among market participants achieves the outcome
that is optimal for individual participants as well as for the natural gas industry as a whole.

Distance-Based Pricing of Transportation

(1) Charges for transportation services sold in the primary transportation market are based on the
fixed and variable costs of a pipeline company per unit of distance over which individual
shipments take place.
(2) A capacity charge is set to recover total fixed costs, while a throughput charge is used to
recover the variable costs of transporting natural gas.
(3) Transportation contracts sold in the secondary market are priced according to the short-run
marginal cost of capacity.