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The U.S. demand for natural gas is outpacing domestic supply. The U.S. Department of Energy estimates that by 2025, U.S. demand will exceed domestic production by more than 10 trillion cubic feet per year. Since North America has only 4 percent of the world’s natural gas reserves, imports from overseas are becoming increasingly important to meet domestic demand. These gas imports typically occur in the form of liquefied natural gas, which is natural gas supercooled into a liquid that can be economically transported by ship to the United States, where it is regasified and sent by pipeline to customers. Despite the opportunity that LNG clearly offers to close the gap between domestic supply and demand, increasing LNG use by building more shipping terminals and regasification facilities will not be simple. Issues in several key areas may impede the development of the LNG industry. • States’ rights. The much-debated energy bill now before Congress contains language that clarifies Federal Energy Regulatory Commission authority to regulate and approve LNG terminals and facilities within the United States. The U.S. Coast Guard and the U.S. Department of Transportation have regulatory authority over offshore LNG facilities. But a number of states believe their local interest in the siting and regulation of these massive facilities should allow them to pre-empt FERC’s authority, especially when all the gas involved will stay within the state where the terminal is to be sited. This issue is so contentious that the California Public Utilities Commission filed a lawsuit against FERC. Commission President Michael Peevey testified before a Senate Energy subcommittee that state and local agencies have a better understanding of the conditions in their region. California is not the only state taking this position. Rhode Island Attorney General Patrick Lynch filed a federal suit against the energy company KeySpan over its plans to build an LNG facility in Providence. Lynch’s suit asserts the state’s underwater sovereignty as its authority for rejecting the project. According to Lynch (as quoted in news reports): “This is a state issue. This is our state land, and you just can’t run us over in this process.” KeySpan has countered with its own federal suit to determine what authority the Rhode Island state Coastal Resources Management Council has in the approval process. At issue is the council’s use of its authority under the federal Coastal Zone Management Act to approve or disapprove LNG projects. KeySpan has asked the court to issue an injunction to prevent the state from trying to exercise independent approval authority. Meanwhile, Maine teamed with several other states in a brief recommending that the federal courts interpret the statutory provisions that give FERC its authority over LNG terminals as not necessarily including siting. In addition, many local communities are conducting campaigns to prevent the construction of LNG terminals in their neighborhoods. One notable exception is Louisiana. Democratic Gov. Kathleen Blanco encourages energy companies to construct LNG facilities in the state, dangling carrots such as proposals to favorably revise Louisiana’s business tax code. The driving force behind the governor’s efforts is simple: the outgoing tide of oil and gas jobs that have been flowing from Louisiana to Texas. Her efforts to stem this tide may be successful, since, as of May 2004, three of the six LNG permits under consideration by FERC are for sites in Louisiana. • Financial risk. The economic health of these domestic LNG investments is very sensitive to U.S. natural gas prices. When U.S. natural gas prices were less than $3 per million British thermal units, the four import facilities in the United States experienced periods of inactivity. As prices have moved into the $5 to $7 per million Btu range, more than 50 new proposals have emerged for expanding and constructing LNG terminals to receive, regasify, and deliver natural gas. If prices decrease by just $1 per million Btu, many of these proposed investments may become questionable again. The LNG industry also may create its own financial health crisis. Given the number of proposed and planned LNG import facilities, U.S. industry may either overbuild capacity or bring capacity online ahead of the growth in demand for natural gas. Or infrastructure such as pipelines may not expand in concert with LNG terminal growth, creating distribution bottlenecks. Increasing supply ahead of demand will inevitably lower the price of LNG. Although that may benefit customers, it will harm all supply-side stakeholders. How is the industry attempting to manage these financial risks? Well before construction, facility owners are entering into contracts with customers to sell the natural gas produced. Success in placing the product prior to construction lowers investment risk and makes capital acquisition easier. Of course, the devil is in the contract details. Right now, facility owners try to enter very long-term contracts that span multiple decades. As long as the LNG industry is relatively small, such long-term contracts are necessary to get new facilities built and protect the facility owners’ and capital providers’ initial investment. As the global LNG industry grows and becomes increasingly competitive, however, the LNG market may experience structural changes. These changes could include the creation of a highly liquid LNG merchant market or an LNG derivatives market, where LNG would trade as a commodity rather than as a long-term contractual obligation. And the resulting competition might make long-term contracts much less appealing to producers and customers alike, thus creating financial uncertainty. There is a tension between the financial security of a long-term contract in today’s infant industry and the eventual ability to play in a world commodity market for LNG. • Geopolitics. As LNG joins crude oil and refined petroleum products as significant energy imports into the United States, the geopolitics that have long afflicted the oil business will, for the first time, affect the natural gas industry. To date, LNG imports themselves have been relatively risk-neutral, because the majority of U.S. LNG imports come from Trinidad and Algeria, both of which have long-term economic commitments to LNG that have caused their approaches to be very stable and supportive. LNG exporters worldwide include Algeria, Australia, Brunei, Indonesia, Libya, Malaysia, Nigeria, Oman, Qatar, Trinidad and Tobago, United Arab Emirates, and the United States (from Alaska). In the future, potential exporters may include Angola, Egypt, Equatorial Guinea, Iran, Norway, Peru, and Yemen. On the one hand, the addition of more sellers will reduce some risk. But the reality is that much of the viable gas production exists in countries that are not politically friendly with the United States. • Environmental concerns. The Gulf of Mexico Fishery Management Council, the Gulf States Fisheries Commission, the National Oceanographic and Atmospheric Administration, and others have raised environmental concerns about LNG. While the specific application of environmental regulations in offshore areas is unclear, these agencies’ concerns relate to ocean temperature. In one common process for revaporizing LNG, the “open loop” system, large volumes of seawater are drawn from the ocean to warm the minus-260 degrees LNG, and are then returned much colder to the ocean. Environmentalists fear that this “thermal pollution” could kill redfish, fish eggs, larvae, and other marine life. The alternative is a “closed loop” system that reheats (by burning natural gas, naturally) and recycles its heat-transfer fluid. A closed-loop system, however, has higher construction and operation costs than an open-loop system. • Safety and security. Many local communities have a “not in my back yard” response to LNG facilities. Opponents often cite fears over safety and security. It is important to recognize that these are two quite different issues. From the safety perspective, LNG facilities and tankers have enjoyed an extremely good record. Design standards for facilities and tankers established by industry organizations and government agencies require risk assessments during the permitting process to evaluate and mitigate any possible danger to the public. Ironically, the low frequency of accidents contributes to the uncertainty � little has happened, so determining how an accident might unfold is a theoretical exercise. Security issues are different. After 9/11, people developed heightened fears of terrorist attacks, especially at large facilities located near populated areas. Government agencies and industry organizations have responded by codifying enhanced security requirements. For onshore LNG facilities, federal regulations require security patrols, protective enclosures, lighting, monitoring, alternative power sources, and so forth. For offshore facilities, the Coast Guard requires 96-hour arrival notification, security exclusion zones around ships and facilities, escorts, armed sea marshals for at-sea inspections, and background checks. With such increased measures, incidents such as the attack on the USS Cole are unlikely in U.S. waters. In addition, LNG tankers are generally newer vessels that come equipped with continuous satellite tracking and active cargo and ship security features, observe anti-piracy procedures, and are owned by well-known, responsible companies. • Gas compatibility. Most natural gas in the United States is composed mainly of methane with a heating value of 1,025 to 1,060 Btu per cubic foot. U.S. gas producers achieve this composition by stripping out most of the ethane and higher hydrocarbons (which are “hotter” and heavier than simpler hydrocarbons) for use in the refining and petrochemical industries. Imported LNG, on the other hand, has a heat value of 1,100 to 1,800 Btu per cubic foot because it retains the ethane and some higher hydrocarbons. These differences in composition raise two main concerns. The first has to do with the dew point of the natural gas from LNG. Heavier hydrocarbons may condense into a liquid in the normal course of operations, creating a liquid stream that can clog and corrode pipelines and damage compressors. The second concern involves compatibility with natural gas appliances. Not all appliances can handle a higher Btu gas without modifications, so higher maintenance costs result. FERC and the industry are working hard to devise workable, consistent gas-quality standards. Because importers must spend money to bring their LNG into compliance with any new standards, the ultimate standards adopted will be a major factor in LNG economics. Importing natural gas as LNG is a significant part of the solution to the problem of meeting growing U.S. demand for clean fuels. While the technology is reliable and safe, battles over states’ rights, security, environmental protection, and compatibility have yet to be resolved. In addition, the industry is poised to create its own financial problems if there is over-construction or poor timing of terminal facilities, or failure to increase pipeline infrastructure in concert with LNG terminal capacity. Stakeholders must resolve these issues before the United States experiences a natural gas energy crisis. David B. Lerman is an associate director in Navigant Consulting Inc.’s energy litigation practice. Richard G. Smead is a director in Navigant’s energy consulting practice, specializing in upstream and midstream natural gas issues. Both are located in Houston. They may be reached at [email protected] and [email protected], respectively.

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