*Ofgem is jumping the gun in advocating intervention in the gas market to secure supplies because it has ignored the enormous impact of US shale gas, says Kash Burchett.*

In its Project Discovery document, Ofgem advocates a radical departure from the free market approach that has defined UK energy policy for the past 20 years. The regulator argues instead for more government intervention to ensure price visibility and private sector investment. In doing so, it has demonstrated an adroit capacity for independent analysis and a readiness to break with convention.

Unfortunately, these admirable qualities are less forthcoming in Ofgem's questioning of the assumptions that underpin the received wisdom concerning the problem itself: it has yet to recognise the massive impact of shale gas.

*Unconventional extraction*

It is hard to overestimate the effect that advances in unconventional gas extraction techniques have already had on the US gas industry. High prices on the Henry Hub in the early part of the past decade encouraged investment and a spate of innovations in the field of hydraulic fracturing. This entails firing steam at high pressure deep underground, splitting tightly formed rocks open to release gas trapped in the pores. The spread of horizontal drilling techniques has also reduced production costs.

From around 2005, these investments began to yield returns. Between 2006 and 2009, US unconventional gas production (mainly from shale but also coal bed methane) increased from 20 billion cubic meters (bcm) a year to more than 80bcm a year. This innovation reversed US gas production trends and output has increased over the past three years at around 4 per cent a year. The Energy Information Administration (EIA) now estimates that the US holds up to 60 trillion cubic meters of technically recoverable reserves, a staggering 50 per cent increase on its 2004 estimate and enough to maintain current consumption levels for 100 years.

*US gas imports decline*

Consequently, net gas imports to the US are set to decline. This is largely the result of domestic unconventional production displacing demand for imports of liquefied natural gas (LNG) Concurrently, the EIA has revised down its estimate of North American LNG demand in 2020 to 40bcm a year, a reduction of 110bcm a year on its 2006 forecast.

At the same time, a slew of new LNG capacity is coming onstream along the entire supply chain. Global LNG production in 2009 increased by 5.5 per cent and is set to continue its upward trajectory. Additionally, a spate of speculative LNG-tanker building in the past five years has led to overcapacity in the current shipping market, which will persist for several years.

Much of this investment was predicated upon the assumption that the US would be unable to meet its gas demand through domestic production alone. The "shale gale" has turned this assumption on its head.

The fact that these two outcomes - increased US gas production and increased global LNG supply - have come at the same time is of critical importance. With the North American market effectively saturated, competition for supply within the Atlantic Basin has declined dramatically. This has been accentuated by the effects of the recession and the consequent decline in demand, but the long-run supply and demand dynamics are a function of technological innovation and investment in new facilities.

*LNG redirected to Europe*

These changes carry important implications for European energy markets. In the short term, much of the flexible LNG supply is being redirected to Europe, particularly the UK. Between March and April this year, as much as 24 billion cubic feet (0.68bcm) was diverted away from the US and into the UK - a trend that is set to continue, with British prices high along the forward curve at 49.35 pence per therm for winter 2011.

A second medium term trend is also emerging. The effects of strong supply, in conjunction with the recession, have depressed European spot prices. This presents a challenge to utilities that went long in 2008 and are locked into high priced contracts. The contracts normally distribute risk between supplier and consumer by indexing the gas price to oil markets (and other variables such as stock markets or currency movements). This means contract gas prices are reflecting the bullish oil market (which surpassed $85 (£56) a barrel in April) as opposed to gas market fundamentals.

Utilities have responded by seeking to include a greater spot market component in their contracts and relaxing take-or-pay conditions. This effectively increases their exposure in trading hubs, thereby boosting liquidity and reinforcing the market's capacity to distribute gas efficiently.

*Shale in Europe?*

Finally, in the long term there is the possibility that the unconventional gas extraction technology used so effectively in the US can be deployed in Europe. This is certainly what international oil companies such as ExxonMobil are hoping. Having acquired TXO for £20 billion in January, Exxon has since bought concessions in Germany, Hungary and Poland. Sweden is attracting interest from ConocoPhillips.

However, it is still early days for the European shale industry. Very little exploration and appraisal activity has taken place so far, and relatively little is known about the geology. Even if recoverable reserves are there, technology transfer faces many hurdles, not least the stark differences between the US and Europe.

Most of the shale plays in America have been located near existing processing and transport infrastructure, but such facilities are less widespread in Europe. Furthermore, Europe is densely populated compared with the southern US and the environmental requirements more demanding. Although concerns about the effects of hydro-fracturing on water supplies have not yet caused disruption in America, they could present an obstacle in Europe.

*Hysteria*

All of this means it is unlikely that significant unconventional gas production will develop in Europe before 2020. But that does not justify ignoring the short to medium term effects of shale gas in America and concomitant LNG supply into Europe. Gas markets may tighten in the next decade, but the pessimism (and in some cases hysteria) that marks the current debate regarding security of supply seems hard to justify.

For the past decade, EU energy policy has focused on untying the Gordian Knot of increasing reliance on gas for generation, declining indigenous reserves and unreliable foreign suppliers. The growth in available LNG supply and the diversity of sources outlined undermine the terms of this problem.

Ofgem's proposals to increase government intervention in the energy market for the sake of security of supply appear to be predicated upon an outdated assumption. Free markets have delivered investment and innovation to Europe's energy market. Ofgem deserves credit for questioning the received wisdom, but ministers should not be so quick to ditch the market for intervention.

Kash Burchett is energy analyst at Datamonitor.