Issue Number: 111   August 2014

Oil going off the boil? The Canadian Case





Figure 1: Mixing Canada's natural beauty with LNG projects. [1]

The shale revolution in North America has had a dramatic impact on its gas markets. It has completely changed the region's gas market prospects: no longer LNG importers, the United States and Canada will soon be LNG exporters. The US is expected to begin exporting LNG as early as next year. Canada has joined the scene slightly later and already has a whopping 15 projects proposed. While the potential prospects of North American LNG look huge, it is likely that only a fraction of the proposed LNG projects will actually go ahead.

Of these North American projects that will be successfully financed, the targeted destination for these LNG exports is Asia Pacific. Traditionally, international LNG trade in Asia has been based on the Japan Crude Cocktail (JCC) price mechanism. But once crude oil prices went above $100/bbl in the early 2010s, there was a chorus of complaints about the correspondingly high price levels of natural gas.

This situation has already led to problems for one Canadian liquefaction project. The 10 million tonne per annum Kitimat LNG project has had its final investment decision delayed due to alleged disputes over the pricing system of the LNG between buyers and sellers[2]. While oil indexation is the ideal for Canadian sellers as it is considered the most lucrative option, there are already signs this could be unrealistic. If Canadian LNG is not linked to oil prices, then what are the alternatives?

Henry Hub

Henry Hub is the American pricing system: it is driven primarily by the supply and demand fundamentals of the US domestic market. The benefit to using this pricing system for Canadian LNG exports is that Asian buyers already know it. For instance, GAIL, India's national gas company, is currently offering gas supplies at prices tied to the Henry Hub index[3].

Since 2011, some American LNG import contracts have priced their gas using a 'Henry Hub plus' system. For instance, Cheniere, operator of the Sabine Pass in Louisiana, has sold future supplies of gas using the following price formula: LNG = 1.15 * HH + B. HH is the Henry Hub futures price on the New York Mercantile Exchange for the month of lifting and B is a constant agreed between Cheniere and each buyer. In a deal between Cheniere and BG, B was set at $2.25/MMBtu (this reflects the cost of liquefaction). The multiplier factor of 1.15 against the Henry Hub price probably intends to cover the cost of gas used as fuel in the liquefaction process (around 8%-11%) and transport costs to the liquefaction facility.

A study by Deloitte suggests that US LNG exports will be a 'major catalyst' for moving away from oil indexation, and towards hub-based pricing[4]. It should not be forgotten that it is possible that some sellers/buyers might be reluctant to use a Henry Hub-based system because it tends to be volatile and exposed to price fluctuations. For instance, Henry Hub fluctuated from $3.64/MMbtu in November 2013 to a high of $6.00/MMbtu in February 2014 because of particularly severe weather. There is also some risk for Asian buyers because if Henry Hub prices increase and oil prices fall, then it is possible that Henry Hub-related prices could exceed current JCC contracts. Memories of $10-$12/MMBtu Henry Hub prices in 2008 might deter some Asian buyers away from this pricing mechanism.

AECO Hub

Often showing a close price correlation with Henry Hub, the AECO hub is one of Canada's own pricing systems of natural gas. There may be some reluctance to index gas to this hub because it is relatively unknown by Asian buyers. Additionally, LNG sellers will be deterred in using this pricing system because over the last ten years, AECO prices have averaged $0.80 per MMbtu less than Henry Hub prices.

A hybrid between oil and hub indexes

If Asian buyers see beyond the price fluctuations of a hub-based pricing system, a possible compromise might involve a hybrid of oil and hub-related pricing. This would involve an indexation of a percentage of a contracted volume to gas hub prices with the remainder of the volume indexed to oil prices.

….But it might be a buyer's market.

On the supply side, markets should remain tight until 2016, but from 2017 onwards it is expected that there will be a steep LNG supply growth in several regions, including North America, Australia, East Africa and Russia. This has given way to what has been called the 'LNG Race', referring to the importance of sellers concluding sale and purchase agreements and getting the gas to international markets before the bulk of the other sellers arrive. With supply possibly outstripping demand in the near future, the risk for sellers is that LNG prices will drop.

This situation might have particular implications for Canada's LNG as it is will be arriving after 2017, with 2020 being a likely date for first production. With a growth in supply, and a more globalised and competitive marketplace for buyers, sellers of Canadian LNG might therefore be put in a weaker bargaining position. This may mean that LNG sellers will be less successful in arguing the case for oil-indexation. Indeed, the Sabine Pass project in the US has already set a precedent for selling LNG at hub-based pricing.

Conclusion

It is clear that pricing of Canada's LNG is a crucial issue as seen in the disputes over LNG pricing and the subsequent recent delays over the investment decision of the Kitimat project. Although there is a variety of pricing options, it is plausible that due to the forthcoming increase of global LNG supplies from 2017 onwards, Asian buyers will be put into a strong negotiating position where oil indexation might be used less, combined with hub pricing systems, or even excluded altogether. While this may prove less lucrative to the seller, the adoption of hub pricing in LNG pricing in Asia could be a market development that is unavoidable.

Written and researched by Nico Cottrell


[1] http://www.lngworldnews.com/chevron-buys-operating-interest-in-kitimat-lng-canada/.

[2] 'Chevron struggles to meet buyer price ideas on Canadian Kitimat LNG' http://www.icis.com/resources/news/2014/03/13/9762677/chevron-struggles-to-meet-buyer-price-ideas-on-canadian-kitimat-lng/.

[3] http://www.bloomberg.com/news/2014-06-06/gail-s-u-s-linked-lng-breaking-from-traditional-ties-to-crude.html.

[4] Deloitte, 'Oil and Gas Reality Check 2013: A look at the top issues facing the oil and gas sector'. http://www2.deloitte.com/content/dam/Deloitte/global/Documents/dttl-er-oilgasrealitycheck2013-08072013.pdf.


August 2014 MZINE