Is LNG Set to Mirror Oil?




In the 1980s the oil market, which had previously had long-term fixed-price contracts, underwent a significant change. Rising non-OPEC oil production flooded the spot market and completely changed the way it operated, with market-based pricing becoming the norm. This article will look at whether LNG is approaching a similar moment in time as well as considering current arbitrage opportunities.

Historically, LNG has offered little potential to those wishing to trade it on the spot market or engage in arbitrage, despite an often volatile price. Arguably the most important reason preventing either is that the capital investment required for LNG projects has meant supply has often been tied up in long-term point-to-point inflexible contracts. Additionally, as a global product LNG has not always been very fungible - interchangeable - meaning that any seller cannot sell to any buyer thus limiting the market it could be sold to.

However, with the LNG market developing and changing in a number of areas both arbitrage and spot trading are becoming more common. Supply is set to outstrip demand, contracts are becoming more flexible and there are a larger variety of businesses in the market as well as a number of maturing terminals selling short-term quantities.

Supply and Demand Gap

The increase in LNG supply is set to significantly exceed the increase in demand. In MJMEnergy's LNG Supply Handbook 2015-2035 [1], MJMEnergy projections estimate mid case supply in 2025 at 708bcm whilst the mid case demand projection is just 608bcm, a full 100bcm below supply. The combined capacity of LNG terminals currently in use and those under construction (which should be completed by 2021) is around 620bcm. To reach supply of 700bcm by 2025 around 35bcm/year of terminals would need to reach FID in the next 5 years [2], most of which would come from North America, although a smaller figure each year could still create a sizable gap of 10%.


Figure 1 - Cameron LNG in the US

Demand is also set to continue to grow but a number of factors may limit its ability to keep up with supply. Despite the global nature of the LNG market, Asia Pacific, which accounts for around 70% of total LNG imports, is likely to be the determining factor in global demand. Currently, there are some doubts concerning its LNG demand.

Japan, which currently imports 120bcm of LNG (over a third of total LNG imports and just under half of total Asia-Pacific imports), is currently beginning the slow process of restarting its nuclear reactors, shut since the 2011 Fukushima disaster. With 24 reactors, totaling almost 20GWe capacity, in the process of restarting [3], natural gas demand in Japan is expected to fall, potentially by as much as 5-10% a year.

Additionally, China, which is expected to continue to increase its LNG imports, is also set to import fairly significant quantities of pipeline gas from Russia. This may well lead to a smaller increase in the quantities of LNG imported from China leading to further quantities struggling to find long-term buyers. The creation of gas-on-gas competition could also further diminish or even remove the 'Asia Premium'.

If the market goes long, empowered buyers are more likely to want spot or short-term sales rather than being locked into long-term sales. This has arguably already begun to play out in Australia. Chevron's Wheatstone project reached FID with only around 60% of its equity off-take covered under long-term contracts. Whilst this figure has since risen it could indicate that many future projects will be unable to lock all their LNG into long-term contracts before reaching FID. This could lead to terminals either having vast quantities of LNG to sell on the spot market or choosing to produce less LNG.

Changing commercial structures

LNG contracts have typically had little to no destination flexibility. In fact, to some extent the market could have been compared to the pipeline market, rigid bilateral deals leaving both sides little flexibility once agreed. The restrictions can affect both arbitrage and spot sales. For instance, neither the buyer nor seller may have been able to divert cargoes to a more profitable destination. Additionally, the buyer may have had significant restrictions on re-export which would have prevented cargoes hitting the spot market.


Figure 2 - Spot/short-term sales as a percentage of overall LNG supply 2000-2014 (Source: GIIGNL)

However, in recent years, there has been increased destination flexibility, partly due to an increase in buyers and sellers and partly due to a finding by the EU Commission in 2001 that destination clauses were anti-competitive. Portfolio players with a diverse location of supplies and buyers, and often their own fleet of ships, can use flexibility to their advantage, redirecting cargoes and capturing arbitrage opportunities. Purchasers are increasingly able to divert or re-export cargoes adding to the liquidity of the market. Tolling - which gives the purchaser an option, effectively acting as a hedge for companies, to buy cheap North American gas - may also lead to increased spot cargoes as much of the risk (and rewards) is reduced.

Maturing terminals are also adding to the amount of liquidity in the market. When their long-term contracts have expired and they have no need to finance large capital investments entering the spot or short-term market is an attractive way to use their spare capacity. This increases the liquidity of the spot market and in conjunction with demand is helping to converge prices.


Figure 3 - One of BG Group's LNG ships

A move towards hub-based pricing could have a significant effect on the market’s movement towards spot. For instance, a final de-linking from oil would allow the price of LNG to actually reflect its value, and be based on fundamentals such as supply and demand. Once there was a pricing-mechanism that truly reflected the shifting values of LNG there might be more inclination for increased spot sales, and should the Asian market opt for hub-pricing it would certainly be further evidence of the commoditisation of LNG.

Conclusion

LNG's march towards market-based pricing mechanisms and a reliance on the market to manage the inherent risks of price and securing supply and demand seems almost inexorable. Perhaps even in 2000, any spot trades could have been an anomaly, the result of increased production beyond nameplate, or another unplanned situation. However, today, spot/short-term trades are beginning to form a larger and larger part of the market. Whilst many of those trades may still be made on short-term, 3-4 year contracts, it still represents a significant trend.

Although it seems unlikely any seller would be willing to risk such a large capital investment with no guarantee of sales the combination of commercial change that seemingly encourages short-term sales, including perhaps the use of tolling which partially unbundles the value chain and reduces the risk, and a potential 'supply glut' could lead the market to switch quicker than previously thought imaginable.

June 2015


Footnotes

  1. LNG Supply Handbook 2015-2035
  2. The Author has taken into account a utilization rate of under 90% and a conservative construction time of around 5 years.
  3. Given the severity of the Fukushima disaster in 2011, the process is likely to be drawn out as reactors will need to pass stringent safety requirements and overcome opposition from nearby concerned residents.

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