|Issue Number: 112||September 2014|
East meets West - Japan Crude Cocktail and Henry Hub
In a previous article 'Oil going off the boil? The Canadian Case' we highlighted the current challenges Canadian sellers of LNG face in reaching an agreement over the price of LNG with buyers from the Asia Pacific. This article will continue to unravel this complicated story. It will explore the changes in attitude towards the traditional relationship between natural gas and oil prices in the Pacific Basin in long-term LNG contracts, the reasons for the change, the incentives for its transformation, the potential risks of linking LNG prices to Henry Hub for buyers and ways to mitigate this risk.
Winds of change
Henry Hub is America's gas pricing system which determines domestic prices for natural gas. But HH pricing is tipped to go global. As America begins to export LNG that is indexed to HH prices, it is expected that America's hub pricing mechanism will increasingly be used to set an international benchmark price for natural gas. LNG-hungry Asia Pacific is likely to be an important destination for America's super-chilled gas. Traditionally, buyers in the Asia Pacific have bought LNG at a price formulae indexed to crude oil, a pricing mechanism known as Japan Crude Cocktail (JCC). However, signs are afoot that this is beginning to change.
As seen in the alleged disputes over the pricing of LNG from Canada's Kitimat LNG project in March 2014, oil may no longer be king of the LNG game. As Yukio Edano, the Japanese Trade Minister said at a LNG conference in Toyko, 'With the paradigm shift due to full-fledged production of shale gas, oil-linked indexing is starting to be less reasonable.' This development has also been suggested by Hiroshi Hashimoto, a senior gas analyst with the Institute of Energy Economics of Japan: 'The aim is to link [LNG price] 100% to Henry Hub prices, rather than JCC'. It is telling that Cheniere, the operator of the Sabine Pass LNG project in Louisina, has sold future supplies of natural gas involving a Henry Hub pricing system. This will help to establish a precedent for the sale of America's LNG using hub-based pricing.
Causes of change
The historic price link between LNG and oil in the Pacific basin has become unpopular since 2010-11 because of a spike in oil prices that saw the crude oil price soar above $100/bbl. This had a subsequent impact on the cost of LNG. The soaring prices for oil also coincided with the Fukushima nuclear disaster in Japan, leading to more expensive LNG imports and increasing the country's trade deficit.
LNG buyers in Asia Pacific cannot do much about their current oil-based LNG contracts (generally long-term in nature) because they lack a provision for price review. However, buyers in the Pacific Basin who are looking to begin new long-term LNG sale and purchase agreements (SPAs) can push for a different pricing system. If gas is not indexed to oil, then the Henry Hub pricing mechanism may prove to be very attractive.
The graph below shows the stark price divergence between Henry Hub spot prices and the Japan LNG import price. The current Henry Hub levels indicate that there is an attractive price differential for buyers in the Asia Pacific if LNG is purchased using the Sabine Pass business model. This was a 'Henry Hub Plus' deal in which Cheniere used the formula: LNG = 1.15 * HH + B. HH is the Henry Hub futures price on the NYMEX for the month of lifting and B is a constant agreed between Cheniere and each buyer. The multiplier factor of 1.15 reflects the loss of natural gas used in the liquefaction process and B reflects the cost of liquefaction. Cheniere initially set B at $2.25/MMBtu, although this later rose to $2.50 and then $3.00/MMBtu.
If the Henry Hub Plus deal is adopted for buyers, then theoretically it could be an extremely good deal in the short-term. For instance, taking July 2014 as an example and applying Cheniere's pricing model to Henry Hub prices, the cost of LNG entering into Japan would work out as $7.65/MMbtu versus the $14.62/MMBtu of the Japan LNG import price in the same period.
Whilst buying LNG priced at HH indexing seems attractive in the short and medium-term, there are a number of risks involved with this pricing option. As LNG contracts are often long-term and span 20 years or more, it is important to consider the possible future evolution of pricing systems.
The dangers of negotiating a long-term LNG contract without much thought for the future is exemplified by the example of BG Group's LNG contract with Equatorial Guinea. In this contract, signed in 2004, BG pays the stakeholders of EG LNG Henry Hub prices for LNG. Shortly after the contract was signed, the US shale gas revolution caused the HH to dip from around $6 MMBtu in 2004 to its current level of around $4/MMBtu today (although prices have varied significantly, with prices hitting rock bottom in 2012, including $1.95/MMBtu in April 2012). BG then ships the LNG to Asia where it reaches $15/MMbtu and makes a huge profit.
Long-term price developments will matter more than short-term prices when it comes to negotiating LNG contracts that last for twenty years or more. On the flipside, it should be considered that Henry Hub prices could reverse in the longer-term. The Henry Hub is defined by its volatility as it represents the supply-demand fundamentals of the American market. Additionally, this is a system that will change independently from issues affecting the Asian gas markets. A variety of factors could work to increase HH prices, such as revised estimations for America's shale reserves, economic recovery or increased demand for natural gas in power generation. This possibility is not without precedent and occurred when low natural gas prices in the 1990s spurred the construction of a number of gas-fired power stations, effectively popping the gas supply bubble and causing HH prices to increase. For these reasons, it is sensible to be circumspect about the evolution of HH prices.
Reducing risk - a kind of hedge
One way to mitigate the potential price fluctuations of Henry Hub is to create a hybrid of oil and hub-related pricing. This is where a percentage of volume is indexed to a gas hub, and the remainder indexed to oil. This has already been highlighted as an option by a senior gas analyst, Hiroshi Hashimoto: 'there will be some options offered to Canadian and US producers of linking 20% of that price to crude oil and the remaining 80% being still linked to gas.'
There are signs that the traditional indexation of natural gas to oil in the Asia Pacific may change in the future. As the US begins to conclude more LNG supply contracts with buyers from this region, the option to use a Henry Hub pricing mechanism will be attractive because of the current price differential against Japan Crude Cocktail prices. However, uncertainties over the future development of Henry Hub prices casts some doubt over the commercial soundness of this option. A hybrid system involving both Henry Hub and oil may prove to be a safer option.
Written and researched by Nico Cottrell
 Reuters, 'Participants' comments at LNG conference in Tokyo', September 2012. http://www.reuters.com/article/2012/09/21/asia-lng-comments-idUSL4E8KK37Y20120921.