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  • PLATTS ANALYTICS GLOBAL LNG

    January 18, 2019

    ANALYTICS REPORT nagasanalytics@spglobal.com

    Ira B. Joseph, S&P Global Platts

    THE LONG-TERM LNG CONTRACT PRICING PROBLEM: CASE SOLVED

    Ira B. Joseph

    Head of Gas and Power, S&P Global Platts

    The LNG market is stuck for Asian buyers. While the Americas can comfortably rely on Henry Hub and Europe indexes to NBP or TTF, traditional oil-indexed pricing methods for LNG contracting in Asia are at odds with emerging trends in LNG pricing, leaving buyers and sellers separated well beyond the normal give and take in negotiating a deal. New deals continue to trickle out based on every type of indexation ranging from Brent crude to Platts’ JKM price for LNG in Asia, but the type of broad-based anchor index traditionally portrayed by the JCC (Japanese Crude Cocktail) over the last few decades remains the elusive glue for tying together the fragmented world of global LNG pricing. Is oil indexation of long-term LNG contracts dead? Not just yet, nor does it have to be. For now, the lack of a long and liquid forward curve in Asian gas pricing will keep oil indexation in the discussion, as the forward curve – accurate or not in terms of outturn pricing – is still the benchmark in terms of creditworthiness and financing. While liquidity in JKM, TTF, and Henry Hub continues to improve and is now a mainstay in pricing spot cargos, the role of oil still remains an important issue, even if the competitive landscape has changed between the two fuels. Bridging this pricing gulf on long-term LNG contracts between buyers and sellers remains the single biggest obstacle to the development of new liquefaction capacity.

  • Introduction

    The LNG market is stuck for Asian buyers. While the Americas can comfortably rely on Henry Hub and

    Europe indexes to NBP or TTF, traditional oil-indexed pricing methods for LNG contracting in Asia are at

    odds with emerging trends in LNG pricing, leaving buyers and sellers separated well beyond the normal

    give and take in negotiating a deal. New deals continue to trickle out based on every type of indexation

    ranging from Brent crude to Platts’ JKM price for LNG in Asia, but the type of broad-based anchor index

    traditionally portrayed by the JCC (Japanese Crude Cocktail) over the last few decades remains the elusive

    glue for tying together the fragmented world of global LNG pricing.

    Is oil indexation of long-term LNG contracts dead? Not just yet, nor does it have to be. For now, the lack of a

    long and liquid forward curve in Asian gas pricing will keep oil indexation in the discussion, as the forward

    curve – accurate or not in terms of outturn pricing – is still the benchmark in terms of creditworthiness and

    financing. While liquidity in JKM, TTF, and Henry Hub continues to improve and is now a mainstay in pricing

    spot cargos, the role of oil still remains an important issue, even if the competitive landscape has changed

    between the two fuels. Bridging this pricing gulf on long-term LNG contracts between buyers and sellers

    remains the single biggest obstacle to the development of new liquefaction capacity.

    Liquefaction, Long-Term Contracts, and Pricing

    With Platts Analytics forecasting the need for new liquefaction capacity by 2022, the ticking of the clock is loudening

    if we assume a three-to-four year process from FID to commissioning for the building of new liquefaction capacity.

    Sellers want and insist on needing long-term contracts to justify financial investments, while buyers appear largely

    uninterested in signing deals due to any number of reasons that start with price and range all the way to volume

    inflexibility. One of the most significant trends this decade has been the migration of long-term contracts from end

    users to portfolios, which tipped the hand on the LNG pricing conundrum we face today, as it reflects how

    assumptions of risk are evolving.

    At the highest level, the question of why long-term LNG contracts need to exist in the future needs to be raised.

    While the lists of proposed LNG projects continues to build on the back of staggering increases in stranded gas

    reserves, the pipeline of new long-term LNG contracts remains small and infrequent. As a stop gap in recent years,

    contracts have become shorter in length and smaller in volume, although this trend is far from irreversible under the

    right terms if the sweet spot can be found between buyers and sellers. Outside of specific utilities, most buyers are

    uninterested in such long-term arrangements in a world where supply seems elastic and abundant, while sellers

    claim the need to have long-term contracts in order to primarily finance the development of liquefaction. From a

    credit perspective, issuing debt without the view of, right or wrong, a forward curve, is much more expensive and

    difficult to undertake. Hence, the need for a long-term contract. The battle lines on future LNG contracts have been

    drawn and the logic goes as follows;

    Buyer: “Exxon or Shell doesn’t need a 30-year gasoline contract in order to build a refinery. They take on the full

    financial risk, so why do LNG producers need long-term LNG contracts in order to build liquefaction plants?”

  • Seller: “If a 5-year forward curve existed for Asian gas like it does for crude, we would consider it, but as it stands, no

    such mechanism exists and neither Henry Hub nor TTF reflect our regional gas balances.”

    In the past, contracts were secured as part of a broader integrated project that addressed security of supply issues

    for the buyer and security of demand issues for the seller. With so many countries now buying, so many countries

    now selling, and so many traders and portfolio holders in between, the idea of a long-term contract could be viewed

    as a bit of an anachronism if looked at through the lenses of crude oil markets. So does a major oil company need to

    sign a 20-year gasoline contract to build a refinery; does an NGL company need to sign a 20-year deal to build a gas

    processing unit? The answer to these questions in the past was that these other commodities offered long-term

    forward curves as a means of offering some price security (or at least price direction), whereas gas did not. Of

    course, this difference is less of an issue these days given the rise of Henry Hub, TTF, and JKM as established

    markers. That said, the use of Henry Hub or TTF in Asia has always come with major caveats. JKM is well on its

    way in terms of surging liquidity, but it is not yet there, which gives it a bit of a chicken and egg problem when it

    comes to using it for long-term LNG contracts. In a positive move, we are starting to see this barrier come down for

    JKM in terms of deals by some portfolio players.

    The Oil/Gas Price Inversion Blows up Rationale for Traditional LNG Pricing

    Another key change for LNG contracts is that the pricing relationship between oil and gas has shifted from

    downstream to upstream and in many cases, it has become completely inverted. In the past, gas offered substitution

    potential for oil in the home heating market or power sector, so pricing one off the other kept gas competitive and

    justified the build out of significant midstream infrastructure such as liquefaction, shipping, pipelines, and

    regasification. In addition, a highly liquid spot market for oil pricing allowed for better hedging, even if oil indices such

    as the Japanese Crude Cocktail (JCC) in Asia were difficult to pin down due to their ever changing import makeup

    each month. In Europe, either gas oil or fuel oil pricing in the north or crude oil pricing in the south were traditionally

    used for LNG pricing due to their use in traditional pricing of pipeline gas. As spot gas pricing has taken over the

    Continent in the past 21 years, the need to tie LNG prices to oil has essentially evaporated in favour of spot prices.

    In the future, the downstream overlap between oil and gas will be extremely limited and therefore the fuel

    substitution-based rationale for using one to price the other makes about as much sense as pricing a Twix Bar off of

    Coca-Cola because they both happen to contain sugar. Within the downstream sphere, the price of gas has largely

    migrated from a seasonal, R/C-related sine wave flowing around a central tendency oil price to a coal-to-gas

    switching price centered on gas consumption in the power sector. Oil's use in the residential/commercial sector is

    now largely based on legacy infrastructure issues in places like the US northeast or NW Europe, as gas prices have

    dropped well below gas oil in both areas on a sustained basis due to the introduction of liquid spot gas markets.

    Substitution is rare and is now tied more to investment than short-term market forces. While gas and LNG are

    making some inroads into the transport sector via fleet trucks and bunkering fuel, the competitive remains fairly

    limited and largely policy driven such as the 2020 IMO change on sulphur specifications.

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    Evolution of LNG Contracts Shows Smaller Sizes; Volume of Long-Term Deals Relatively Steady

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