The Fuse

LNG Buyers Gaining Increasing Leverage over Sellers in Coming Years

by Nick Cunningham | March 16, 2016

The growing oversupply in LNG export capacity has weighed on prices for the key market in Asia, pushing spot prices down by about two-thirds in less than two years. Excess supplies will likely kill off an array of LNG export terminals that have not yet moved forward with final investment decisions.

But a supply glut could claim another victim: The LNG pricing arrangement itself, a decades-old practice of linking LNG cargoes to the price of oil under long-term contracts.

LNG market growing rapidly

In the past, long-term contracts linked to the price of oil made sense. The market for LNG was not large and it did not have enough liquidity (no pun intended). Without a proper market, prices could not easily respond to supply and demand changes. New liquefaction capacity and export terminals are capital-intensive and have long lead times. Financing and building export terminals only worked if purchasers were guaranteed in advance. Thus, bilateral agreements that guaranteed shipments under a fixed price suited both buyers and sellers.

The increase in new LNG export capacity that has hit the market in recent years, and the coming tidal wave of new supplies, is starting to transform LNG markets.

The increase in new LNG export capacity that has hit the market in recent years, and the coming tidal wave of new supplies, is starting to transform LNG markets. Global liquefaction capacity is set to rise by around 130 million metric tons per annum (mtpa) by the end of the decade, a more than 40 percent increase from the 301 mtpa in total capacity that the world had at the beginning of 2015. Australia alone is expected to add 58 mtpa between 2015 and 2017. Chevron’s completion of Gorgon LNG, announced in early March, is just one of a handful of massive LNG export facilities to come online in Australia.

The U.S. too is entering the fray, although to a much smaller extent. Cheniere Energy shipped its first LNG cargo from the Sabine Pass terminal in Louisiana in late February, the first LNG cargo to depart from the contiguous United States. There are four other export terminals under construction in the United States, three on the Gulf Coast and one in Maryland on the Chesapeake Bay. Around two dozen more have applied for permits or are in the pre-filing exploration phase.

Many may not see the light of day, however, because LNG prices have collapsed since 2014, following oil prices down to lows not seen in years. Prices for LNG cargoes set for delivery to East Asia in April dropped below $5 per million Btu (MMBtu). That is less than a third of the prices seen for the same month in 2014, when prices topped $18/MMBtu.

The plunging prices for LNG are not just a supply-side problem. Demand is also weak. In 2015, the combined imports of LNG for Japan, China, and South Korea—the three largest LNG importers in the world—fell by 5 percent year over year.

Low prices will make breaking ground on new projects difficult. After factoring in the cost of liquefaction and transportation, margins become pretty thin for exporters with landing prices in Asia below $5/MMBtu. A 2015 report from Moody’s predicted that “low LNG prices will result in the cancellation of the vast majority of the nearly 30 liquefaction projects currently proposed in the U.S., 18 in western Canada, and four in eastern Canada.”

On March 11, the Federal Energy Regulatory Commission (FERC) denied a permit to the developers of the proposed Jordan Cove LNG export terminal in Oregon, citing the project’s inability to lineup buyers in Asia for the capacity.

Pricing practices quickly evolving

The growing LNG export capacity is accelerating trends that have been slowly underway for some time. LNG markets are shifting away from long-term fixed contracts based on oil-indexed prices, transitioning instead towards deals that are shorter in duration.

Supplies are ample, a spot market is growing, prices are more fluid—all of which are working in favor of buyers at the expense of sellers.

In December, Petronet LNG, an Indian oil and gas company, managed to achieve a price reduction for LNG deliveries from Qatar. The Qatari company RasGas Co. cut the price by half under the existing 25-year agreement it had with Petronet, from $13/MMBtu down to $6 to $7/MMBtu.

Now China is following suit. China National Petroleum Corp. (CNPC) is also seeking pricing cuts to its LNG contracts with Qatar, according to Bloomberg, hoping to reap the benefits of abundant LNG supplies and lower prices.

“The pressure is building for long-term LNG contracts,” James Taverner, a Tokyo-based analyst at IHS, told Bloomberg in an email. “Buyers serving markets with the strongest long-term prospects for LNG growth, such as India and China, will likely be in the strongest position in contract discussions.”

It isn’t just the price reductions themselves that are so significant. The contract terms are also being altered. Long-term contracts have periodic review periods, and prices are linked to a formula based on a five-year average crude oil price. Under the Petronet LNG renegotiation, the formula was revised to use only a three-month average. The Indian company agreed to purchase more LNG cargoes in exchange.

The switch from a long-term pricing formula to something much more short-term is noteworthy. While that trend has been underway for some time, short-term contracts are starting to proliferate, with significant implications. It is not hard to imagine LNG transactions increasingly pegged to rolling spot prices rather than long- or even short-term pricing. Bit by bit, the old arrangements that benefited suppliers are starting to erode, giving way to more flexible transactions. Fixed destination clauses will start to go away as well, allowing for the reselling of cargoes. That will contribute more liquidity to a spot market.

Jonathan Stern, chairman and founder of the Oxford Institute for Energy Studies sees the threat coming for LNG exporters. “Asia is going to work its way towards market prices and adjusting to a recent average of spot oil prices is just the start,” Stern told Bloomberg.

At some point in the future, oil-indexing itself could start to grow obsolete, as LNG markets develop their own pricing that depends on the fundamentals of LNG cargoes and capacity, which makes much more sense than linking prices to oil, a separate commodity that has very little to do with LNG supply and demand.

Bit by bit, the old arrangements that benefited suppliers are starting to erode, giving way to more flexible transactions. Fixed destination clauses will start to go away as well, allowing for the reselling of cargoes. That will contribute more liquidity to a spot market.

Japan is trying to add momentum to this unfolding shift in power from sellers to buyers. Japan’s Tepco and Chubu Electric Power have teamed up to form Jera Co., a joint venture to cooperate on LNG purchasing. Jera is working with other LNG buyers in Korea and China to form an alliance, hoping that buyers representing a third of global LNG purchasing can squeeze more concessions from sellers. “We can work hard to lower prices by using our large volumes,” Hiroki Sato, vice president of fuel purchasing at Jera, told Bloomberg in February. “The bottom line is we should work together to reduce costs in Japan, as well as the rest of Asia.”

Will the market swing back?

The rapid shift in the market is ominous for LNG exporters, already growing concerned about the recent decline in prices.

To be sure, the picture could shift back in favor of exporters by the end of the decade and into the 2020s after the wave of projects under development reach completion and demand catches up. But, it is not inevitable that suppliers will regain the upper hand. Growing market liquidity, the emerging spot market, and the erosion of long-term and oil-indexed contracts are all granting substantial leverage to LNG importers, a situation that could be hard to reverse.

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