The global LNG market is approximately 55 years old. As identified in the August 2019 edition of Project Global Insight, the market in the Asia Pacific region has traditionally been underpinned by contract structures based on crude oil linked prices and long-term offtake. These contract structures are changing. Thought leadership will be necessary in order to navigate the challenges and leverage the opportunities generated by the shifting nature of the LNG market.
The price of LNG sold under long-term LNG sales contracts has generally reflected the energy economics of the market into which the LNG was being sold – the predominant LNG markets being Asia, Europe and the US.
Historically, LNG pricing in Asia has been indexed against crude oil prices. This is because when Japan started importing LNG in 1969, crude oil was the major competing source of fuel for generating power. As other Asian economies began importing LNG, oil linked LNG pricing was already well established, and accordingly it is oil linked LNG pricing that prevails throughout the Asia Pacific region today.
This contrasts with the more developed spot market pricing of natural gas in North America, and to a lesser extent Europe, where competing sources of gas (pipeline and LNG) are priced in hubs, which also act as the pricing and delivery points for natural gas futures contracts. These hubs reflect the interaction of multiple sources of natural gas supply and demand.
Recently, LNG pricing in the Asia Pacific region has been delinking from crude oil indexation in favor of gas-on-gas indices such as the Henry Hub in the US, and the Platts Japan-Korea Marker (JKM) index in Asia. The JKM is a benchmark price for LNG that is developing in popularity and has been used to price deals. First launched in 2009, JKM reflects the spot market value of cargoes delivered ex-ship (DES) into Japan, South Korea, China and Taiwan (the majority of global LNG demand).
These new indices are supporting development of separate physical and futures markets in natural gas and LNG at various nascent trading hubs, including in Shanghai and Singapore. These markets are increasingly independent of the more mature and sophisticated markets in oil. The LNG market is slowly becoming more commoditized (i.e. priced against its own fundamentals).
Meanwhile, as the relevance of crude oil indexation for LNG pricing declines, long-term LNG contracts are also being indexed to other separate commodities. For example, in early 2019, Shell and Tokyo Gas signed a contract with coal indexation, reflecting the main competitor for gas in the power market in Asia today.
Contract duration trends
LNG procurement has traditionally been underpinned by 15 to 20-year supply agreements, often with take or pay obligations, with buyers holding high investment grade credit ratings. This model was attractive because it provided long-term price certainty and gave sellers and financiers sufficient confidence to finance the massive up-front capital requirements of LNG projects.
Recent experience shows that this model may be coming to an end. Data shows that in 2018 the volume of LNG traded globally without a long-term contract increased by 18% year-over-year, following a growth of 19% year-over-year in 2017. By the end of 2018, the non-long-term contract share of total gross LNG trade globally surged to 31% (approximately 50% higher than the market share in 2008).
This trend away from long-term contracts to non-long-term contracts (defined by the International Gas Union as contracts of less than five years in duration) has arisen primarily due to the following factors:
- a growth in destination flexibility or destination-free terms in LNG contracts, facilitating diversion of sales to higher priced markets;
- the emergence of diverse portfolio players and aggregators (including large producing IOCs such as Shell and BP, but also large importers such as European and Asian utilities like Uniper and JERA) and global commodity traders in the market;
- an increase in the number of LNG exporters and importers, including small-scale LNG and FLNG exporters and FSRU importers, increasing the complexity of the industry and providing new linkages between buyers and sellers; and
- volatility in supply and demand dynamics (e.g. the Fukushima disaster in Japan and geopolitical uncertainties such as the trade hostilities between the US and China).
Most notable in the market is the surge of new LNG demand in the Chinese market. In 2018 China accounted for the bulk of Asian LNG import growth by adding 15.8 million mt of new imports (41% higher than 2017), almost all of which was procured from the non-long-term and spot market. Almost 40% of existing Chinese demand remains under non-long-term arrangements, and this is growing annually. This is primarily due to low spot prices, the pending startup of the Power of Siberia pipeline from Russia in December 2019 and the trade dispute with the US government that limits China’s long-term procurement from the US.
South Korea is also contributing to the general shift away from long-term contracts in the region by continuing to rely on the spot market to offset ongoing nuclear outages, with an overall rise in non-long-term imports of 47% year-over-year in 2018.
Also notable is the fact that a significant number of legacy long-term contracts in established Asian markets are expiring in the coming years (reportedly more than 200 mtpa of contracts by 2030). These are likely to be renewed and renegotiated on more flexible conditions or on a non-long-term basis, following the trend in the US and European markets.
Source: IHS Markit, IGU
It is clear that the Asia Pacific LNG market is shifting. In the coming years, LNG contracts in the region will increasingly move away from pricing formulae linked to crude oil and towards gas-on-gas pricing linked to trading prices at gas hubs around the world. Henry Hub indexation in term contracts agreed by US LNG sellers is increasingly common, and as the Asia Pacific LNG market matures, JKM indexation in term contracts is likely to grow in popularity. In the past year, preliminary sale agreements for 15-year offtakes between Tellurian and Vitol, and Tellurian and Total, were linked to JKM. More LNG buyers and sellers are likely to consider including JKM indexation in term contracts, even if only as part of a mix of different indexations in the contract price formulae.
Spurred on by new pricing models and trading facilities, non-long-term and spot supply arrangements and hedging transactions are also set to become more dominant in the Asia Pacific LNG market. Although the LNG market is still less commoditized than the oil market, it is increasingly liquid, flexible and spot oriented.
The changing market conditions and trade dynamics for LNG will of course influence new entrants to the market, potentially adding greater complexity to the critical path to final investment decision. We are also likely to see more merchant LNG project developments in the region, underpinned not by long-term contracts but multiple non-long-term and spot arrangements. This merchant model will, however, take time to develop, particularly in higher-cost jurisdictions such as Australia. There are also numerous structural issues, such as the regular tightness in the LNG shipping market, and the lack of a true trading hub with pricing transparency and standardized trading terms, that will need to be addressed before a fully commoditized, merchant LNG market can emerge in the Asia Pacific region.
The changing Asia Pacific LNG market conditions will also affect existing market participants and contracts that are already on foot, by creating situations where the terms of an agreed contract do not reflect the existing market. The emergence of new types of LNG pricing formulae means that LNG prices are increasingly independent and divergent from crude oil prices.
Whenever a wide gap emerges between long-term contract and non-long-term or spot prices of the same commodity, history shows that the long-term contract counterparties will have tough negotiations on the revision of the contract terms and conditions, particularly around pricing. Long-term LNG sales contracts in the region often include price review mechanisms, with temporal triggers (e.g. first price review after five years) or – much less commonly – non-temporal, market-based triggers (e.g. price review after “significant change in economic circumstances in the buyer's market”). These price review mechanisms are designed to address major market fluctuations and adjust the contract price accordingly.
It is already clear that the price review mechanisms in existing long-term, oil linked LNG contracts in the Asia Pacific region are under increasing scrutiny and many will be triggered to renegotiate oil linked LNG pricing, including to make structural changes to the price formulae away from oil linked pricing to a pricing mechanism that is more representative of the prevailing gas market. This price review risk for LNG sellers is a real issue, particularly in the current low price environment, as buyers are increasingly prepared to trigger price review and then negotiate that price review more aggressively than ever before. It was recently reported by Credit Suisse that, for the first time in LNG industry history, a large Japanese LNG buyer has pursued arbitration with an LNG seller in the Asia region. Other buyers will be watching closely and the instances of use of third-party dispute settlement mechanisms such as arbitration or expert determination as part of price review processes may increase. Of course, while LNG contracts are similar, they are not on identical terms and there could be significant variance between the result of a disputed outcome depending on the terms of the relevant contract and steps taken by the parties prior to any disputes.
Given the ongoing need to sell LNG to Asia Pacific buyers, there is also an increased likelihood of buyers and sellers agreeing negotiated outcomes, such as a middle-ground adjustment to the price slope as against oil, or additional destination flexibility or Downward Quantity Tolerance provisions (ameliorating take or pay conditions for the buyer).
As legacy long-term contracts reach expiry throughout the Asia Pacific region over the coming years, we anticipate a shift towards renegotiated non-long-term and spot pricing structures. Thought leadership will be necessary in order to navigate the challenges and leverage the opportunities generated by the shifting nature of the LNG market in the Asia Pacific region. Buyers and sellers will need to be willing to explore partnerships and find a middle ground between the price, term and volume flexibilities demanded by buyers and the revenue stability sought by sellers, and financiers will need to adapt their risk profiles and assumptions. Additionally, with LNG demand widely tipped to increase over the coming decade, in order to sanction new LNG projects, LNG sellers and their financiers will need to take on additional volume and price risk.