LNG grows up
The global gas trade is casting off its past and becoming more like other internationally traded commodities
Not so long ago, the global liquefied natural gas business was made up of relatively few international oil companies, state oil companies or the entities of producer states on one side, and utility businesses in a comparatively small number of consumer states on the other. Producers knew their consumers, and the contractual arrangements between them tended to be relational in nature, with the commercial deals based largely on fidelity and "point-to-point" trading. There were occasional disputes, but these arrangements and this community appeared comfortable, or even cosy.
Since the turn of the century, political, regulatory and commercial forces have progressively loosened and then pulled apart these traditional ties. These forces have created a wide array of LNG contracting structures and provided LNG buyers with a range of products that have allowed them to be much more transactional in their approach to the market. Going into 2018, the LNG industry has a looming overhang in uncontracted demand, which is likely to further transform an already dramatically evolving market.
The transformation of the LNG market in the past decade has been driven by both supply and demand factors. On the supply side of the equation, the emergence of America as a global supplier of LNG sourced from the interconnected US natural gas market has fundamentally altered the historical relationship between sellers and buyers. Long-term LNG buyers through US facilities are effectively sourcing American natural gas at the domestic US market price and paying a fee for preparing it for delivery to their home market. As a result, offtakers from US facilities are more akin to pipeline customers than traditional commodity buyers.
The US LNG market has also had broad implications for global supply. LNG buyers are now aggressively pursuing contracts from traditional LNG producers that are linked to the market price of natural gas (such as US Henry Hub) instead of the market price of an alternative but wholly unrelated commodity (like crude oil). More importantly, given the lack of an upstream component, the competitiveness of a US liquefaction facility is based almost entirely on how efficient it is in producing LNG. This has led to massive reductions in the cost of production through both technological innovation and by accessing capital from infrastructure funds, institutional investors, and other financiers with dramatically lower cost of capital than traditional suppliers and their lenders. In such a hypercompetitive market, the balance between sellers and buyers has been wholly upended.
A second factor on the supply side of the equation is the emergence of a global LNG spot market. While the vast majority of LNG continues to be subject to long-term contracts, the rapid expansion of the underlying LNG market over the past 20 years has meant that the remaining percentage of uncontracted LNG has increased substantially, when measured on a volumetric basis. This will be further accelerated as US projects continue to come on line in the near term, as these projects have significant uncontracted non-firm volumes that will likely find their way into the spot market. Whether the spot market develops in Singapore, Tokyo, or elsewhere, LNG buyers will increasingly have the ability to contract on an as-needed basis for LNG on a delivered basis. If the global spot market continues to deepen, one can expect a market price for LNG that's based not on artificial markers, but rather on physical supply and demand factors, with the cost of natural gas feedstock and production determining the profitability of sellers instead of the price to buyers.
On the demand side, Europe was ground zero for the changes reshaping the LNG market. What started as relatively small steps towards regulatory liberalisation on the continent led in quick time to the unbundling of utility businesses. Assertive European competition authorities pushed to outlaw some of the industry's traditional structures, such as destination restrictions and price splitting, which saw long-term contracts rewritten. New project developments were also subjected to regulatory and competition supervision. Similar themes have more recently appeared in the traditional consumer markets of Asia; and the newer LNG consumer markets have developed quite differently, with no need to undo those binary structures first.
The pace of recent change around the world is as notable as its scale. The development of floating technologies and "small LNG" are enabling new sources of production and new sinks of demand to participate in the globalising LNG sector. At the same time, the traditional way of developing projects has changed. It used to be that a new liquefaction plant would only be built with the financial certainty of a firm supply deal in place. But as LNG trading grows with the proliferation of traders and brokers, and with many traditional participants acting as aggregators, new project developers see less risk in a more liquid and flexible market. The pricing of LNG has also been transformed as the trade has grown and matures, with clear regional pricing and indications of steps towards global pricing. The hub-based gas pricing of the US and much of Europe is prompting a number of those in Asia to seek similar developments and the likely availability of excess quantities of LNG from the United States has the potential to fuel this. Whether that Asian hub emerges and is in Singapore, Tokyo or elsewhere remains to be seen.
On the demand side, Europe was ground zero for the changes reshaping the LNG market
There has also been an entrance of new financiers to the LNG market, particularly in the US' emergent export sector. Liquefaction in the US has experienced the participation of funds and private equity into its largely tolling or utility-based model, whereas recent and planned liquefaction in Africa has witnessed the primary presence of export credit agencies. Commercial banks continue to feature and there are growing examples of purchasers, particularly from a trading background, participating in novel financing arrangements, at least for the LNG sector.
But amidst this exciting new world, many of the long-term contracts and structures, from which today's expanding LNG sector has grown, remain in place, and still account for the majority of the world's LNG trade. Whereas markets, regulations and commercial influences change quickly, the long-term contracts and financing arrangements, which have been assembled with such care over long periods, won't. They'll have typically been made under common laws such as those of England and Wales or New York, and these will have been chosen by the parties for, among other things, their resistance to change. The previous generations' long-term arrangements may be seen to limit the pursuit of new opportunities, but their very nature means that they're unlikely to be easily undone.
The European market is regarded as particularly enticing for burgeoning LNG supplies from the US and other parts of the world. Europe is seen to have transparent and liquid gas markets, but these didn't easily come to supplant the former long-term, fixed arrangements. One only has to look at the number and scale of arbitral proceedings in relation to European LNG supplies over recent years and the corresponding actions of regulators and competition authorities. These arbitral proceedings have mainly concerned price reopeners under traditional, long-term LNG contracts and have led to a recognition of gas-to-gas competition and reliable hub or market prices in many of Europe's jurisdictions.
Often, the disputes have led to a round of renegotiations and the introduction of increased flexibility (for the seller and the buyer) into those long-term arrangements, with contractual provisions being adopted from shorter-term trading arrangements. For example, the earlier preference for annual take-or-pay commitments has largely been superseded by cargo take-or-pay with mitigation sales and the ability to close out each transaction.
As customary sale and purchase arrangements are being pulled and stretched to fit changing LNG markets and transactions, tensions are rising within established relationships. Failures to deliver or take, sometimes to take advantage of other commercial opportunities, are showing the established contractual sanctions to be unsuited to the circumstances of the new, changed markets. An industry, which has become accustomed to price reopener arbitrations, is now also becoming used to formal resolution of disputes arising from failures to deliver and take LNG, to meet quality or technical specifications, and more besides.
A number of the primary consumer markets in Asia are seeing similar assertive steps by regulators and competition authorities towards liberalisation, the unbundling of businesses and the ending of pass-through pricing to consumers. And whereas the relevant contracts are similarly made subject to common laws such as those of England and Wales or New York and provide for reference to international arbitration in the event of dispute, the resulting tensions aren't yet leading to formal dispute resolution. Perhaps this is the result of the value of relationship and context prevailing over the opportunistic assertion of the accidentally beneficial text of the long-term contracts, or maybe it's just a matter of time before things come to a head.
The US market has grown in different ways from those in Europe and Asia, and as LNG from America makes its way towards Asian markets, the terms on which those supplies are bought and sold could prove disruptive to the established order. That's especially true of pricing provisions linked to Henry Hub and US markets, rather than those of Asia.
It's also becoming increasingly difficult to recognise what have long been identified as the separate links of the LNG chain. Each of the distinct activities of production, liquefaction, shipping, regasification and distribution would once have been carried out by different participants under separate projects with an aligned connection of back-to-back contracts. However, the presence of many new participants and the increasing use of tolling structures have tended to loosen these ties; and the rapidly growing use of floating technologies and small-scale LNG developments have meant that maritime vessel owners and operators of storage and transportation facilities are featuring more prominently.
Geopolitical and macroeconomic influences are also likely to contribute to changes in the markets, contracts and participants of the international LNG business. While the US' decision to withdraw from the Paris Agreement was a blow to international climate diplomacy, the role of natural gas and LNG as a bridge fuel towards a lower-carbon future seems undoubted. The likely displacement by natural gas and LNG of coal and oil consumption in the large consumer markets of China and India, and the introduction of LNG to new fast-growing markets like Pakistan and the Philippines seem likely to undermine existing long-term arrangements and contribute towards market disruption and uncertainty.
Together, the forces are reshaping both the way LNG is traded and financed. It's a brave new world for the LNG industry.
Paul Griffin is Senior Advisor and Counsel to the Global Gas Group, at law firm White & Case
This article is part of Outlook 2018, our annual book looking at energy market trends for the year ahead. To purchase a copy, click here