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LNG to test market and infrastructure limits

The global LNG market will face significant change as a supply glut, infrastructure constraints and a rapidly restructuring market test market participants

The LNG market has already had a taste of the challenges to come as the past year saw an unprecedented surge in supply that swamped European and Asian markets, overwhelmed global storage capacity and tested the ability of market participants to manage a growing array of risks.

Although it was expected, a surge of US LNG supply has struggled to find markets as slowing demand growth in China, a warm 2018-19 winter that left global storage higher than normal and a well-supplied European gas market have made it difficult for sellers to place cargoes. While Europe has taken large volumes of cheap LNG, Russian and Norwegian pipeline gas supply—combined with full European natural gas storage—has led to soft prices and backed-up supply on the water as ships queue up for limited slots at congested European LNG import terminals. 

Market development lags

In most other commodity markets, low prices and constrained infrastructure would trigger production shut-ins, higher demand or some combination of both. However, LNG’s rigid commercial structures and historical lack of demand elasticity have reduced the ability of market participants to adjust to changing conditions.

Although there has been significant growth in spot and short-term LNG markets over the past few years, the bulk of global LNG supply is still sold under long-term take-or-pay contracts priced as a percentage of an oil benchmark, most often Dated Brent. US LNG is more flexible but is largely sold under long-term contracts that oblige lifters to pay liquefaction fees even if they choose not to take their committed volumes.

LNG’s rigid commercial structures and historical lack of demand elasticity have reduced the ability of market participants to adjust to changing conditions

Over the past few years, LNG pricing has become significantly more fragmented.  Unlike most other commodity markets, LNG is rarely priced against LNG benchmarks. Rather, most volumes are priced against crude oil or natural gas pipeline prices such as the main US benchmark, Henry Hub, or European natural gas prices such as the Netherlands’ TTF or UK’s NBP. In the past, most LNG was sold directly to utility companies, which generally were able to pass through the cost of natural gas to consumers. Provided the utilities could demonstrate to regulators that their purchases were in line with the market and their peers, they shouldered little market risk and were insensitive to the cost of LNG supply. However, with European markets largely deregulated and Japan and South Korea moving in the same direction, utilities have become more sensitive to fuel costs.

The fact that LNG is priced against a range of benchmarks that reflect the fundamentals of markets that are not directly linked to LNG means that buyers are now exposed to a range of market risks that they did not face in the past. For example, the surplus of LNG has caused European natural gas prices and the Platts’ Japan Korea Marker (JKM)—the only widely accepted LNG spot benchmark–to plunge since the beginning of the year, while LNG priced against Brent, which has remained high relative to gas prices, has been relatively expensive.

For example, TTF prices averaged just under $3.10/mn Btu in September, while JKM averaged slightly over $5.25/mn Btu during the same period. By contrast, Brent averaged just shy of $62.50/bl during the month. A typical term contract price level of 13.5pc of the value of Brent would have yielded an average price north of $8.40/bl during the month, 60pc higher than JKM and 165pc higher than TTF.

Adding to the challenge posed by these substantial price divergences, there are few risk management instruments that market participants can use to manage these changing dynamics. JKM swaps, which trade on the ICE and CME exchanges, have gained in liquidity over the past couple of years. However, relatively few companies have JKM physical exposure. Hedging the spread between Brent and other LNG and natural gas prices requires market participants to execute at least two trades, resulting in higher transaction costs and imperfect hedges given that the pricing relationships between the relevant markets continue to shift. 

Future looks like the past? 

If the past year has challenged market participants, 2020 looks very likely to present many of the same issues. Without a severe winter to help drain the vast amount of natural gas in storage around the world, the global market is likely to face another year of supply surplus.

However, with spot markets still relatively immature and illiquid, and few risk management tools available for use, market participants will continue to face difficulty managing price risk. With constrained infrastructure and the supply/demand response expected to once again be limited—although predictions of supply shut-ins are, admittedly, becoming easier to find—the emerging global LNG market is likely to find itself struggling once again to adjust to rapidly changing circumstances.

Jason Feer, Head of Business Intelligence, Poten & Partners

Keep up-to-date with how the predictions in Outlook 2020 are playing out and get a first look at the themes that will shape Outlook 2021, as well as with relevant events such as the Outlook launch party and publishing schedules, by subscribing to Petroleum Economist’s bi-monthly Outlook newsletter.

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