New freight derivative set to change the LNG transportation game
After the boom in JKM futures volumes, LNG traders now have another addition to their risk management toolkit
One of the unintended consequences of the ongoing commoditisation of the LNG industry has been the growth of the spot shipping market. As contract duration decreases and the number of market participants increases, mid-market traders need more flexibility from their freight portfolios to service demand.
This inevitably leads to more spot market shipping requirements, shorter duration charters and increasing sub-chartering activity, as these portfolios are rebalanced and optimised to suit different market conditions.
Although seen as somewhat distasteful by established players with long-term contracts and portfolio shipping locked against it, this development has resulted purely from the growth in spot LNG cargo activity as the LNG customer base diversifies.
Just as with the underlying commodity prices, the increase in short-term vessel activity has led to an increase in rate volatility. As with any market, prices are set by supply and demand, but LNG freight players found themselves caught between having little transparency of what the spot rates were—before even mentioning any way of managing them—and a market price convention that can make fixing a ship not dissimilar to defusing an unexploded bomb.
Rather than paying a steady headline time charter rate for hiring a vessel for a period of months or years, spot charters involve the payment of a ballast bonus or positioning fee on top of a daily hire rate. This is meant to compensate the owner for positioning the vessel and the inevitable idle time that occurs in between charters.
As contract duration decreases and the number of market participants increases, mid-market traders need more flexibility from their freight portfolios to service demand
An owner is, of course, forced to swallow the cost of positioning in a weak market and also takes the utilisation exposure of waiting for business. But, in a strong market, they can pass these costs (and often more) onto the charterers.
In the build-up to the peak demand northern hemisphere winter season in 2018, freight rates broke above $200,000/d as charterers were forced to pay positioning fees on top of roundtrip freight rates. The following spring, rates crashed to below $25,000/d as Asian demand backed off.
In 2019-20, the effects of weaker-than-expected winter demand, followed by Covid-19 and subsequent US Gulf cargo cancellations, have seen a similar boom and bust in rates. And this has had an impact even on longer-term contracting—with LNG shipowners and charterers increasingly struggling to cross each other’s bid/offer spread.
Since the market’s take-off in 2017, LNG traders in Asia have been able to use JKM futures as a viable risk management tool to hedge cargo pricing. Most players also use oil derivatives to manage their exposure to longer-term oil-indexed supply contracts.
But the same cannot be said for freight. Indeed, the inability to hedge freight rates has long been a fundamental issue both for gas producers seeking to sell on a delivered ex-ship (Des) basis and end-users moving to buying free-on-board (Fob). In just a few weeks (and the actual lead time can be much more), a cargo trade with unfixed freight can blow into the red as effective rates can oscillate wildly on relatively modest changes in vessel availability.
Relatively few companies have possessed the scale, capital and knowhow to overcome the challenge and become genuine portfolio traders. For some, dabbling in the freight market has not been a pleasant (or profitable) experience, while others have found the freight risk too great an obstacle and not progressed their plans.
In 2018, supported by a group of independent shipbrokers, the Baltic Exchange launched its BLNG indices to be a set of benchmarks that would cast a light on the genuine rates seen in the spot market. Using a methodology that incorporates the ballast bonus and/or repositioning fees paid to shipowners, the BLNG indices brought a new degree of transparency to LNG freight.
Sectoral interest in having a tradeable derivative underpinned by these benchmarks was not far behind. It is still only just a year since the first bilateral test trade was concluded, but LNG forward-freight agreements (FFAs) are now available on a cleared basis via the CME exchange and have been traded by over a dozen counterparties with contracts covering periods out to the end of 2021. In the first nine months of trading, CME has cleared almost 1,000 days of FFA contracts.
The LNG FFA market allows participants to manage exposure to spot freight rates. Smaller end-users that felt compelled to buy Des LNG from traders can now commit to Fob cargoes having covered any freight risk in advance. And shipowners can look to balance utilisation and price risk with a combination of long-term charters and hedged spot trading, something commonplace in dry bulk and tanker shipping for decades.
>$200,000/d – Freight rates before peak demand winter season in northern hemisphere in 2018
Is this a game-changer for LNG transportation? I would call it more of a next logical step in the market’s evolution. One that was inevitable and will likely lead to a more efficient LNG shipping market but following an established path.
In fact, as LNG is a relative newcomer in seaborne commodity trading terms, we see a ‘fast-track’ ahead. As gas in all its forms now trades as a global commodity, the financial traders of the Henry Hub and TTF pipeline markets have become significant players in the JKM futures market. And we are now seeing funds and banks trading LNG FFAs within its first activity wave—way in advance of how other FFA markets developed.
Ben Gibson is an LNG derivatives broker at Affinity