US LNG: Cooperative rather than swing producer
The US has a vital role in promoting flexible and transparent LNG markets
It is easy to forget that the global LNG market was on the floor even before the unprecedented events of 2020 as the Covid-19 pandemic spread around the world. Months of over-supply from a surge in new capacity and softening demand, in part due to the impact of tariff wars, had sent prices plummeting.
During previous price troughs, LNG market participants—producers, buyers and traders—would look towards diverting volumes to other markets, fuel switching in the power sector, and increased demand in price-sensitive sectors such as fertilisers to rebalance the supply-demand dynamic.
But a new and much more efficient tool has now been introduced into the toolbox—the ability to contractually limit, not just divert or reload, supply. And it is available only to long-term contractual buyers of US LNG.
Prior to the US liquefaction era, the majority of global LNG supply was controlled, either directly or indirectly, by a cosy club of majors and large state-owned entities. Their sales contracts terms were rigid, with delivery destinations restricted, prices linked to non-gas indexes and volumes dictated by the dreaded ‘take-or-pay’ system.
In this world, buyers were expected to forecast, within a relatively narrow tolerance range, their LNG requirements for the next 25 years, and sign up to purchase these contracted volumes with little price or volume flexibility. If they could not accept their forecast volumes because of market changes, they could expect scant sympathy from suppliers, who still expected buyers to pay in full on the basis that, sometime in the future, they could ‘make up’ volumes without being exposed to any future price fluctuations.
A new and much more efficient tool has now been introduced into the toolbox—the ability to contractually limit, not just divert or reload, supply
US LNG changed the paradigm. Because a majority of producers purchase some or all of their feedgas from a liquid and transparent market—rather than having dedicated production—they can be more receptive to buyers’ requirements. US producers, most of which are privately held independents rather than majors, have invested only in their liquefaction plants, or, in some cases, also in feedgas pipelines to the plant, not in the upstream assets.
Thus, these producers do not need to recover upstream development costs or expect a premium to be paid for exploration risks—very different from the model still largely prevalent outside the US. Although the commercial models of non-US LNG plants have some variations, generally the same consortium—most of which include NOCs and one (or more) major or large IOC—owns the upstream, the pipeline and the liquefaction plant. The ‘all-in’ price of LNG includes actual incurred costs as well as risk premia for each aspect of the value chain—without a buyer ability to conduct price discovery or seek alternatives.
Pivot to the buyer
A key strength of the US LNG model is a buyer’s ability to cancel a contracted cargo. Although said buyer would still likely be liable for its share of liquefaction plant costs, with sufficient notice, feedgas, pipeline and shipping costs can be credited, saving the buyer a substantial portion of the total delivered cost.
In the summer of 2020, buyers from around the world took advantage of this flexibility and cancelled contracted cargoes. Cancellations from non-US suppliers were much less prevalent because of a contractual inability to do so without incurring a much higher loss. This should be viewed as a fundamental strength of the US model versus the traditional, rigid, non-customer-focused model still prevalent from most suppliers.
Because of this greater ability to reduce production during a price lull, some market observers have begun to refer to the US as the global LNG swing producer, much like Saudi Arabia in the oil markets. But, upon closer examination, this may not be an accurate summation.
In an oft-cited study from 1990, system dynamics expert John Morecroft defined a swing producer as having the “physical and economic capacity to increase or decrease production quickly… in order to absorb unexpected variations in demand or to compensate for cuts in the output of other producers” with the intention of defending a preferred price. He described two types of swing producer behaviour: normal swing mode and punitive mode. In the former, the producer responds to market price fluctuations by increasing or decreasing its output to ‘defend’ a preferred price.
In the spring and summer of 2020, it is fair to say that US production as a whole fell in response to market price fluctuations. But it was driven by buyers through contractual mechanisms, not by sellers working collectively or via government obligation to reduce supply.
Different sort of swing
In contrast to some other commodities’ swing producers, US LNG supply is composed of independent projects owned by different investors, working competitively against each other. Saudi Arabia can—through NOC Saudi Aramco’s single point of control of all of the Kingdom’s production—pursue a coordinated strategy to ‘defend’ a preferred price, a more traditional ‘swing’ role. It is far harder to argue that US cargo cancellations formed any sort of collective attempt to ‘defend’ a price.
Some market observers have begun to refer to the US as the global LNG swing producer
In Morecroft’s punitive mode, a swing producer takes advantage of its advantageous position to flood the market on a short-term basis, reducing prices and, ultimately, driving out supply competition. The oil markets are familiar with this behaviour, most recently seeing it just before Covid-19 when Saudi Arabia and Russia moved briefly to unlimited output in an attempt to reduce prices and curb US shale volumes.
For US producers, contemplating punitive mode is not realistic, feasible, desirable or even legal. While US LNG output volumes should continue growing to be the largest in the world over the next few years, no one company or entity can control the total output unilaterally, unlike other state-dominated LNG producers such as Qatar, Indonesia, Nigeria or Russia.
US liquefaction growth is driven by global customers demanding a change from the traditional, rigid commercial terms of the past few decades. The US has played and will continue to play a key role as a cooperative producer—working with buyers to promote flexible and transparent markets—rather than a potentially market-abusive swing producer.
As the market moves back towards greater normality, we expect buyers to support new US supply developments, such as Texas LNG, once again. Without their innovation, those that dream of creating a ‘gas Opec’ to influence global gas and LNG markets will only have their hand strengthened.
Vivek Chandra is founder and CEO of Texas LNG and author of Fundamentals of Natural Gas: An International Perspective.