Streetwise Professor

October 31, 2015

On the Spot: How a Surfeit of Supply is Transforming LNG Trading

Filed under: Commodities,Derivatives,Russia — The Professor @ 6:22 pm

In September of last year, I gave the dinner speech at the CWC LNG Asia Pacific Summit conference in Singapore. The dinner was held at the Singapore Aquarium, and I spoke in front of the Aquarium’s giant shark tank. I couldn’t help but think of the scene with Kim Jung Il and Hans “Brix” Blix from Team America. Especially after the way my remarks were received, which ranged between cool and rather hostile.

I predicted the demise of oil-based pricing, and increased reliance on the spot market or long-term contracts indexed to spot prices. There were three basic parts to my argument. The first was that the large increase in supplies coming online in 2015-2017 combined with the even-then apparent slowdown in demand in China, and the likely decline from Japan due to the restarting of its nuclear plants, would lead to a large overhang of cargoes that would need to find a home. The trading of these cargoes would lead to increased spot market activity.

The second part of my argument was that the dynamics of liquidity would then take over. Liquidity creates liquidity. More spot market activity reduces the transactions costs of trading spot, which leads to more spot trading. There is a virtuous cycle in liquidity, and the increase in spot trading to dispose of contracted of but now unneeded cargoes would start the cycle.

The third part of my argument was that a robust spot market would support gas indexing, as opposed to oil indexing, in term contracts. Oil indexing is akin to the drunk looking for his wallet under the lamppost, because the light is best there, not because he lost it there. LNG buyers and sellers looking for a price benchmark looked to oil in the early days because in the 70s oil was a substitute for gas in power generation, so there was some connection between the markets, but mainly because oil was the only lamppost around. But especially now, with gas and oil having little fundamental connection in either consumption or production, oil prices are not closely correlated with the marginal value of a ton of LNG. The development of a liquid LNG spot market would-will, in my view-allow contracts to be indexed to a price that reflects gas values. This would also permit the development of a paper hedging market.

My unpopular prediction is now looking much better, though not all are persuaded. There is a huge LNG overhang, with Australian and US supplies about to come on stream. This supply increase is occurring simultaneously with a protracted decline in demand growth. Much of this overhang will find its way to the spot market. That, in turn, will start the virtuous cycle.

The supply overhang will have other consequences. It will force down prices world-wide, and lead to a redirection of supplies from Asia to Europe. One of the biggest losers from this will be Russia, which will face more intense price competition in its biggest export market in Europe, and a reduced Chinese appetite for the gas it had hoped to send east. Another will be Qatar, at present the world’s largest supplier.

Making things even more interesting is that Russia and Qatar are adversaries in Syria. (And by the way, those conspiracy theorists who think that the Syrian civil war was started by Qatar because Assad would not allow the construction of a pipeline to bring Qatari gas to Europe-spare me. Qatar’s big LNG investment dramatically reduced its need for a pipeline, and it anticipated being able to sell all it could to a growing Asian market.)

The next few years will be interesting in LNG. I am even more convinced that in 3 to 5 years the market will look nothing like it does today. It will look more like the oil, iron ore, and coal markets. Furthermore, in the near-to-medium term it will be more of a buyer’s market, and indeed, these things are connected. The surfeit of supply that makes it a buyer’s market will catalyze the development of a spot market.

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  1. I wonder how this will apply to the price of LPG. It is more amenable to transportation and storage (at least with current infrastructure) than CNG and so might track the prevailing oil price more closely. But it is also used extensively for the same residential and industrial purposes as Natural Gas is, so maybe the two will converge?

    Comment by HibernoFrog — November 1, 2015 @ 4:49 am

  2. Just a few points, in random order:

    1. The spot market in LNG will be limited in size due to the fact that, unlike oil infrastructure, LNG projects are usually financed by pre-selling the gas (presumably at a rate which tracks some other index, or a fixed rate: sorry, I’m an engineer not a finance guy!) – or rather, the projects are financed by capital raised using the pre-sold contracts as security. With the gas price falling, and interest rates remaining low, it is unlikely that the oil companies (private nor national) will want to move away from this model and fund new LNG plants out of cash reserves (not that they do this anyway, but AFAIK they borrow at a higher interest rate compared to a loan secured against future sales).

    2. Unless LNG plants are fed by non-associated gas, the production of LNG will always be linked in some capacity to oil production. Ideally, you’d produce gas from a non-associated gas field, as the Qataris are extremely fortunate enough to be able to do. But in general, there are not that many non-associated gas fields around which could support an LNG plant (especially with low prices). However, the disposal of gas associated with oil production is becoming increasingly difficult, because operational flaring has been outlawed and there is often no local market for the gas in increasingly remote fields and/or no potential tie-back to an existing gas system. So there are serious efforts ongoing to develop small LNG facilities, usually floating but also on concrete barges, in order to monetise the associated gas which you cannot do much else with. This is proving to be quite difficult because, due to the process and type of equipment required, LNG only really works on a large scale. But nevertheless efforts are ongoing to develop small, floating LNG units in an effort to allow isolated oil fields to be exploited. If we assume the non-associated gas fields will be developed using LNG in the conventional sense, i.e. using pre-sales contracts, and the non-associated LNG gas sold on the spot market, you would expect some sort of link between the LNG spot market and the oil price to remain. This is especially true because, if your LNG plant is reliant on associated gas from oil production, your feed gas specification will be of secondary consideration to that of the oil production, meaning you’ll be upgrading your plant every so often during which you cannot produce.

    3. LPG doesn’t come in the volumes that LNG does: it is normally produced from associated gas when there is a local market situated nearby. There are concept developments for a “virtual pipeline” using LPG carrying ships, but don’t know if any are actually operational.

    None of the above is intended to dispute what you have written, I’m just throwing in my ten-cents worth. Keep up the good work!

    Comment by Jake Barnes — November 1, 2015 @ 10:16 am

  3. @Rob You mention the case “Unless LNG plants are fed by non-associated gas…” Well, I think that’s part of the point. The marginal cubic foot of gas feeding these facilities is coming (will come) from the liquids-rich gas plays of North America, and coalbed methane in Australia. As for yours and @HibernoFrog’s comments on LPG, to use Canada as an example, the tsunami of liquids-rich development has destroyed pricing. Propane netbacks went negative in the early part of this year, and the slowdown in oil sands development will increase the spread between condensate and Edmonton light IMO. This points to continued decoupling as opposed to convergence/stronger correlation, in this part of the world anyways.

    I thoroughly enjoy your commentary Prof, thank you. First time commenting but long-time reader.

    Comment by Eric — November 1, 2015 @ 4:33 pm

  4. @Eric-welcome to the party. Thanks for commenting, and for your kind words.

    The ProfessorComment by The Professor — November 1, 2015 @ 6:40 pm

  5. @Jake-Just a quick response. More later.

    Another thing that I said that made me wonder whether I was going to be thrown in the shark tank is that the LNG market would be better off on the gold standard than the oil standard, because the LNG-gold correlation is actually slightly higher than the LNG-oil correlation. Thus, even though there are some fundamental connections between oil and LNG these are insufficient to produce a high price correlation. The correlation is actually quite low, on the order of 10 percent.

    Correlations are a measure of short-run association, but oil and LNG prices aren’t even cointegrated, meaning that they don’t even seem to have a long-run relationship.

    The ProfessorComment by The Professor — November 1, 2015 @ 6:50 pm

  6. @Jake-One more thing. There can still be long-term contracted volumes, but the contracts needn’t be linked to oil prices. That’s what I meant when I referred to gas-indexed contracts.

    If the US becomes the marginal source of LNG (which seems likely) Henry Hub-linked contracts would be attractive, because HH (or some other US location) will drive world prices (because prices are determined at the margin). This would permit the exploitation of a well-developed and liquid paper market.

    The ProfessorComment by The Professor — November 1, 2015 @ 6:54 pm

  7. @HibernoFrog

    LPG and LNG aren’t as similar as you might think. LPG is a refined product that can, up to a point, be injected into the gasoline pool, or substituted by kerosene as portable fuel, or used as petrochemical feedstock; so it has three applications where price is affected by oil-related alternatives.

    Natural gas can be used as petrochem feedstock too, so I guess there will always be *some* element of oil influence in the price in that there’ll be a bid for gas from petrochems players whose alternatives are to lift naphtha or LPG offers.

    Its *chief* use, though, I think, remains burning to fire either power generation or home heating – which so far is not the case with LPG. Incidentally, LPG is much, much nastier to handle than LNG. LPG can explode apocalyptically; LNG fires ordinarily produce a plume of flame, but no blast or overpressure.


    I remember doing consulting projects on the LNG outlook 10 years ago, and at that time, we could see no prospect of spot trading in LNG emerging any time soon.

    The reasoning was that LNG requires a liquefaction plant; a liquefaction plant requires about 6 to 7 tcf of gas to make it pay; and having 6 to 7tcf of gas requires that you be a country, rather than a company. Consequently, all such plants would be built on the basis of guaranteed supply by some petrostate and guaranteed offtake by clients’ national grid, just like the first one ever, in north Africa in the 60s.

    These factors mean there would probably never be a merchant producer selling surplus spot LNG cargoes to the highest bidder. One of those factors would have to change for spot trading to emerge. Interestingly, we did see a couple of necessary-but-not-sufficient underpinnings to LNG trading developing, which were surplus regasification capacity, and surplus freight. An LNG train cost $2 billion, a regas plant $500 million, and an LNG tanker $90 million. So if you wanted a piece of the gas action, the cheapest piece of it was to own a ship, and the most expensive was a liquefaction plant. Interestingly, even 10 years ago, there was a surplus of ships in prospect and also of regas plants (although I think a lot of projects never got built). What was cheapest to build got over-built.

    So what is the source of the surplus gas that now buggers this magisterial analysis? Is it all shale? And is there surplus spot demand anywhere (at some price, I presume so)?

    Comment by Green As Grass — November 2, 2015 @ 8:47 am

  8. @Jake-One other point. The existing financing mechanism was endogenously determined, and one of the factors that determined it was the absence of a spot market. In the absence of a liquid spot market, sellers (buyers) had to be concerned about buyers (sellers) acting opportunistically, i.e., engaging in “hold-ups.” A buyer could tell a seller “I won’t take delivery unless you cut the price,” (with a reverse scenario for the seller), and in the absence of a spot market the seller had no outside option (again with a reverse scenario for the buyer). This is a classic transactions cost economics problem in which long term contracts with a transparent, relatively non-manipulable pricing mechanism is necessary to reduce hold-ups and wasteful haggling.

    Put differently, in the absence of a spot market, security of supply and security of demand must come through long term contracts.

    A spot market means that the market can provide security of supply and demand. A seller can’t hold up a buyer because the buyer can obtain supply elsewhere. Similarly, a buyer can’t hold up a seller because the seller can dispose of the cargo on the spot market.

    The oil sector transformed rapidly from one based on equity contracts and vertical integration to one based on spot contracting and investment on “spec” once the spot market evolved in the 1970s. The oil shipping sector underwent a parallel shift (which I documented in my PhD thesis in 1987, subsequently published in J. Law & Econ.).

    If a spot market develops, it will have seismic effects on contracting, financing, and investment practices generally.

    The ProfessorComment by The Professor — November 2, 2015 @ 9:34 am

  9. @ Eric:

    The marginal cubic foot of gas feeding these facilities is coming (will come) from the liquids-rich gas plays of North America, and coalbed methane in Australia.

    I don’t know much about the US shale-fed LNG market, but I know the coalbed methane reserves in Queensland have been, erm, overstated somewhat. One proposed LNG plant (Arrow) has been canned and another (Curtis) looks to be struggling for feed gas in the near future.

    Comment by Jake Barnes — November 2, 2015 @ 12:17 pm

  10. @ SWP:

    Thus, even though there are some fundamental connections between oil and LNG these are insufficient to produce a high price correlation.

    For now, yes. But it all depends on where the future supply comes from. As Green as Grass asks above, where does this surplus gas come from? I think we could probably divide the LNG supply into three categories:

    1. Large non-associated gas fields, producing LNG which is sold in advance.
    2. The US shale fields.
    3. Smaller non-associated gas fields or associated gas, producing LNG which is sold on the spot market.

    I agree with you that No. 1 need not be priced based on the oil price, but then this LNG is not going onto the spot market. I don’t know how much No.2 would influence prices, but No.3 is going to be linked somehow with the oil price, because it will, in the main, come from oil production. I guess the size of the spot market and the market rate for gas will be driven partly by the relative size of Nos.1-3.

    Comment by Jake Barnes — November 2, 2015 @ 12:26 pm

  11. @ Green as Grass:

    Incidentally, LPG is much, much nastier to handle than LNG. LPG can explode apocalyptically; LNG fires ordinarily produce a plume of flame, but no blast or overpressure.

    The worst case scenario for the technical safety engineers is an LNG leak which, due to its high molecular weight, drifts at ground level from a leak into a populated area where it then ignites. Then you’d get a serious blast. I know we look at this seriously when designing the liquefaction plants, but the re-gasification plants which, by necessity, are near population centres? I have no idea. 🙂

    Comment by Jake Barnes — November 2, 2015 @ 12:28 pm

  12. @Jake

    The average molecular weight of spec LNG is less than that of air at STP, so I presume you mean density; in which case I wonder how close a populated area would have to be before most of the LNG dissipates. My guess is quite close.

    Comment by Eric — November 2, 2015 @ 10:06 pm

  13. Correction. The average molecular weight of spec LNG is less than that of air at any condition.

    Without turning this into a technical discussion, my understanding is that the vaporization of even significant amounts of LNG occurs very quickly due to the significant temperature change.

    Comment by Eric — November 2, 2015 @ 10:31 pm

  14. Methane is lighter than air while other longer chain alkanes are heavier. Ethane even is slightly heavier than air. LNG from Alaska is essentially 100% methane while LNG from Algeria has maybe 9% ethane. With a gas release from LNG the compoenets will gravity segregate and so methane will tend to higher elevation whil ethane+ will tend to lower elevation.

    The Japanese are very concerned about the phenomena of “rollover” in LNG tanker design but as best I know there has never been a documented case of “rollover” in the history of LNG tankers.

    The first LNG sales to Japan were from a tiny LNG facility in Alaska with Mitsui the buyer.

    Comment by pahoben — November 3, 2015 @ 3:13 am

  15. Funny that different specialties often use LPG to refer to different things. For production people LPG refers to butane and propane and the acronym is Liquefied Petroleum Gas. Power people often use LPG to refers to propane+ andd the acronym is Liqufied Petroleum Gasoline.

    The real intent of producing LPG or LNG is to increase the BTU content per unit volume. Gas is difficult to transport because very low BTU content per Unit Volume.

    Comment by pahoben — November 3, 2015 @ 3:51 am

  16. @ Jake –

    I should have stated that I was thinking of spills from ships, rather than elsewhere. LNG leaking from a ship would sink to the water’s surface and if set alight would be more likely to burn than explode. With LPG leaks, you’re in trouble right away. If your LNG fire happens ashore, you’ve got a bigger problem, of course. AIUI regas terminals can be remote if safety requires, because you just inject into the local grid, and if that overbalances the grid, gas elsewhere goes into whatever storage is nearby to rebalance it.

    On the matter of where spot LNG cargoes come from, one possible source I recall from 10 years ago was declining fields, whose output gets both smaller and more erratic as exhaustion nears. Once this starts to happen, offtakers historically tended to look for gas elsewhere; they’d rather lift 20 cargoes a year from each of 2 reliable players than lift 5 cargoes apiece from each of say 8 declining plants. So this was another source.

    The issue was that there was then no spot demand for long range cargo (in gas terms, something of an oxymoron), nor was there strategic storage, and nor were the futures very liquid outside the USA at that point (which has certainly changed) so no merchant interest.

    Comment by Green As Grass — November 3, 2015 @ 6:33 am

  17. @ Jake, Eric, Green As Grass: Just wanted to say thanks for your interesting responses to my comment.

    @ All: What a great comment thread. No abuse or wild accusations – there is hope for the internet yet!

    Comment by HibernoFrog — November 5, 2015 @ 4:34 am

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