Streetwise Professor

January 25, 2021

LNG Skyrockets: Is Excessive Reliance on Spot Markets to Blame, and Will This Cause Contracting Practices to Change?

Filed under: China,CoronaCrisis,Derivatives,Economics,Exchanges,LNG — cpirrong @ 8:26 pm

After languishing in the doldrums in the Covid era, and at times touching historic lows, the price of LNG delivered to Asia skyrocketed in recent weeks before plunging almost as precipitously:

As always happens with such big price moves, there has been an effort to round up suspects. Here, since the visible price increase occurred in the spot market, the leading culprit is the spot market–something that has been growing rapidly in recent years, after being largely non-existent prior to 2014 or so.

For example, Reuters’ Clyde Russell writes:

What is more likely is that some buyers misjudged the availability of spot cargoes, and when hit with a surge in demand found themselves unable to secure further supply, thus bidding up the prices massively for the few cargoes still available.

Frank Harris of Wood Mackenzie opines:

“Buyers are going to become aware that you may not always be physically able to source a cargo in the spot market regardless of price,” Mr Harris says. “The most likely outcome is it shatters some of the complacency that’s crept into the market over the last 12-18 months.”

It is incorrect to say that a shortage of spot cargoes per se is responsible for the price spike registered in the spot market. It is the supply of LNG in toto, relative to massive increase in demand due to frigid weather, that caused the price increase. How that supply was divided between spot and non-spot trades is a secondary issue, if that.

The total supply of LNG, and the spatial distribution of that supply, was largely fixed when the cold snap unexpectedly hit. So in the very short run relevant here (days or weeks), supply in Asia was extremely inelastic, and a demand increase would inevitably cause the value of the marginal molecule to rise dramatically. Price is determined at the margin, and the price of the marginal molecule would be determined in the spot market regardless of the fraction of supply traded in that market. Furthermore, the price of that marginal molecule would likely be the same regardless of whether 5 percent or 95 percent of volume traded spot.

If anything, the growing prevalence of spot contracting in recent years mitigated the magnitude of the price spike. Traditional long term contracts, especially those with destination clauses, limited the ability to reallocate supplies efficiently to meet regional demand shocks. The more LNG effectively unavailable to be reallocated to the buyers that experienced the biggest demand shocks, the less elastic supply in the spot market, and the bigger the price increase that occurs in response to a given demand shock. That is, having less gas contractually committed, especially under contracts that limited the ability of the buyers to sell on to those who value it more highly, mitigates price spikes.

That said, the fundamental factors that limit the total availability of physical gas, and constrain the ability to move it from low demand locations to high demand locations in the short time frames necessary to meet weather-driven demand changes (ships can’t magically and instantaneously move from the Atlantic Basin to the Far East), mean that regardless of the mix of spot vs. contract gas prices would have spiked.

Some have suggested that the price spike will lead to less spot contracting. Clyde Russell again:

The question is whether utilities, such as Japan’s JERA, continue with their long-term vision of moving more toward a spot and short-term market, or whether the old security blanket of oil-linked, but guaranteed, supplies regains some popularity.

It’s likely LNG buyers don’t want a repeat of the recent extreme volatility, but perhaps they also don’t want to return to the restrictive crude-linked contracts that largely favoured producers by guaranteeing volumes at relatively high prices.

The compromise may be the increasing popularity of short-term, flexible contracts, which can vary from a few months to a few years and be priced against different benchmarks.

Well, maybe, but color me skeptical. For one thing, contracts require a buyer and a seller. Yes, buyers who didn’t have long term contracts probably regretted paying high spot prices–but the sellers with uncommitted volumes really liked it. The spike may increase the appetite for buyers to enter long term contracts, but decrease the appetite of sellers to enter them. It’s not obvious how this will play out.

I note that the situation was reversed in 2020–buyers regretted long term contracts, but sellers were glad to have them. Ex post regret is likely to be experienced with equal frequency by buyers and sellers, so it’s hard to see how that tips contracting one way or the other.

This conjecture about the price spike leading to more long term contracting also presupposes that the only way of managing price risks is through fixed price contracts (or oil-indexed) contracts for physical supply. But that’s not true. Derivatives allow the separation of who bears price risk from the physical contracting decision. A firm buying spot (and who is hence short LNG) can hedge price risk by purchasing JKM swaps. This has the additional advantage of allowing the adjustment of the size of the hedge in response to more timely information regarding likely quantity requirements, price projections, and risk appetite than is possible with a long term contract. That is, derivatives permit unbundling of price risk from obtaining physical supplies, whereas long term contracts bundle those to a considerable degree. Moreover, derivatives plus short term/spot acquisition of physical supplies allows more flexible management of supply, and management of supply based on shorter term forecasts of need: these shorter term forecasts are inherently more accurate than forecasts over contracting horizons of years or even decades.

So rather than lead to more long term contracts, I predict that this recent price spike is more likely provide a fillip to the LNG derivatives market. Derivatives are a more flexible and cheaper way to manage price risk than long term contracts.

This is what happened in the pipe gas market in the US post-deregulation. Spot/short term volumes grew dramatically even though price spikes were a regular feature of the market: market participants used gas futures and swaps and options to manage these price risks, and benefited from the greater flexibility and precision of obtaining supplies on a shorter term basis. This shifted a lot of the price risk to the financial sector–which is the great benefit of the much bewailed “financialization” of commodity markets.

The same is likely to occur in LNG.

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  1. Who Squeezed the JKM February 2021 swap ?

    I continually hear skepticism about the JKM index: starting by why Platts use Bids by the Houses on the Paper to fix a daily physical index ?

    Winter prices in Asia and cancellation in the U.S, and limited transportation options have caused JKM gas prices to rise. (OK)

    The arbitrage economics would also provide a low risk of detection. All they need is to wash a sale really above the delivery value and take the long side in the derivatives.

    Simplified example
    Day 1 concluded a deal at $21.70,  about $90M cargo, benchmark is at $12.73 for February delivery
    Day 3, the benchmark is now $15.1, Platts integrated this deal into their daily calculation. 
                  Position                                                 P&L
                  Cash                    JKM swap
    Day 1 :  418 contracts.      2000 contracts        – 37.518M      = (418* 21.70-12.73)* 10000mmbtu
    Day 3:   418 contracts.      2000 contracts         +211.2990M  = (2000*15.1-418*21.70)* 10000 mmbtu…
    On day 10, (next week) the February contract expired and can cash out, exit.

    By sporadically inflating one deal to favor the prompt month (JKM feb) they can capture, via the derivatives, an opportunity greater than the hubs relative prices and transportation costs only. 

     What can work nicely for manipulator can also be a matter of interest for the CFTC.

    Who Squeezed the JKM February 2021 swap ?
    Time to revisit “The Economics of Commodity Market Manipulation”

    Comment by Jacques S. — January 26, 2021 @ 1:28 am

  2. Seems like a perfectly plausible outcome, very similar to how airlines have been hedging their fuel needs for decades…

    Comment by HibernoFrog — January 26, 2021 @ 10:47 am

  3. Well, what would you expect in Biden’s America?

    Comment by dearieme — January 26, 2021 @ 3:53 pm

  4. Craig – you are almost correct on the potential solution or part of the solution to the price volatility that the Asian marketplace experienced.
    The solution is not a financial index with no correlation nor convergence to the physical market rather a transparent LNG physically delivered Futures contract with a forward curve that would/could give an indication of the volatility that is coming in coming months.
    If the buyer of the cargo in Japan in November saw that Nov, Dec and Jan say were in contango he/she could have bought the Jan Futures contract and either sold it en route as the market rallied or taken the futures contract to delivery with Abaxx Exchange being the buyer/seller of last resort. This has been done in Futures markets for decades but does not exist in the current state of global LNG.
    Financially settled market are not the solution to help manage risk and volatility in this market. Ask any FCM or Trading Risk Manager if they are happy with $2.50 Natgas in the USG or $39 in Asia on the same day – the answer is no to both – you cannot properly manage risk with this level of volatility on either side of the market. It would be interesting to see if current Exchanges modified their margins sufficiently and in time to cover the moves that were experienced. I bet that many FCM Risk managers had some sleepless nights.

    Comment by Joe Raia — January 26, 2021 @ 4:34 pm

  5. I think one key aspect that many commentators missed – not the Prof mind you – is that we are talking about the marginal molecule delivered (or rather the marginal LNG cargo landed). It’s not that the whole of North Asia procured at that exorbitant spot price.

    Many ways to hedge, JKM obviously, but also Japanese power futures now available at EEX and soon at the CME.

    Comment by [email protected] — January 27, 2021 @ 8:16 am

  6. Also not sure what source you are using for that chart, but if you are simply following the front-month futures contract, some of those extreme value changes are simply due to the monthly roll from one maturity to the next, which happens on the 15th each month in JKM.

    Comment by [email protected] — January 27, 2021 @ 2:19 pm

  7. @Joe-I’m actually a big proponent of delivery-settled contracts as opposed to cash settled. That’s a staple of my classes in Houston and Geneva. In particular, I agree completely that they do a better job at achieving convergence. Even cash-settled contracts that are tied to some sort of auction for the physical (like Platts windows, or the gold or silver fixes) are ripe for games and manipulation.

    My post was more about the unbundling of the physical flows from price risk. The issue of the best contract design to do permit an efficient unbundling is distinct but very important issue. We’re in agreement on that issue. Delivery settlement is the way to go.

    Comment by cpirrong — January 29, 2021 @ 5:23 pm

  8. JKM is a mechanism of “price discovery” in the gas market.

    From the shipowner in Oslo, the LNG board room in Houston and the utilities in Japan.

    What I understand is that the actual Bids on JKM are derived from the derivatives the “expectations not necessarily based on actual trades but representing “tentative deals”.
    There is an ambiguity also about its locational basis, is it a cargo delivered to china, korea, taiwan or Japan ?

    It is a contract far from perfect but gives “indications”. If I used my free-speach of the free-society I would say these Platts swap units are garbage…

    Like the Platts CU ethanol (ADM v. AOT Holdings).
    They manipulated in a way or other. But more academic work must be done !
    Giving you some pointers:

    In Energy some ships were fixed/proposed by the Houses at reported rates of “250K per day in the vlcc trade during March”, later we found they were “on subject”, “tentative”. ***** No actual ship deal was concluded at these indicative rates.****

    However this information formed the indexes in crude oil and freight during march aka the market structure => and how deals are then priced.
    These never happened and the whole market used them as a pricing based for the oil contango…(had to)

    The LNG froth ‘expectations”… (right or wrong) this has shift the market structure in January 2021.

    If you are an utlity needing the molecule or the U.S LNG developer signing clients I am not sure how this paper game UP or Down are productive in your price discovery
    Jacques S.

    Comment by Jacques S. — January 30, 2021 @ 5:10 pm

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