Streetwise Professor

The unprecedented spike in European (e.g., TTF, UK Balancing Point) and Asian (mainly JKM) gas prices has apparently subjected major trading houses (e.g., Mercuria, Gunvor, Trafigura, Vitol, Glencore) to massive margin calls that have put strains on their liquidity resources. This happens every time there is an epic rally, as traders are usually short paper: Cargill, for example, ran into this problem when ag prices spiked in the first decade of this century.

I wrote about this in one of my Trafigura whitepapers:

This mismatch between timing of cash flows on a hedge instrument and the underlying physical can create extraordinary cash flow strains that can put a trader into financial distress.

The question is whether this is all that is going on in the natural gas markets now, or whether there is something more. There has been some hyperventilating about the potential collapse of trading firms, notably Gunvor and Mercuria. Is there anything to this?

Well, the answer is: not as described in that article.

Not to trivialize funding risk–I will come to that in a minute–but the biggest risk a hedger faces is basis risk: the price of the hedging instrument moves a lot relative to the price of the underlying being hedged. This basis risk depends on the relationship between the hedging instrument and the underlying.

The article linked above presents a situation where a trader (e.g., Gunvor) has purchased LNG on a netback basis, which essentially means that it pays the LNG supplier the difference between the price of gas at a destination market (e.g., TTF or JKM) and the price at the origin (e.g., Henry Hub). (There is also a shipping charge deducted.) But this means that the trader is short TTF (or JKM–to keep it simple, I’ll stick with TTF): its purchase price goes up as TTF goes up so a high TTF price is harmful, and harm resulting from a high price is the definition of a short position.

That can cause an increased need for cash to pay the supplier, but that’s different than a margin call on derivatives as represented in the article. And the article incorrectly identifies a purchase at a price linked to TTF as a long position in TTF: it is clearly a short position because a higher TTF translates into a higher cost.

How would the trader hedge this risk? One way is by selling LNG at TTF-linked prices: the higher the TTF, the higher the sales price, and assuming the sales linkage is the same as the linkage in the netback deal, the TTF risk is hedged tightly. (I never say “hedged perfectly”: the only perfect hedge is in a Japanese garden.)

Whether there is a funding liquidity risk here depends on the timing of the cash flows under the netback deal and the sales contract. It could be that the trader has to finance the purchase because revenue from the sale will be received later than the contractual payment to the supplier.

Another way is just to sell spot at into Europe. Here there could be a risk because the price obtained in the sale may not exactly match the TTF price in the netback contract.

There could also be a timing mismatch here that gives rise to funding risk.

The important thing to note is that neither of these strategies involves selling futures or swaps as a hedge. Indeed, selling forward would be an insane way to “hedge” a netback purchase. It would actually be what some wryly refer to as a “Texas hedge”: doubling down on a price bet, not entering into offsetting positions. Under the netback the purchase price goes up when TTF goes up. A rise in TTF also would cause losses on the short futures/swap. That is, both ends of this “hedge” would lose, meaning that it is actually a supersized short position in TTF.

Indeed, the netback seller (e.g., the LNG producer) would be the one to short futures as a hedge because the contract makes it long TTF. Selling TTF forward would lock in a sales price.

So the claim that netback purchases are going to kill Gunvor or Mercuria or whoever because margin calls makes no sense if these traders actually hedging: as netback-based buyers they wouldn’t be selling as hedges futures that would be subject to big margin calls in these markets.

Where hedging traders would be subject to margin calls is if they had fixed price purchases of LNG, not floating price purchases like netbacks. Then they would have sold futures/swaps as a hedge, and have received margin calls as prices spiked.

The main risk to the fixed price purchaser/futures hedger is the basis risk between the futures price and the sales price of the LNG. TTF futures prices will typically not track perfectly spot prices, giving rise to some basis risk, which could be acute in volatile market conditions.

Another reason to be skeptical about the claimed connection between margin calls and netbacks–netback pricing is not the current pricing model in LNG: it is largely aspirational.

In the US, Cameron operates under a tolling model, where the buyer pays a fee to Cameron and acquires its own gas. (A buyer could hedge these purchases by buying US natural gas forward, e.g., buying HH futures or swaps.) Cheniere operates under a pass through model. It buys the gas it liquifies. and charges the buyer Henry Hub plus a fixed fee. (A buyer could hedge these purchases and convert them to fixed price by buying HH futures/swaps.). Most non-US LNG has been sold under Brent-linked contracts (which could be swapped into fixed price by buying Brent forwards or swaps).

Gunvor has entered into a large netback-based contract with Tellurian (as have Total, Shell, and Vitol). But Tellurian’s Driftwood project has not even made FID, let alone is it actually selling gas. Tellurian touts netback pricing as an innovation. It’s certainly not the standard way of doing business in LNG now. (Full disclosure: Streetwise Daughter works for Tellurian.)

So pray tell from whom is Gunvor or Mercuria or whomever buying on a netback basis from now, especially in massive quantities? It is possible that there are unreported short term deals that have been done on a netback basis. But it’s not the current way that LNG producers sell gas. The article asserts that 80 percent of Gunvor purchases are on a netback basis. What is the support for that claim? It is certainly not the case that 80 percent–or anything close to that–of LNG overall is bought on a netback basks. What is the basis for asserting that Gunvor is such an outlier?

Meaning, color me very skeptical about this alleged impending implosion of commodity traders due to netback deals.

I think that a more plausible explanation of the huge margin calls is that the traders are short TTF/JKM futures/swaps against fixed price purchases, Brent-linked purchases, or Brent-linked purchases hedged into effective fixed price purchases.

And yes, as seen historically, and described in my white paper, this cashflow mismatch between what is hedged and the hedging instrument can cause major liquidity problems. And banks, for various reasons (e.g., exposure limits, asymmetric information), may not be willing to extend credit sufficient to meet these liquidity needs. This would lead firms to have to cut positions. This hurts, but it’s not Armageddon.

Margin calls are one big headache for traders. Another is credit risk. A trader that has sold LNG basis JKM or TTF has to worry that the counterparty will default at such elevated price levels, either because of financial distress (e.g., the counterparty must sell power or gas at fixed prices, hasn’t hedged its purchases, and goes bust) or “price majeure” (the counterparty just refuses to adhere to the contract. because of the high price): price majeure has long been a major issue in selling commodities to China. Perhaps the CCP’s desperation for energy and its order for utilities to obtain fuel at any price will reduce the PM risk, but it’s always dangerous to count on the CCP.

Another interesting aspect of the recent LNG spike is that unlike the one last winter, this one has not seen an explosion in LNG shipping rates. Thus, the yawning spread between TTF or JKM and Henry Hub (upwards of $50/mmBTU) cannot be explained by shipping rates.

So, to reprise one of my favorite games with my students: Find the Bottleneck!

Spreads price bottlenecks. The spread between TTF/JKM and Henry Hub cannot be explained by shipping cost, so shipping is not the bottleneck. So what must be the bottleneck?

To find the bottleneck, always look what is between the consumption and production location. What (other than shipping) is between importing markets (Europe, Asia) and the gas supply locations (e.g., Henry Hub)? Liquefaction capacity. So the huge spread (which exists even after deducting shipping costs) between JKM/TTF and Henry Hub means that the shadow price of liquefaction capacity is huge. That capacity is the bottleneck.

Qui bono? Well, Cameron and Cheniere have sold their capacity at a fixed price. By selling at oil linked prices, Qatar, etc., are not capturing the shadow price of capacity via that pricing mechanism. So the buyers profit–if they have not hedged their purchases/sales. If they have hedged, the counterparties to the hedge transactions (those that bought TTF or JKM swaps) are the winners.

That is–the speculators in TTF or JKM win by profiting on an explosion in the shadow price on liquefaction capacity.

Meaning . . . how long before this becomes understood, and therefore how long before “kill the speculators!” again becomes the cry heard throughout the land.