Streetwise Professor

February 27, 2013

Who is the Sucker Here?

Filed under: Commodities,Derivatives,Economics,Politics,Russia — The Professor @ 10:17 am

Gazprom has announced that it is entering into exclusive negotiations with Levant LNG to secure the rights to market 100 percent of the gas produced by the Tamar floating LNG plant:

OAO Gazprom (GAZP), the world’s biggest natural gas producer, is seeking exclusive rights to export liquefied natural gas produced from fields off Israel’s Mediterranean coast.

Gazprom Marketing & Trading signed a heads of agreement with Levant LNG Marketing Corp., outlining the terms of a 20- year sales deal from the Tamar floating LNG plant, the unit said today in an e-mailed statement.

Levant and Gazprom’s marketing unit will hold exclusive talks on LNG sales for six months, according to a separate statement to the Tel Aviv bourse today. Sales may amount to 3 million tons of LNG a year, linked to Brent crude prices, according to the statement. That equals the plant’s total planned output volume.

My first reaction is that I cannot believe the Israelis will be so stupid as to lock themselves into Gazprom on an LNG project.  Why not?

Most importantly, Gazprom has little interest in seeing gas from the Mediterranean come onto market, and hence has an incentive to throw roadblocks in way of the project.  Interestingly, the announcement indicates that Gazprom plans to sell the gas in Asia, even though eastern Med gas is perfectly positioned to sell into Europe-which is probably precisely the reason that Gazprom wants to send the gas east rather than north and west.  But even if those tons of Israeli LNG don’t go to Europe, they would displace other gas that would otherwise go to Asia, and which could show up on European shores.  Thus, Gazprom still has an incentive to delay the gas coming on line any way that it can.  Yes, as a marketer, Gazprom would have less ability to do that than would the project developer, but it could still throw up obstacles.  If the Israelis do deal with Gazprom, they should be damned sure that the  contract is written very tightly.  And it would not be wise to give Gazprom the exclusive marketing rights, because that would maximize the Russian’s leverage.

But my second reaction is that the Russians may be signaling that they will overpay.  I base this on one detail in the announcement:  the price in the deal will be tied to the Brent crude oil price.  It is ironic that this announcement came out on the same day that the FT ran an article detailing how Japan-which is a major LNG buyer and which will purchase substantially more in the future as it moves away from nuclear power-is seriously considering ditching oil linked contracts for contracts tied to Henry Hub gas prices.

A flurry of projects has now emerged to harness the plentiful supplies of cheap shale gas by selling it on to international markets as LNG. And the exporters are pricing their gas off Henry Hub, the US natural gas benchmark, rather than off Brent or WTI. Henry Hub gas is now selling for about $3 to $4 per million British thermal units, less than a quarter of the price LNG cargoes are sold for in Asia. Japanese, Korean and Chinese buyers have, understandably, been flocking to the US in search of deals.

As a consequence, says Professor Jonathan Stern, head of gas research at the Oxford Institute for Energy Studies, Japanese utilities are increasingly reluctant to commit to oil-indexed LNG.

“They recognise how dangerous it is to sign up to any contracts on the old formula,” he says. “They can see the degree of commercial exposure, which is huge.”

What has spurred the Japanese into action is the way that rising LNG prices have stoked the country’s mounting trade deficit and exposed power utilities to big financial losses. Not only is LNG becoming more expensive, Japan has also been importing more of it: with most of the country’s nuclear reactors shut down in the wake of the 2011 Fukushima disaster, gas is filling the gap.

. . . .

Other Japanese gas importers, including Tokyo Gas and Osaka Gas, are also trying to move away from oil-linked prices, even for gas not produced in the US. Kansai Electric Power, for example, signed an innovative long-term agreement where the LNG it buys from BP, sourced from various parts of the world, is linked to daily Henry Hub settlements. Kepco is hoping for a 30 per cent reduction in LNG import costs.

So if it did an oil-linked deal with Levant LNG anticipating selling to Asia on the same terms, Gazprom will face increasing difficulty in doing so.  It therefore runs the risk of being effectively short oil (i.e., being hurt by rising oil prices) and long North American gas (hurt by falling gas prices).

But maybe this is the attraction of the deal to the Israelis.  If they anticipate a widening spread between oil and gas prices, and the Russians are willing to pay them the oil price when other marketers, anticipating that the market will soon transition to being priced off of gas (especially North American gas) will only be willing to do deals based on the gas curve.

So although the potential exposure to Gazprom opportunism would suggest that the Israelis would be suckers to enter into an exclusive deal with the Russian firm, Gazprom’s increasingly frantic attempts to defend the oil link may be leading the firm to overpay.  So maybe the Israelis are thinking that Gazprom is the sucker.

The pricing mechanism in gas is in a state of transition.  Moreover, these transitions tend to be very abrupt and “tippy.”  Once the market starts to shift from one benchmark to another, the move is self-reinforcing: there is a positive feedback effect as the liquidity in the new benchmark increases, attracting more trade, which increases liquidity, and so on.  The tipping process is well underway in Europe, and if Japan truly does move to gas based pricing and away from its historic commitment to oil linkage, that would likely start the snowball rolling downhill in Asia too.

Just look at what has happened in iron ore.  In a period of about two years, the industry has moved from annual negotiated contracts to spot price indexed deals between miners and steelmakers.

The economic case for gas linkage is compelling.  Gas prices reflect, well, gas market supply and demand fundamentals.  Oil prices, not so much.  The potential for misalignment of prices and values, which is so evident in European gas markets in particular, is much greater with oil indexing than gas indexing.  It is this misalignment that leads to misallocation of resources, and to disputes between buyers and sellers.   This provides a natural impetus towards the move to gas indexing.

But Gazprom is wedded to oil linkages.  Its commitment is likely what makes it willing to offer such a deal to the Israelis, and it is at least plausible that the Israelis see the writing on the wall that oil linkage is dying, and are calculating if Gazprom wants to be the sucker and lock itself into this obsolete mechanism, why should they say no?

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