Until recently there has been a strong market consensus that LNG market tightness will continue well through this decade. But the recent Russia-China pipeline deal and plunging Asian LNG spot prices (shown in Chart 1 below) have shaken that consensus. The LNG industry is becoming increasingly concerned over the possibility of a transition towards a state of oversupply as the decade progresses.
The potential for LNG oversupply has been a theme of this blog over the last 12 months. In a recent article we set out the factors that could drive a transition from tightness to oversupply. We now consider the implications of a tight versus oversupplied market on LNG portfolio value.
A tight versus oversupplied LNG market
Tight market continues
If the post-Fukushima tightness continues the LNG market will continue to favour sellers, with incremental volumes of new supply (e.g. from Australia and the US) absorbed without a major pricing impact. Premium markets (e.g. in Asia and South America) will continue to attract flexible supply with higher prices. However, the flexible nature of US export supply contracts should act to some extent to dampen global LNG spot price differentials and spot volatility.
In this outcome, the long run marginal costs of incremental supply (e.g. from Australia, Canada, the US and East-Africa) are likely to drive longer term supply contract pricing. Producers are also likely to be in a position to ensure oil-indexation remains dominant. But flexible US export supply contracts will increase the influence of Henry Hub (HH) on LNG spot market price dynamics. The majority of US and divertible European supply will likely flow to Asia and South America, but spot market volatility should continue to ensure the ‘fallback’ utilisation of European regas terminals in times of low Asian spot prices (as it has over the last three summers).
Transition to oversupply
If an oversupply situation develops, the LNG market will instead shift to favour gas buyers. Surplus gas will flow into the LNG spot market, increasing liquidity & the influence of both European and US hub price signals. US exports will likely have a disproportionate influence on spot prices given their flexibility and the fact that utilisation of US LNG with a Henry Hub cost base will be driven by netback spot price signals.
This outcome is much more supportive of a transition to hub indexation for new long term LNG supply contracts. Henry Hub and NBP are the obvious candidates, but an Asian spot hub may develop also, although it is likely this would be strongly influenced by the HH/NBP Atlantic price signal. US export and European supply contract flexibility will likely have a more significant impact in driving global LNG spot price convergence & dampening volatility. Global price convergence should support an increased flow of gas back into Europe and the higher utilisation of European regas terminals. This may cause significant downward pressure on European hub prices and spark another round of long term supply contract renegotiations.
Contract and portfolio implications
Recognising uncertainty
In our view the first factor to accept is the reality of uncertainty around the evolution of the LNG market balance and future pricing dynamics. This is an inevitable bi-product of the rapid growth & relative immaturity of the LNG market (e.g. compared to the oil market).
‘Betting’ on market outcomes is a risky business. So commercial or investment decisions that depend heavily on market balance or pricing dynamics should be made with a clear recognition (& pricing) of the risk involved. Several factors could drive structural changes to market dynamics e.g. weaker Chinese LNG demand or supply contract hub price penetration.
Current market expectations reflect the post-Fukushima period of market tightness, price divergence and volatility. The LNG market may transition to a very different state by the end of the decade.
Supply contract pricing
Supply contract terms (e.g. price levels and indexation) will be driven by the balance of power between sellers & buyers. Contract hub price linkage is set to increase, with US exports an important driver, particularly if oversupply develops. We addressed some of the potential outcomes with Asian supply contract pricing in our last article.
An important theme in the negotiation of supply contracts is ensuring contract structures that reflect uncertainty over market evolution, and apportion value and risk appropriately. This may incorporate the sharing of value upside (e.g. from diversion flexibility). It may also include the sharing of downside risk exposure (e.g. oil vs gas hub price risk).
LNG influence on European hubs
The link between LNG spot prices and European hub prices has been convincingly demonstrated over the last three months. Weakness in Asian spot prices (currently trading close to 12 $/MMBtu) has seen a substantial increase in LNG flowing back into European hubs as a liquid alternative. This could happen on a much larger scale if Asian spot prices remained weak for a more prolonged period as a result of a period of global oversupply. The increase in European supply contract flexibility that has been negotiated post Fukushima has resulted in a larger volume of divertable LNG supply that can return to Europe if prices in premium markets weaken.
Europe is unlikely to have a structural requirement for large volumes of new LNG this decade (given pipeline supply options). However, LNG supply contracts may still play an important role in meeting the incremental requirements of larger European gas portfolio players (even if the LNG flows elsewhere). An increase in the volume of flexible US exports as the decade progresses should strengthen the Henry Hub vs NBP relationship over time, even if US gas predominantly flows to Asia.
Case study: European regas terminal implications
The table below illustrates some of the challenges faced by European regas terminal operators, given that the approach to monetising regas terminal value and developing/selling new capacity differs in a tight vs oversupplied market.
LNG portfolio value impact
Producers face the greatest risk from the transition to an oversupply scenario. Falling prices would clearly threaten the viability of many uncontracted new liquefaction projects. This is particularly an issue in countries where project costs are increasing rapidly (e.g. Australia and Canada). If an oversupply situation does develop, it is the cancellation or delay of new projects that will likely act over time to alleviate the LNG surplus.
Suppliers stand to gain from falling prices in the sense that they may be able to contract new supply on more favourable terms. However, continued concern from some Asian buyers at being exposed to spot prices in tight periods may limit the pressure they apply in negotiations over new supply. There are some key risk considerations around price exposures on existing LNG supply contracts. European suppliers are familiar with the pain that lower spot prices can inflict on legacy contract positions, given the linkage between spot prices and retail pricing. There are some prudent contract and portfolio structuring measures that can be taken now to manage the risks posed by spot price declines.
There is also an important risk for both producers and suppliers that an oversupply scenario reduces global price spreads and volatility, eroding LNG supply flexibility value. The (re)negotiation of supply contract flexibility value has been a key industry focus post-Fukushima, with market players placing a hefty value premium on access to flexibility.
A view on the risk of an oversupply outcome is an important factor driving commercial strategy in negotiating supply contracts. For example, a view on market outcome is important in:
- Valuing the flexibility implicit in a supply contract pricing structure
- Choosing whether to pay for flexibility with cash versus other contract concessions
- Deciding whether portfolio focus is on ‘buying’ new flexibility versus monetising existing flexibility
- Timing the purchase or sale of incremental portfolio flexibility
An oversupply scenario may be relatively short lived, or it may not eventuate at all. But the risk around a transition to an oversupplied LNG market is increasing. Now is a good time to take some defensive measures, in case that risk becomes a reality. And defence need not be the only focus. As market uncertainty increases, there are likely to be attractive opportunities to create portfolio value via exploiting differences in company expectations of future outcomes.
