Mitigating price risk in Asia’s flourishing LNG markets

Mitigating price risk in Asia’s flourishing LNG markets

The speed at which the liquified natural gas (LNG) market is maturing has created inconsistencies in how LNG is priced – not least in Asia, where growth is fastest. The obvious but untested solution – an Asian pricing hub – will take time to develop, but in the meantime benchmark assessments could offer a viable alternative to existing pricing methods.

John MacDonagh ([email protected])

Mitigating Price

A burgeoning market

Rapid growth in the LNG market is being fueled by a number of factors:

  • Developments in infrastructure.
  • Shale gas exploration.
  • Flexible usage and delivery.
  • Bunker fuel regulation.
  • Drives to reduce coal use in growing numbers of countries.

Both supply and demand of LNG are increasing. Demand has been rising due to initiatives to reduce reliance on coal – in addition to LNG’s potential as a replacement for heavy fuel oil in the shipping industry – while increased shale gas production and additional LNG infrastructure (mostly liquefaction, purification and regasification terminals) boost supply. Distributors benefit too: liquefying natural gas increases its energy density (by reducing its volume) and makes it suitable for transportation by truck, train or tanker, rather than through costly and limited pipelines.

LNG’s characteristics mean that large amounts of natural gas can be supplied to geographies that previously lacked access (to high volumes, at least). The shale revolution in the US has produced a glut of natural gas, and the first wave of investment initiatives in the country (including ‘LNG trains’, in which natural gas is purified and liquefied) have now completed.

Asia is now the fastest growing LNG market. Within the region, China recently overtook Japan as the largest importer of LNG, since the latter’s nuclear power sources have started to come back online. In addition, many smaller economies in Asia are taking advantage of this new delivery mechanism for natural gas.

Problematic pricing

Decoupling large-scale natural gas trading from pipelines has allowed several new participants to enter the global natural gas market. But it has introduced risks around pricing. Geographies that do not have a well-developed market for natural gas do not have access to local pricing data to index prices against, and must rely on an alternative pricing method.

For longer-term futures contracts, two popular options are currently used:

  • Oil indexation. Contracts for natural gas can be priced against other (non-natural gas) energy commodities. This is most commonly done by indexing natural gas prices against existing oil benchmarks (either global benchmarks like Brent or WTI, or regional benchmarks like Japan Customs-cleared Crude), and linking the two by comparing their potential thermal energy output. The benefit of this approach is that pricing broadly reflects prices for other energy commodities in the relevant region.
    • This approach is not without its downside, however. As trading volumes of LNG increase, it is becoming clearer how distinct it is from other energy products (including oil). Pricing via oil indexation can lead to a variation in gas prices based on factors specific to oil and its sale* (including the imposition of sanctions or tariffs, or conflicts in oil-producing regions). In many situations, using this method to price LNG is relatively problem-free, although risk is introduced wherever the fundamentals of oil and gas markets diverge.
  • Foreign hub-based pricing. To avoid the problems of differing fundamentals, gas prices can be indexed to prices at a well-established gas trading hub. Indeed, if LNG is being sold into a region that already has an established gas market, it makes a great deal of sense to price according to the local hub, which reflects both the fundamentals of the commodity and local market conditions.
    • However, a sparsity of local hubs means that problems can arise when LNG is priced against distant ones.

The (regional) hub of the issue

At the moment, well-established pricing hubs with good liquidity exist in the US (the ‘Henry Hub’) and Europe (the ‘National Balancing Point’, based in the UK, and the ‘Title Transfer Facility’, based in the Netherlands). But hubs in other geographies are less well developed. In these places, contract prices calculated using oil indexation or hub-based pricing could be inaccurate in terms of either geography or asset fundamentals.

Geographical markets without well-developed regional gas hubs are at risk of relying on pricing systems that don’t represent gas trading in those markets. In rapidly growing Asian markets, pricing import contracts against the popular ‘Henry Hub’ in the US exposes such contracts to US-specific market influences, which may not reflect local market conditions.

One solution is to establish a trading hub for natural gas in these markets – but this can be easier said than done**. Current gas trading hubs are based on pipeline gas trading, and a trading hub based entirely on LNG has not been attempted before. In addition, specific market conditions must exist for a successful hub to endure. Among these is non-discriminatory access to regasification terminals. This is a key step on the path to market liberalization, which in turn enables the competitive wholesale gas market required for a trading hub to exist. In some Asian countries this access has recently become available.

An alternative?

Nevertheless, creating an LNG hub in Asia is at least some time away. Fortunately, however, other options are available. One is to use benchmark price assessments. These employ an assessment methodology – often based on actual trade data, bids, offers and other relevant price indicators – to produce a price index for a particular commodity.

Some bodies have already attempted this approach. In 2015, the Singapore exchange launched the ‘Sling’ (Singapore LNG Index Group) exchange to provide pricing data on natural gas – only to announce that, due to limited usage, it would cease to operate, and stop publishing indices, on 31 October 2019. Other efforts in the region are enjoying more success, among them the Japan/Korea Marker (JKM), a benchmark that covers spot delivery into Japan and South Korea.

Benchmarking best for now, as opportunities emerge

As the LNG market continues to thrive, inconsistent pricing remains one of its most significant hurdles. While market players wait for the possible emergence of an Asian natural gas trading hub for robust contract pricing, other interim options are available. Benchmark price assessments are by no means perfect mechanisms for pricing LNG: their methodologies include bids, offers and other information that might not reflect prices as effectively as high volumes of actual trade data. But they offer a strong alternative to both oil indexation and foreign hub pricing. Using them, firms trading LNG in Asia’s markets can avoid fundamental differences in oil-indexed pricing, and the geographic differences inherent in pricing via distant natural gas hubs. But for benchmark price assessments to be considered fully robust, they need higher liquidity in LNG markets, plus more transparency around actual trades.

A shift in pricing paradigms also represents an opportunity for traders, data vendors, and software vendors. A move to benchmark assessments (or a local gas trading hub) would provide region-specific pricing that isn’t tied to other commodities, and it could also help to reduce exposure to other markets, shifting traders’ focus to local LNG market fundamentals, and altering their data requirements. Data vendors that cover LNG-relevant metrics are well-placed, because their data offerings are in demand from providers of benchmark price assessments and traders. Software vendors with commodity trading offerings may also seek out data partnerships if the demand warrants it.

A mature Asian LNG marketplace (and indeed a global LNG marketplace) can be achieved, but it requires a journey with several unique obstacles. By effectively navigating these, however, many players could benefit from its bounty.

At Chartis we pay close attention to the issues and challenges faced by institutions in a broad range of industries. Typically, we focus our efforts on financial services. However, the team covers a broad spectrum of risk – including that associated with energy and commodities. In the near future, Chartis will develop research that analyzes different aspects of the energy and energy trading markets. For more information, contact us at [email protected]

*Carriere, C. (2018). 'The effects of Japan's push for greater LNG market flexibility on LNG pricing and destination restrictions'; The Journal of World Energy Law & Business, 11(2), 136-144.

**Shi, X., & Variam, H. M. (2018). 'Key elements for functioning gas hubs: A case study of East Asia'; Natural Gas Industry B, 5(2), 167-176.

Further reading

The risk of clean air (Chartis Point of View)

Asian LNG derivatives trade surges on increased hedging (Risk.net, 19 July 2018)

Points of View are short articles in which members of the Chartis team express their opinions on relevant topics in the risk technology marketplace. Chartis is a trading name of Infopro Digital Services Limited, whose branded publications consist of the opinions of its research analysts and should not be construed as advice.

If you have any comments or queries on Chartis Points of View, you can email the individual author, or email Chartis at [email protected].