LNG swap trades in Japan: A question of when, not if?

Gone are the days when LNG procurement was relatively straightforward for Japanese utilities and security of supply concerns dominated everything else. Now the Japanese domestic gas and power retail markets are deregulating and global LNG demand and supply dynamics are shifting, with more focus placed on managing risks and ensuring profitability. The listing of Platts JKM™ swaps on the Tokyo Commodity Exchange (TOCOM), through the Japan OTC Exchange, JOE, from April 3 comes when price risk is at the forefront of Japanese minds.

The question then may become how fast Japanese needs for LNG hedging will grow.

The deregulation of Japan's electricity and gas markets is slowly but surely progressing. Since April 2016 when Japan's retail electricity market began opening up, new suppliers have gained about 3% of the market share as of October 2016, according to the Ministry of Economy, Trade and Industry (METI).

For the power market for large-scale factories or commercial buildings, the first sector that was liberalized in 2000, new suppliers hold more than 10% of market share, according to the METI.

Trading electricity is also gaining currency. Annual trade volume on Japan's Electric Power Exchange (JEPX) from April 1 2016 to March 25, 2017, stood at 2.25 billion kWh, on its way to a record high since its inception in 2005. In the previous fiscal year 2015-2016 (Apr-Mar),  the annual volume was 1.54 billion kWh, according to JEPX.  Still, trading on the JEPX currently only accounts for 3% of the country's overall power sales.

METI plans to introduce a gross bidding system whereby Japanese incumbent power utilities are obliged to trade certain volume on the exchange starting from April 2017, as the METI tries to boost liquidity and aims for trade on the JEPX to represent 20% to 30% of overall sales volumes in the next  few years.

Also in April 2017, the gas retail market is scheduled to open up. This will likely further fuel competition between gas and power utilities targeting each other's territory, especially in densely populated areas.

Any rises or falls in fuel costs have been passed onto the consumer under the regulatory scheme and this cost-pass through required no need for hedging. However, now that the retail market has opened up and power utilities will have more discretion to set prices, this will likely change the behavior of LNG importers as they will be exposed to price risk.

Japanese utilities are also expected to have more than enough LNG in coming years. S&P Global Platts Analytics estimates that Japanese LNG buyers have over-committed to long-term contracts.  Based on the assumption that  16 nuclear reactors would be operating by October 2022, Japan is estimated to have over-contracted by 7.8 million tonnes in 2017, growing to 21.5 million tonnes in 2019, before declining to 1.5 million tonnes by 2023.

The prospects of more uncommitted excess LNG raises expectations that Japanese utilities will increasingly become sellers and that they will have to manage buy and sell positions.

In fact, many have already indicated they would swap out or resell cargoes from US LNG projects where they have offtake or tolling agreements. Most of these agreements often have no destination restrictions and thus give the flexibility buyers need to cope with fluctuations in demand in their downstream markets. But can they manage these trades in a profitable manner?

Meanwhile, trade volume for Platts JKM™ swaps is growing. In 2016, 12,717 lots were traded and cleared through ICE. The volume is equivalent to about 42 cargoes, meaning on average 3.5 cargoes equivalent of LNG was transacted every month last year.

In January and February this year, 1,730 lots and 2,460 lots were traded and cleared ICE respectively. The February volume nearly tripled compared to 2016.

The majority of swap transactions currently trade during European trading hours. Some market players are understood to be using JKM swaps, along with NBP futures, to hedge their physical LNG positions in both the Pacific and the Atlantic basins.  More details on Platts JKM Swaps are explained on Platts Snapshot.

It will take some time for LNG futures to take off as Japanese LNG buyers are still at the early stage of getting ready for handling financial instruments. There have been only four entities which have set up accounts with clearing houses to execute LNG derivatives in Japan, according to ICE and CME.  Most JKM swap trades are currently cleared through ICE, but TOCOM is offering clearing through CME.

In its report, which outlined its strategy to nurture LNG markets, METI said in May last year the establishment of price index and growth of LNG futures market should go hand in hand. It added that if financial service providers or other risk takers participate in the futures market, this should help increase the “depth of the LNG market.”

It can be said that participation of Japanese trading houses and banks will be the key for the growth of LNG derivatives market.

Still, market sources said there should be more JKM hedging needs during Asian hours. JKM swaps offer much-needed tools for Japanese LNG players to hedge their positions in the physical LNG spot market. The TOCOM will also start offering physical LNG trading  starting from April 3, through JOE, including fixed price and JKM-linked physical contracts. Platts will consider trade information and transactional data on the new TOCOM physical market in its assessment of JKM, provided it meets Platts' LNG methodology.