The LNG industry is well into its third and most significant expansionary phase, one in which supply is racing ahead of demand. But to turn an old adage on its head: there is nothing like low prices to cure low prices.
The industry’s expansion is part and parcel of two overarching trends: the gradual spread of gas-on-gas competition that has emanated from both the US and North West Europe for more than a decade, and the global transition to lower emission energy sources, which is making LNG a key fuel of choice for many countries seeking to address chronic energy deficits.
LNG is well but ambiguously placed. It can bring the cleanest of fossil fuels to global markets and expansion has de-risked the supply chain. But when it arrives it must compete with local gas, other domestic sources of energy and alternative imported fuels.
Moreover, the supply of LNG is only as good as the weakest link in the chain. It requires heavy investment from both seller and buyer alike.
It needs gas production, liquefaction, transport, import facilities, storage and then distribution infrastructure before a single, chilly molecule can reach the end user. And it needs efficient markets at each and every point along the line. A market distortion in one element can have huge ramifications all the way back up to the supplier.
The high risk this entails has historically promoted in inflexible supply agreements, necessary to provide investment certainty, but LNG is increasingly landing not in regulated but liberalized, competitive markets.
The juxtaposition of external in inflexible supply and internal competition cannot help but create stresses and strains that are ultimately unsustainable.
It is not just a “buyers’ market” in temporary supply and demand terms; it is a market that is structurally changing at both the point of production and the point of consumption.
This poses major challenges for the traditional LNG supply model, but within it also provides the seeds of resolution.
The industry’s expansion is making LNG a global commodity in its own right, but to consolidate that trend new markets must be opened, and that means extending LNG supply chains into less credit-worthy, higher-risk markets and into industries relatively new to LNG, such as maritime and land transport.
It is a simple equation: in both these markets, and in existing, liberalizing markets, LNG must be at least as flexible as its competitors to succeed.
This inevitably shifts the focus of risk from buyers to sellers. The question then becomes how to mitigate this new risk, and the answer lies, as in other markets, in the development of improved financial architecture, greater market liquidity, and transparency, which allow risk to be shared by third parties, whether financial institutions, pension funds, traders or otherwise.
That transformation is taking place, and innovation and adaptation are required to transition from the in inflexible, supply agreements of the past into a more versatile and nimble industry capable of opening the doors to new markets.
The growing pains are sometimes acute, but the LNG industry is finally coming of age.
The emergence of US LNG and Australian coal seam gas-based LNG production have created significantly larger direct connections between the domestic gas markets and exports of LNG producing countries. At the same time, the expansion of LNG trade has formed bi-directional price transmission mechanisms between previously fragmented regional markets. Some countries are now both LNG exporters and importers.
On the demand side, legacy LNG markets are liberalizing, creating a much more diverse and competitive environment, in which LNG is just one competing energy source. More actors on the buy side sensitive to internal domestic market competition means sellers must build new relationships and change their value propositions to address the requirements of the new conditions emerging in these markets.
The allocation of risk is shifting to different parts of the supply chain; buyers face new risks in their home markets, and are pushing that risk back up the supply chain to LNG suppliers, making the traditional LNG supply model – long-term, oil-indexed, take-or-pay contracts with destination restrictions – no longer t for purpose.
Traders and portfolio LNG suppliers are grasping the opportunities these new conditions offer by finding innovative ways of mitigating the changing allocation of risk. Aggregating both demand and supply allows trading entities to break the direct link between a single LNG source and buyer, and at the same time enhance security of supply. Of equal, if not greater, importance, it allows them the flexibility to take maximum advantage of temporary periods of scarcity pricing in any of the growing number of LNG markets.
When taken together, the changes on the supply side and in these different import markets create a new and fast-evolving environment in which the point-to-point, bilateral trade model of the past no longer meets requirements. As a result, suppliers need to develop flexible business models that can meet the needs of all market types in a non-discriminatory manner. This means shorter, less-restrictive contracts with new pricing mechanisms.
In this more fluid, flexible and interconnected environment, both buyers and suppliers alike require more sophisticated financial instruments to mitigate the changing allocation of risk. Price transparency and liquidity are essential and it is incumbent upon Price Reporting Agencies, such as S&P Global Platts, trading platforms and exchanges, and market participants to engage in the construction of the financial architecture that can mitigate the challenges presented by the new world of LNG trade.
With these changes, LNG markets are evolving, albeit in different directions. Some are ‘ flux’ markets subject to rapid change — for example in the Middle East, with the development of East Mediterranean gas, and in Latin America, with the development of Argentinean shale and Brazil’s sub-salt oil and its associated gas. In these markets, LNG appears destined for an uncertain, and potentially temporary, often seasonal, balancing role.
Other markets are more clearly ‘option’ markets, where LNG provides a more significant balancing role and meets a variable proportion of baseload gas demand subject to price, for example in Europe and China. Pipeline gas supply and alternative energy sources provide a price ceiling, but these markets are also likely to deliver periods of scarcity pricing that require large supply volumes.
The third type of market – baseload — is the most dependable, although not without uncertainties. Here, LNG already occupies or promises to build a long-term position in baseload gas provision, for example in the populous nations of South Asia or in the legacy markets of North Asia. The expansion of gas use in key sectors, such as power, fertilizer production, petrochemicals, city gas or transport, is a major and well-articulated component of the country’s energy policy, which promises long-term demand growth. In these markets, there are few alternatives: those that do exist carry significantly higher risk in terms of safety, cost, local air pollution or achieving national commitments to global climate change mitigation.