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Oil indexation: the virus behind LNG disruptions

The spread of coronavirus across the Middle East, Europe and the Americas has revived fears of a major global economic and energy demand slowdown, and raised concerns over the consequences for global LNG trade and fundamentals.

But the chronic epidemic destabilizing LNG markets and causing disruptions across supply chains pre-dates the COVID-19 outbreak. This virus has been around for much longer, gaining strength over time, and has become particularly disruptive at times of supply and demand shocks.

LNG oil-indexed price vs JKM

Oil indexation has not only hindered the ability of China’s LNG market stakeholders to resell unwanted volumes to other buyers with appetite for opportunistic purchases when faced with falling demand, high stocks and limited gas storage; it has also made supply less responsive to demand shocks and falling prices.

Export facilities across Australia, Qatar, Indonesia, Malaysia and Russia, which supply China with long-term oil-indexed LNG contracts, have been running at an average utilization rate of more than 90% in the year to date. This comes despite China’s struggle to keep up with deliveries and low demand elsewhere, adding to Asia’s supply glut and pushing spot prices even lower.

Australian exporters, which account for almost half of China’s total LNG imports, have said the virus outbreak has had limited impact on their operations given their low exposure to spot markets. A similar statement was made by Russia’s Novatek, which also supplies China with oil-indexed LNG contracts.

Meanwhile, disruptions in Asian LNG trade flows have worsened. Tens of contractual cargoes destined for China have been delayed, diverted or turned into distressed floating storages awaiting alternative buyers at significant commercial losses.

And while contracted volumes have been left stranded in Asia-Pacific waters, some of China’s importers returned to the spot market in late February looking for prompt purchases. PetroChina secured a spot cargo for April 20-22 delivery from Vitol at $3.05/MMBtu February 26 through the Platts Asia Market on Close assessment process.

When the price isn’t right

China’s largest LNG importer CNOOC’s force majeure declaration in February and the struggles of its trading unit show the inadequacy of oil indexation to price a product that is increasingly commoditized, and therefore reliant on LNG market-based pricing for trading, risk management and investment decisions.

Oil indexation creates a disparity between expected delivered prices when contracts are originally signed and LNG market-based pricing when deliveries begin. This disparity has widened as growing US LNG supplies, weak demand growth and, more recently, disruptions in China have pushed spot prices lower.

Platts JKM , the benchmark for LNG deliveries into northeast Asia, remains at historic lows in both absolute terms and relative to oil-indexed LNG contracts, which account for nearly 60% of China’s LNG imports.

JKM plunged to an all-time low of $2.713/MMBtu February 14. The cumulative average for April deliveries was $2.96/MMBtu February 28, and Platts Analytics expects the benchmark to remain below $3.25/MMBtu through the third quarter.

On the other hand, Chinese importers have been paying nearly $9/MMBtu for their contractual deliveries, the equivalent of more than $30 million for a standard-size cargo, according to customs data. That’s triple the amount they would pay for a spot cargo purchased end-February for April delivery.

While the temporary demand shock of COVID-19 has put a spotlight on the inherent risk of pricing long-term LNG against a different commodity, the disruptive force of oil indexation can only increase in the long run, as the correlation between Brent and LNG prices dilutes further.

This divergence will be inevitable as significant additions of elastic LNG supply and demand propel spot liquidity and transparency, and downstream markets in Asia become more competitive and exposed to global LNG fundamentals and prices.

However, the break from oil indexation is not the endgame.

For stakeholders to navigate and survive supply and demand shocks, market-reflective pricing will need to be accompanied by a solid risk strategy at both ends of the supply chain and initiatives to build liquidity further, standardize trading practices, improve the industry’s financial architecture and enhance transparent LNG price formation mechanisms.