When it comes to the trading of LNG cargoes, why do stakeholders see long-term and spot as two separate markets? To answer this question, one can examine the differences in the pricing basis between the two. But this may not provide the most accurate view since one can't separate the two sides of the same coin.
As the LNG market matures, the commodity's spot price has emerged as the driving force behind prices of all contract types, including long-term contracts. This is especially relevant for exporting countries like Australia that are undergoing changes in their downstream gas market development and pricing policies. To delve into how today's perception of LNG markets were formed, it is worth looking at the history of LNG trading.
When LNG started shipping to Japan more than half a century ago, it was a point-to-point shipment system that was essentially a rigid long-term energy security arrangement. Between then and now, the most profound changes are on the pricing basis of term contracts, including from fixed price to indexation.
LNG term contracts used to be linked to crude oil prices since indexation began as a credible LNG benchmark didn't exist. The benefit of the linkage was evident—buyers and sellers needed a central ground to price their LNG cargoes, and a relatively transparent and well-established price that would not cease to exist in the duration of their LNG contract seemed to be the most appropriate choice.
LNG trade has since evolved to resemble the modern-day oil trade, where suppliers source cargoes from multiple production points for delivery to multiple buyers. Ironically, through this practice, LNG has developed its own price formation process and its own pricing dynamics that are quite distinct from oil.
The market has also reached a point where production and pre-determined demand no longer match perfectly. Some projects are built without 100% matching offtake agreements. Furthermore, when the market enters a period of contract renewal at legacy projects, new contracts are being signed with smaller volumes and shorter tenors. These factors have contributed to the creation of a liquid spot market where producers and end-users connect and resolve supply and demand imbalances.
In this sense, the spot LNG trade, though still smaller than the volume of term contracts, is a reflection of the value of a marginal cargo where demand and supply meet.
While spot LNG prices fully reflect the fundamentals of LNG markets, including the portion covered by term contracts, crude-linked term contract prices cannot keep up with LNG market fundamentals. This was not an issue when LNG flows were mostly point-to-point, but it has become problematic as the LNG market continued to develop into an increasingly functional market of its own.
A major concern with crude-linked term contract prices is the broken feedback loop between price and LNG fundamentals. For example, higher crude oil prices encourage LNG producers to produce more, regardless of LNG demand. In this case, an oversupply in the LNG market would fail to affect LNG term contracts linked to crude oil pricing, meaning LNG producers remain indifferent towards such the supply situation, exacerbating the imbalance.
It was exactly this distinctive feature of non-market pricing in LNG market that contributed to both the oversupply of LNG in 2020, resulting in record-low spot LNG prices, and the tight market seen in most of 2021, resulting in some of the highest spot LNG prices in history.
Platts JKM reflects value of spot LNG cargoes delivered into North Asia. It has been adopted by participants from all sides of the market in different ways to price their LNG or natural gas contracts, spot or term, as the importance of market-based pricing continue to be recognized.
It's now more common to see one- to two-year long-term contracts linked to JKM, the Asian LNG benchmark, than to any other price, as market participants started switching away from fixed prices or crude linkage two to three years ago.
Australia's reliance on Asian LNG demand
JKM-linkage in longer term contracts are still less common compared with crude-linkage, but many high-profile announcements prove that it is being recognized in the Asian market. These include both LNG export contract from and the domestic pipeline gas supplies in Australia.
Australia's natural gas market is dominated by its LNG export sector, accounting for 65%-70% of the country's production in the last two years.
There's an undisputable close relationship between Australian supply and North Asian demand, with the value of marginal volumes fully reflected in JKM. Japan, South Korea, Taiwan, and China take more than 90% of Australia's total exports.
JKM LNG benchmark development
Since 2009, JKM has been an indispensable anchor and reference to the LNG market in Asia and beyond. With a derivatives market growing around the physical benchmark in the following years, the JKM complex has continued its evolution. Multiple netback calculations have been launched, including one for Australia.
The formation of standard terms for the assessment was a defining moment not just for the benchmark itself, but also the wider LNG market, which has seen a higher degree of standardization both in terms of cargo qualities as well as operational requirements.
In 2018, the JKM further cemented its credibility and influence with the publication of the first firm Market on Close information for the assessment, bringing the process to the highest standard in terms of information reporting and analysis.
The majority of Australian LNG project operators and equity holders have gone through the review process to participate in this price assessment process, contributing to the single most important LNG price in the multi-billion dollar a year industry's continued evolution towards sustainability and efficiency.