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Natural Gas Markets in Asia: Recent History and Potential Developments

Peter R. Hartley

George & Cynthia Mitchell Chair, Economics Department Rice Scholar in Energy Economics, Center for Energy Studies, James A. Baker III Institute for Public Policy

Rice University

and

BHP-Billiton Chair in the Business of Resources University of Western Australia

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Some recent developments in the LNG markets

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Increasing fraction of spot and short-term trades

Source: International Group of Liquefied Natural Gas Importers (GIIGNL)

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 20140

100

200

300

400

500

600

0%

5%

10%

15%

20%

25%

30%10

6 m3 li

quid

LN

G

LNG volume from liquefaction plants Spot and Short-term Trades/Total LNG Re-exports/Total LNG

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Increasing numbers of LNG traders

Source: GIIGNL

10

20

30

40

50

60

70

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90

100

110

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Regasification terminals

Liquefaction plants

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Spot trading versus number of buyers

Source: GIIGNL

SpotFrac = 0.19174

(0.0143)ln(Regas)− 0.60722

(0.0581); R2 = 0.9324

0%

5%

10%

15%

20%

25%

30%

30 35 40 45 50 55 60 65 70 75 80 85 90 95 100 105

Spot

sal

es/T

otal

LN

G s

hipp

ed

Regasification terminals

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Spot and re-export trades are longer distance

Sources: Author calculations based on GIIGNL and VesselDistance.com

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 20142000

3000

4000

5000

6000

7000

8000

9000Vo

lum

e sh

are

wei

ghte

d di

stan

ce in

nau

tical

mile

sTotal

Spot, <4 yrs

Contract >4 yrs

Re-export

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Recent evolution of spot natural gas prices

Source: Platts

0

5

10

15

20

25

2009 2010 2011 2012 2013 2014 2015

$US/

MM

BTU

Japan/Korea Marker Henry Hub National Balance Point

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US LNG imports relative to marketed production

Source: US Energy Information Administration (EIA)

Jan-1996

Jan-1997

Jan-1998

Jan-1999

Jan-2000

Jan-2001

Jan-2002

Jan-2003

Jan-2004

Jan-2005

Jan-2006

Jan-2007

Jan-2008

Jan-2009

Jan-2010

Jan-2011

Jan-2012

Jan-2013

Jan-2014

Jan-2015

0%

1%

2%

3%

4%

5%

6%

7%

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Japanese LNG imports: Long-term contract and other

Source: GIIGNL

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 20140

20

40

60

80

100

120

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160

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mill

ions

m3 li

quid

per

yea

r

spot, < 4yrscontract, > 4yrs

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Other recent developments

v  LNG swaps and other spot trades increasingly are aimed at exploiting arbitrage opportunities rather than compensating for force majeure episodes

v  Many regasification terminals are adding storage capacity to support arbitrage

v  Expiration of long-term contracts for some early liquefaction developments has created spare capacity and without a need to finance large investments

v  More of their output is being sold short-term and spot

v  Many recent contracts have greater volume flexibility, and less than 100% off-take commitments by buyers

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Other recent developments

v  After the EU restructuring directive of 1998 (promoting competition in EU gas markets), the Commission found destination clauses anti-competitive in 2001

v  This stimulated re-export of cargoes and increased destination flexibility

v  Growth of “portfolio LNG” sourced from many sellers and sold to many buyers

v  Interest in LNG in Eastern Europe to provide competition for Russian gas v  Intent seems to be to reduce prices, not import large volumes on a long-term basis

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Effects of US developments on LNG trade

v  The first few US terminals are proposing exports under a tolling arrangement v  Typical feed gas price 115% of Henry Hub and liquefaction fee $3–3.50/mmbtu

v  Several buyers are adding the LNG to their global portfolios

v  Some proposed facilities are smaller and more modular than traditional trains v  Along with the ability to use infrastructure previously built for regasification

terminals, this reduces the financing requirements

v  Future co-location of regasification and liquefaction facilities in the US with pipeline connections to a deep market will facilitate short-term arbitrage

v  US projects may be well-suited to play a strategic role in European gas markets

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The value of long-term LNG contracts in an uncertain environment

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Explanations for long-term contracts v  We focus on two main explanations for the desirability of long-term contracts:

1.  The hold-up problem

2.  Securing a lower cost of finance by reducing cash flow variability

v  Commercial parties emphasize the risk sharing benefits of contracts, but the academic literature has focused on the hold-up problem

v  The academic literature has also focused on the efficiency benefits of take-or-pay clauses in long-term contracts

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The hold-up problem v  This can occur when trading partners make large up-front investments dedicated

to the trade partnership

v  Once investments are made, the counter-party has an incentive to bargain for prices covering operating costs but not yielding a competitive return on capital

v  This incentive for opportunism can also apply to re-negotiating an indexation formula

v  The problem can become more acute if some information is known only to one party, so the rents associated with the relationship are not public knowledge

v  Contracts often allow more quantity adjustments than price adjustments v  Price adjustments are zero-sum, while quantity adjustments leave the other party with

alternative avenues for making up lost profits

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Rent in the contracting relationship

v  The next best price for the buyer pM and the next best price available to the seller pX will vary randomly

v  Parties in a long-term contract tend to be better matched to each other than to outside parties

v  The contract price will tend to be toward the top of the pX distribution and the bottom of the pM distribution

v  While the two contracting parties generally are better off trading with each other that may not always be true

Contract price p

Best spot prices for seller pX

Best spot prices for buyer pM

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Take or pay clauses v  In the situation illustrated, the importer would prefer to buy

spot rather than honour the contract

v  But it would be efficient to buy from the exporter since they would both be better off trading at a price between pX and pM than both using the spot market

v  A take-or-pay clause requires the importer to make the exporter “whole”, that is pay pay p – pX to the exporter, if the contracted volume is not taken

v  Then the buyer would choose to not take delivery only when pM < pX in which case this is efficient

v  But the take or pay clause also leads to a transfer from the buyer to the seller in situations like the one illustrated

Contract price p

Best spot price for seller pX

Best spot price for buyer pM

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Model of long-term LNG contracts

v  Key idea: A long term contract is “bankable” because it makes cash flows less volatile

v  This in turn allows increased leverage, and reduces the cost of project finance

v  The total amount of debt is limited by a “value at risk” type constraint: v  The constraint requires an upper bound on the probability that the random after-tax

cash flow will be insufficient to service the debt in any given year

v  In addition, parties may want to limit volumes under long term contract in order to retain more flexibility to exploit profitable spot market trades

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Bilateral contract v  The bilateral long-term contract has the following features:

v  There is a contract price p paid by the buyer at the importer’s location (p–S paid at the exporter’s location) and a contract volume q

v  The supplier must deliver q unless both parties agree to a lesser amount

v  Importer taking M<q when pX<p–S pays (p–S–pX)(q–M)≡𝜑(q–M) to the exporter, where 𝜑 + pX = p–S

v  The exporter can fulfill contracts with swaps or sell surplus production spot

v  The importer can re-export q spot or supplement q with spot market purchases

v  The contract terms p and q maximize the sum of the expected NPV of profits of importer and exporter

v  The contract has to be incentive compatible in the sense that both parties

v  Obtain positive expected NPV from the contract; and

v  Prefer the contract outcome to expected NPV under trade without a contract

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Key implications of the model v  The long-term contract makes both parties strictly better off on average by allowing more debt finance

v  In the numerical examples, the combined surplus is about 30% higher

v  Contracts can enable trade where it would not otherwise be supportable

v  Contracts are more valuable when there is “rent” in the relationship

v  The benefits of extra debt exceed the final gains in net present value, so there are partially offsetting losses from inefficient ex-post trades mandated by the contract terms

v  While contracts preclude some profitable trades, they also bestow an option value

v  Both parties use spot transactions to supplement long-term contract trades

v  By limiting long term contract volumes parties retain more flexibility to exploit profitable spot market trades

v  Increased spot price variability generally raises the benefits of long-term contracts

v  General increases in spot prices are indexed 85–90%

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Indexing in long-term contracts v  Energy relative prices tend to be much more stationary than the prices of individual energy commodities

v  For demand, energy content is the dominant determinant of value, although energy density, ease of handling, environmental effects and other attributes are relevant

v  For supply, resources that can be used to produce natural gas in particular can also be used to produce oil and relative output shifts in response to relative prices

v  Many studies have shown that oil prices tend to be the most exogenous energy price in markets where both prices are free to fluctuate independently

v  Natural gas prices are the most volatile fossil fuel price (next slide)

v  US natural gas prices have looked more attractive recently because the foreign exchange value of the $US has affected the oil/gas price ratio (see later slides)

v  After US LNG is traded, US gas prices may be a less attractive index to Asian buyers

v  Other spot natural gas markets need to become sufficiently deep and liquid to reduce risks to investors in these large capital intensive projects

v  Indexing to natural gas hub prices may exchange geographical basis differentials for commodity basis differentials

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Rolling 28-day standard deviations of log prices February 2009 – May 2015

Source: Author calculations based on data from the US Energy Information Administration (EIA)

010

2030

0 .05 .1 .15 .2 .25

Brent Henry Hub

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v  Long-run relationship includes relative heat rates and foreign exchange value of the $US

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Within sample fit of the dynamic model

v  Adjustment to long-run error is approximately 6% per month v  Unexpected inventory changes have about 2x the effect on prices as expected ones v  HDD and CDD deviations and major hurricanes have expected effects on Δln(pNG)

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Concluding remarks v  More traders give more elastic supply and demand curves and reduce LNG spot price volatility

v  Intermediaries providing hub services and having access to storage will allow more effective price arbitrage, further reducing price variability

v  The gap between spot prices available to importers and exporters will decline as market liquidity rises

v  Spot market trades from parties to contracts should continue to increase

v  Greater use of spot and short-term trading may favor lower capital cost projects

v  Growth in spot trading may reduce volumes under contract and raise spot market participation, further raising spot market liquidity

v  Long-term contracts will also become more flexible to allow parties to better exploit the optionality of spot and short-term trades

v  The exogeneity of oil prices suits them as the main indexing variable for long-term contracts, but limited use of gas price indexes from deep natural gas markets might provide some risk diversification benefits