The derivatives market in Asian liquefied natural gas is finally taking off, as the world’s largest importers look to diversify the pricing structures of their purchases by increasing short-term agreements.
LNG is one of the few remaining commodities where buyers and sellers are locked into multiyear contracts, and the long-awaited development comes as new supply projects have come online and the LNG price has fallen.
Tobias Davis, head of LNG broking at Tullett Prebon, says: “[The Asian derivatives market] is becoming more liquid, enough to become a fair price indicator.”
Historically, a large portion of LNG sold to north-east Asia, the world’s largest buyer of the commodity, have been traded under long-term, fixed destination contracts linked to oil. However, an increasing number of Japanese and Korean buyers are signing full or partial short-term contracts linked to LNG price indices.
The shifts in the prized Asian market come amid wider changes in the LNG industry. Long the preserve of the largest energy groups such as Shell and Exxon, independent energy traders including Vitol, Gunvor and Trafigura are entering the sector, agreeing on relatively short-term deals with new pricing mechanisms.
Trading volumes of LNG derivatives linked to the Asian benchmark have soared as more LNG dealers and companies look to hedge their short-term agreements. Spot and short-term trade in 2016 rose 9 per cent to 74.6m tonnes from the previous year, accounting for 28 per cent of all LNG trades, according to the International Group of Liquefied Natural Gas Importers.
Volumes in August cleared through ICE linked to the east Asian spot LNG index Japan-Korea Marker, assessed by S&P Global Platts, reached over 21 cargoes — a new monthly high. After more than quadrupling in 2016, volumes in 2017 overtook that of the previous year in the first five months of the year.
The short-term trades have risen as LNG supply has grown with the launch of new LNG plants, which chill and condense gas so it can be shipped on tankers overseas. New projects in Papua New Guinea and Australia have come online over the past few years, increasing the amount of LNG on the world market.
The LNG price has been in decline since 2014, when the JKM hit a record high of $20.20 per million British thermal units. It is currently trading just above $6 per mBtu.
On the demand side, energy saving practices and the restart of nuclear plants in Japan led to a fall in LNG consumption over recent years in the world’s largest importer. Moreover, Japan has contracted far more LNG than it needs, and the country’s utilities have had to turn themselves into traders in order to resell some long-term supplies. This has increased the short-term contracts, which in turn need to be hedged on the derivatives market.
“Some of the Japanese power supplies don’t need all the LNG they’ve signed up for,” says Kerry Anne Shanks, head of Asia Pacific gas and LNG research at energy consultancy Wood Mackenzie.
The rise in short-term contracts has led to a significant increase in the number of participants in the LNG derivatives market, with the market now comprising between 20 to 30 counter parties, according to S&P Global Platts. More traders are also taking proprietary positions, adding depth to the market. “They are helping to pull [in] liquidity,” says Mr Davis.
Additional changes in Japan could boost liquidity further. In June, the Japanese Fair Trade Commission said it was banning clauses limiting resale of LNG and called on companies to change their business practices for existing contracts. This is likely to lead to some contracts bring renegotiated.
In addition, a bulk of the Japanese utilities’ long-term contracts are expiring in 2019 to 2020, and are likely to be replaced with more diverse maturities and flexibility on destination.
“After 2019 many existing long-term contracts will expire. They want to allocate a certain portion of that to short-term contracts,” says Tomoko Hosoe, at consultants FG Energy.
But despite the rise in trading liquidity, the LNG derivatives market is still a small portion of the whole physical market.
“The futures market in oil is multiples of the physical market. JKM [derivatives] is only 1-2 per cent of the LNG physical market if you assume spot trade to be around 40 per cent of production,” says Mr Davis.
Some industry executives warn that the liquidity in the derivatives market could dry up as the market tightens beyond 2020. Industry experts see the growth in new demand and the slowing of new production capacity growth leading to a supply dearth in 2022-2023.
“The LNG market is going to tighten driven by [demand] growth in Asia,” says Eric Bensaude, in charge of LNG Commercial Operations and Asset Optimisation at Cheniere Energy.
He warns: “Yes, the spot market is in favour but I’m not sure that the market liquidity is here to stay. ”