In the first half of 2006, the majority of short-term LNG cargoes went to Europe. In a reversal, higher prices pulled those cargoes into the U.S. from Europe in the first half of 2007, with more than 12 bcm delivered into the U.S. market. However, the ability of the U.S. to secure short-term LNG cargoes was short-lived, as Japan and East Asia have cornered the short-term LNG supply since mid-2007.

The variability of the short-term LNG cargoes’ destinations is testament to the market’s flexibility, as more infrastructure and supply capacity become available. (For example, new liquefaction capacity now exists in Equatorial Guinea, Qatar, and Norway and further capacity from Nigeria, Australia, Russia, and Yemen is under construction for commissioning in the next two years.) However, it was the shutdown of Tokyo Electric’s huge 8.2 gigawatt Kashiwazaki-Kariwa nuclear complex after the July 2007 earthquake that suddenly pushed Japan’s LNG demand higher and increased their willingness to outbid U.S. short-term gas prices.

Japanese utilities increased their LNG imports dramatically from August to October 2007 – mostly from Atlantic Basin LNG suppliers – paying $2.50 per million Btu more than prevailing Henry Hub prices. Notably, several of the initial cargoes exported from Equatorial Guinea LNG by BG under its FOB purchase contract have been diverted to the East Asian market. If demand for LNG from Asia and Japan remains strong, and winters in the U.S. and E.U. are harsher than usual, Japan can be expected to pay more than $13 per delivered mmbtu in the first quarter of 2008. These recent events in Japan have made the current global LNG market tighter and more competitive than previously expected.

LNG spot sales (short-term deals or the sale of one cargo) remain, at less than 15 percent, only a minor part of the global market. Nevertheless, it is a lucrative one for companies with flexibility and access to infrastructure (such as BG’s Equatorial Guinea operation). The high short-term LNG prices recently paid by Japan do not reflect the average LNG prices it had become accustomed to. In contrast to the U.S., much of the global market is underpinned by the long-term sales contracts necessary to secure commitments to build the expensive supply-chain infrastructure. From July 2005 to August 2007, the dominance of long-term contracts in which LNG prices are not indexed solely to crude oil prices (such as those in France and Spain) or which involve formulas to dampen the impact of oil price increases (such as Japan), have helped to secure lower and more stable LNG prices (Figure 1). In contrast, Henry Hub price volatility is reflected in U.S. LNG prices.

Figure 1. Average LNG prices in seven major LNG
markets from July 2005 to August 2007.
Source: Argus Global LNG Monthly Average Prices, 2007

However, the relative stability of Japan’s recent LNG prices may not exist for much longer. The sudden increase in Japan’s gas demand coincides with unprecedented high oil prices, and several of Japan’s long and medium-term LNG supply contracts are due for renewal and price renegotiation. For the past four years, the S-curve price formula that prevailed in Japan’s last major round of term LNG contract negotiations in 2001 has protected it from the rapid rise in oil prices. Indeed, Japan’s LNG prices have remained significantly lower than crude oil by some 35 percent on an energy equivalence basis. However, suppliers will be reluctant to renew supplies on such a formula unless the coefficients are adjusted to secure higher prices when oil prices increase.

The S-curve mechanism is worth considering, as, with modifications, it should continue to allow Japan to maintain LNG prices and spark spreads competitive with other power generation fuels (coal, oil products, and nuclear). The primary objective of the S-curve mechanism is to limit the impact of extreme oil price fluctuations on LNG prices. It has certainly been tried and tested in this regard in the past seven years. The formula is generically defined as:

P $/mmbtu CIF Japan = AX + B + S

Where:
A, B are constant coefficients
X is the crude oil(Japanese Crude Cocktail – JCC) CIF price
S coefficient or curve is added to the price formula to further flatten or dampen the price curve only when the JCC price (which historically has averaged WTI price, less about $1 per barrel), lies above or below a preset price range, which in 2001 contracts ranged from $15 to $ 35 per barrel.

Applying the S-formula established in 2001, term LNG prices change linearly in proportion with crude oil prices in preset price ranges – approximately $20 to $40 per barrel. That preset range seemed likely to cover all upside oil price eventualities when they were negotiated. If the price of crude oil rises or falls outside that range, then the rise or fall in LNG prices is further dampened by the additional S coefficient that then becomes effective, providing transitional floor and ceiling LNG prices (Figure 2).

Figure 2. Changing market conditions are likely to
dilute the S-curve LNG price formula that has
Japan’s LNG prices since 2001 under some
long-term contracts.

Relating to the 2001 agreements, the price of Qatar LNG sold to Japan was reported to involve a floor price of $3.60 per mmbtu (some $2.50 per mmbtu FOB-Ras Laffan), and for the preset price range the A coefficient of the formula was 0.1485. To my knowledge, the values of the B and S coefficients and the exact limits of the preset price range have not been disclosed. In 2003, China and India managed to secure term LNG contracts on similar formula arrangements with a much lower value of A, but no S term. Such contracts lead to a lower, flatter, and more stable price relationship than Japan’s S-curve formula. At the JCC price of $20 per barrel, the Guangdong price formula was reported at $3.10 per mmbtu delivered, 20 percent lower than Japan’s price formula.

In some recently renewed term contracts with Australian suppliers, Japanese buyers have had to accept LNG prices linked to crude oil prices on an energy equivalent basis without the dampening effects of the S coefficient, in order to secure supply. Such changes will likely result in an average LNG price for Japan that will be within 20 percent of the crude oil price on an energy equivalent basis after 2010. Japan’s import prices for both long and short-term LNG cargoes can therefore be expected to become more volatile in response to oil price movements beyond 2008 (Figure 2).

Tightness in prevailing global LNG supplies, as illustrated by recent short-term LNG cargo redirections, has provided LNG producers the upper hand in recent price negotiations. This is quite different from the situation in 2001-03 when buyers had the advantage, and it was possible to negotiate low prices with gentle indexation formulas (e.g. the Guangdong pricing deal mentioned above). The markets may yet turn again in that direction.

Conclusions

In addition to the availability and price of short-term LNG cargoes, a number of other factors should influence East Asian long-run gas and LNG prices:

- Nuclear and coal contributions to the primary energy mix for power generation.
- Restrictions on gas flaring, promoting utilization of stranded associated gas.
- Legislation to restrict carbon and greenhouse gas emissions.
- Competition induced by deregulation, unbundling of infrastructure, and more extensive third-party access to liberalized markets.
- Investment in new gas supply chain infrastructure, both LNG and pipelines (for instance, Russia to China and Korea).

These factors will also influence the ability of the U.S. to attract a greater share of available short-term LNG cargoes.