Coming Change in the Asian LNG Market?

  • photo courtesy of SimonQ www.flickr.com/photos/46214148@N00/6038168658
    Mar 28, 2014

    Asia is by far the largest liquefied natural gas (LNG) importing region in the world, accounting for two thirds of the global trade in LNG. Japan and South Korea alone imported about half of globally traded volumes in 2011, and their import volumes have only risen since then despite rising LNG prices. Between 2010 and 2013, Asian LNG prices to Northeast Asia increased from $10-12 per mmbtu (million British thermal units) to $15-18 per mmbtu, with significant fiscal consequences reverberating throughout the region. For example, Japan’s annual trade gap reached a record $112 billion, up over 40 percent year-on-year. High prices also threaten industrial competitiveness.

    The precipitous ascent of Asian LNG prices is a result of a very tight market with little prospect of short-term relief. Post-Fukushima nuclear closures have resulted in surging natural gas demand in Japan to avert a shortfall of 49 gigawatts, while rising consumption and nuclear closures have also affected Korea.  Attempts by Japan to secure more natural gas for power generation drove self-fulfilling fears that the regional LNG market would tighten. The supply side, however, has been slow to respond due to the complex and expensive nature of LNG facility construction, the front-loaded nature of the costs, and the long lead time necessary to bring projects online. In addition, supply tightness has been compounded by declining availability from Indonesia, a leading global LNG exporter faced with rising domestic gas consumption. As a result, LNG prices have soared while prices in the United States, based at Henry Hub, hovered between $3-4 mmbtu (until this winter). This regional divergence in prices is a huge change from historical experience; before 2008, Japanese prices were only three percent higher than Henry Hub. Low Henry Hub prices combined with soaring LNG prices in Asia have generated considerable interest among Asian buyers to acquire cheaper gas and explore alternatives to the current market and pricing structures.

    There are two distinct issues with regards to LNG prices that are often conflated. The first is the price mechanism. The price mechanism is how the gas is priced (the price system), essentially, whether it is oil-linked or not. The price formula is how the price is calculated, the formula by which the price is set. We use the term price paradigm here to encompass both the mechanism and the formula. Efforts by Asian buyers (both commercial entities and governments) to change the Asian LNG price paradigm have received a great deal of attention.  Due to historical circumstances, LNG in Asia is currently priced based on a price mechanism tied to the Japan Customs Cleared Crude price (JCC, also called the “Japan Crude Cocktail.” Japan custom-cleared crude is an average price of customs-cleared oil imports into Japan). Every month, the Japanese government publishes data used to calculate JCC The price of Asian LNG is indexed to the JCC and therefore “oil-linked,” but the exact relationship between the JCC price and the LNG price varies by contract. Traditional LNG contracts in Asia are long-term, meaning once they are finalized, they remain in place for several decades (20-30 years) and are rarely up for renegotiation, regardless of changing market conditions. Another major feature of Asian contracts is destination clause, which prohibits a buyer from re-selling LNG in the market and therefore competing with the original seller. Both the length and rigidity of these contracts are designed to provide LNG suppliers with means to ensure the return on their infrastructure investment, which can easily meet or exceed several billion dollars. 

    In response to high prices, Asian LNG buyers are seeking cheaper gas and exploring alternatives to the current LNG market and price structures as follows:

    1. Non-price changes

    • Fuel-switching:  Both in Japan and South Korea, government and industry leadership emphasize the economic efficacy of nuclear power, which they view as an indigenous source of stable base-load electricity necessary to sustain their manufacturing base economies.  Coal is also beginning to regain the share in power generation mix in these economies.  For example, Tokyo Electric Power Company—the largest Japanese electric utility—burned twice as much coal for power generation in 2013 than in 2012. However, coal use in Japan may be constrained by a carbon tax that is being phased in. 
    • Liberalizing domestic markets:  Korea recently passed legislation that allows LNG importers to resell part of their imported gas into overseas markets, reversing a law that limited LNG sales to within the Korean market.  (Meanwhile, Korea Gas Corp. or KOGAS remains the sole wholesaler within Korea.)
    • Developing a futures market:  The Japanese government, in efforts to create a more competitive domestic gas market, has initiated the establishment of an LNG futures market.
    • Taking an equity stake in upstream LNG assets to try and secure reasonable prices:  For example, KOGAS, Mitsui of Japan and PetroChina are equity holders in the LNG Canada project in British Columbia.  
    • There are rumors, but no concrete examples, that some companies are pushing for greater contract flexibility, especially as it relates to destination clauses.
    • Government-level consultations:  Major Asian consumer governments have been holding international discussions with producer governments under the auspices of the LNG Producer-Consumer Conference to explore alternatives to oil-linked pricing and destination clauses.

    2. Price changes

    • Looking to alternative suppliers to drive down prices: the threat of new suppliers has allegedly led Qatar to modify the price formula for oil-indexed LNG, which in turn would result in a lower price. Anadarko has reportedly reached multiple non-binding agreements for long-term LNG sales in “premium Asian markets” from its future East African trains.
    • Revising the price formula on new contracts:
      • Contract term changes involving a hybrid linking to gas and oil, not exclusively to oil. BG group, a British LNG supplier, reportedly concluded a deal with China’s CNOOC in 2012 with a hybrid price structure—70 percent linked to oil and the remainder linked to Henry Hub.
      • Contract term changes linking LNG price exclusively to Henry Hub natural gas prices. In 2012, KOGAS and India’s GAIL signed 20-year contracts linked to Henry Hub from Cheniere’s U.S.-based Sabine Pass facility.
    • Jointly procuring LNG at the company level:  Chubu Electric Power Co. of Japan and KOGAS has a joint procurement agreement with Italy’s ENI.  Similar joint procurements are being explored between Chubu and GAIL, and by Tokyo Electric Power Co.
    • Creating an Asian gas hub. There has also been some interest in an Asian natural gas hub which would make the Asian LNG market more competitive by providing transparency and price benchmarking for the region. The IEA report on the subject, released last year, outlined a range of regulatory, market structure and geographical challenges faced by key LNG buyer economies in Asia and cited “limited” prospects for such a “competitive wholesale natural gas market” for the foreseeable future because no country at the moment meets such key conditions.  Meanwhile, Singapore has expressed interest in becoming a regional hub and has appeared willing to address some of the challenges. But it is still to be seen whether or when a competitive hub may emerge in Asia; significant hurdles remain.

    Oil de-linkage and broader pricing reform may be a distant dream, however, as most sellers will continue to need long-term guaranteed sales to finance costly LNG facilities.  While many of the proposed U.S. LNG export projects are designed to capitalize on LNG terminals built last decade to prepare for LNG imports, projects currently being built outside the United States are greenfield projects and thus have little flexibility to accept lower prices.  As for the government-led efforts, it remains highly unclear whether Asian importers can align their broader interests in the name of driving down import prices.

    Even more fundamentally, a pricing mechanism and a price level are separate things. Oil de-linkage—as opposed to lower prices—is not necessarily in buyers’ interests. There was the general complacency with the oil-linked price formula until the beginning of this decade. Additionally,  the efficacy of the Henry Hub price based contracts is predicated on North American gas prices staying low enough to present an arbitrage opportunity relative to competing supplies to Asia after cost is incurred for liquefaction and transportation. Sustained Henry Hub prices of six dollars or above generally negate the price benefit—and this is especially true if global oil prices come down.

    At the end of the day, gas prices are high in Asia because of a lack of competition. The lack of competition is due to both geographic and structural reasons.  Among the traditional LNG buyers (Japan, South Korea and Taiwan), geography constrains the ability to import piped gas, restricting gas-on-gas competition (unlike in Europe). But geography is only one factor. The natural gas sector is generally more regulated in Asia than in Europe (and far more than in the U.S.), and as a result, LNG suppliers have found no strong reason to lower prices to their Asian consumers.  Oil de-linkage and/or price formula revision does not fundamentally change the market dynamic as it tries to shift around risk. There is no guarantee that either oil de-linkage or gas-to-gas competition will result in lower LNG prices. 

    Nonetheless, the potential evolution of the LNG pricing paradigm in Asia and, more broadly, the range of strategies Asian consumers have begun to employ in response to their desire for lower energy prices will be worth watching, even if there is little prospect for change in the short term. 

    Jane Nakano is a fellow with the Energy and National Security program at the Center for Strategic and International (CSIS). Michelle Melton is a research associate with the Energy and National Security program.

    Commentary 
    is produced by the Center for Strategic and International Studies (CSIS), a private, tax-exempt institution focusing on international public policy issues. Its research is nonpartisan and nonproprietary. CSIS does not take specific policy positions. Accordingly, all views, positions, and conclusions expressed in this publication should be understood to be solely those of the author(s).

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