A broker in LNG trade analyses increasing LNG demand, changing patterns of LNG trade, LNG pricing, and other factors which will affect the LNG industry in the 2006/2008 timeframe.
 

The unprecedented expansion of LNG trade currently unfolding is the result of a number of simultaneous favourable circumstances and structural changes in the energy sector. Firstly, the acceleration of worldwide gas consumption resulting from environmental factors as well as technological factors which is reigniting interest for remote gas sources. Secondly, the newly acquired competitiveness of LNG in worldwide energy markets thanks to much lower costs along the chain. And thirdly, the rapid deregulation of energy markets which facilitates LNG penetration as an efficient alternative or complement to other energy sources.

These factors of LNG growth are also shaping a different structure of LNG trade. Some of these changes are already apparent as regional demand imbalances, asset under-utilisation and price differentials are stimulating more flexible contracts; however, this is only the beginning of deeper changes to come. In order to analyse the extent and impact of these changes, the 2006/2008 period is particularly interesting to focus on as these three driving factors will become fully effective.

Power-led gas demand

The recent growth of LNG trade stands at 8 to 10% per year, with the Atlantic moving faster at 12% per year and the Pacific at 5% per year but now catching up with the Atlantic. The vast majority of this additional demand is the result of new gas-fired generation/cogeneration (single and combined cycle) capacity worldwide, and this should be the case at least until 2006/2008 when the bulk of decided/under construction power plants become operational. For this new demand, which can be particularly volatile in volume and price (merchant plants), LNG provides an alternative/additional source of supply and is also acting as a buffer to mitigate volatility.

The flexibility offered by LNG to a power generator, when combined with active storage management, can prove very effective. The first flexibility is the possibility to buy incremental quantities under short/medium term agreements from diversified sources of supply as a complement to long-term interruptible contracts. The second flexibility is the price formula, which, depending on the type of risk management profile of the power generator, can either be fixed or based on electricity netback (tolling agreement). For the LNG supplier, a partial volume and price linkage to some major electricity markets could also have significant advantages due to the diversification of exposure and the depth / liquidity of these markets.

Overall, LNG appears to be in a good position to address a large portion of the "flexible" part of gas demand, consisting of power producers exposed to the market and weather-sensitive demand, mobilising up to 25% to 30% of overall LNG trade. This naturally comes on top of large base load long-term agreements signed with utilities operating in regulated environments or under Power Purchase Agreements (PPAs), an area where LNG is also competitive.

Gas deregulation

Gas deregulation is already effective or underway in several parts of the world, and this movement is accelerating in Europe and in East Asia. The 2006/2008 period should see the maturing of this process, when household deregulation will take place in continental Europe for example. This will fragment the market and multiply the number of active LNG players, even taking into account demand aggregation from new entrants in the market.

The consequences for the LNG markets will be far-reaching. As more eligible customers enter the market, LNG offers them the possibility to purchase gas on different and flexible terms. By combining long-term (take or pay), medium-term and short-term contracts, these new buyers can optimise their supply portfolio.

Regulators will also influence the structure of LNG trade in coming years. They see the importance of stimulating LNG projects in order to enhance gas competition, to the extent that they do not lead to overcapacities. Their influence on contractual arrangements has already been felt in Europe, in terms of destination clauses for example. As a general rule, they will want to see an opening of 10% to 20% third party access for new terminals, even if they are prepared in some instances to accept exemption to third party access in order to encourage project developers.

Overall, gas deregulation will act as a strong incentive for development of open and flexible LNG trade, and its effects will be effective by 2006/2008.

LNG competitiveness

The sharp cost reduction at all stages of the LNG chain is still underway, thanks to technological developments as well as economies of scale of new assets (terminals and ships). Gas producers are also eager to monetise reserves which would otherwise not be developed immediately and are prepared therefore to keep production prices at competitive levels, absorbing to a certain extent cost differences between gas sources. LNG is therefore becoming competitive worldwide, whether in large gas hubs or in isolated markets, whether in short-term or long-term deals.

This new competitivity of LNG has also been "helped" by the constantly increasing gas prices worldwide. Prices on Henry Hub have grown steadily on average from 2 US$/million BTU in 1994 to over 5 US$/million BTU in 2003. Prices in Take or Pay contracts for pipeline gas in Europe and LNG contracts in the Far East have been sharply up in tandem with oil prices. These high levels have raised questions on gas competitiveness in general compared to other sources of energy.

These very high gas prices however cannot be sustained as we approach the 2006/2008 period. Once major assets are in place, low-cost LNG penetration in worldwide markets will act as a price moderator and reduce significantly price volatility. Negotiation of flexible contracts, not dependent on the price of oil, will also act as a cap to price increases. Furthermore, LNG markets will offer in the near future a buyer's market bias, due to the "push" of several exporting projects, and the time lag for deciding the construction of receiving terminals. This bias could be maintained until the period 2006/2008, when a new balance is reached by the market.

Another emerging trade pattern in LNG is the increasing arbitrage positions between regional/local markets. Prices between the US and European markets on the one hand and between the Atlantic and Pacific are shifting very rapidly, with differentials reaching or exceeding +/- 2 US$/million BTU (see Figure 1). Arbitrage cargoes (diversions, swaps, spot cargoes) have emerged and this movement is accelerating with more players wishing to extract value from these differentials, even if swaps are relatively lengthy to implement (contractual complexity, physical storage limitations, time-lag between decision and actual implementation) and should in theory narrow the gap, leading to a price convergence. In reality, regional gas prices differentials are here to stay as local factors in major hubs or markets, such as electricity prices or weather, move independently. Therefore, LNG arbitrage trade can be expected to increase significantly and the Suez Canal to play the role of a large "Interconnector"!

Although the driving forces for prices may well be concentrated in the existing and future major hubs in 2006/2008, LNG "plugged" into these hubs will have a growing influence, and from being a passive "price taker" could become a real (moderating) force especially on the "flexible" end of this market, while increasing steadily its market share.

LNG players' strategies

The shape of LNG trade in the coming years will be the result of a number of different, either competing or complementary, strategies of various LNG players:

• National gas producers: the incentive to monetise the reserves in place is very strong at the level of economic policy of mostly emerging economies
  
• International oil/gas companies: they also have a strong incentive in relation to the booking of additional reserves, and will pursue further a "pipeline" strategy, i.e. an end to end integration to the largest extent
  
• Utilities: in order to gain control on the LNG chain, they are seeking "reverse integration" up to and including tolling export terminals or even to some extent in upstream gas field development
  
• New eligible customers: they are the "joker" in the equation, as their strategy

is not yet clearly defined in terms of asset control. Their role in LNG markets
will in any case become crucial as these buyers will want tailor-made flexible solutions for their needs, even if their investment commitment is limited to equity stakes in receiving terminals and shipping assets. Once the "baseload" asset developments (the "backbone" of the system) are launched, any incremental development will be largely dependent (for financing particularly) on these buyers acting separately or in aggregation.

The cross movements of "downstream integration" of gas producers on the one hand and the "reverse integration" of buyers on the other hand will meet at certain parts of the LNG chain and can lead increasingly to cooperative agreement within tolling schemes.

Asset development

The urge to monetise reserves quickly and reinvest local money has meant that oil/gas companies have tended up to now to finance export projects on an equity basis. This could still be the case in 2004 as a number of "baseload" projects are decided and launched. In the future however, new incremental projects, especially those based on tolling arrangements and those resulting from joint-ventures between sellers and buyers, may have to be based on non-recourse project finance. Banks and financial institutions are inclined now to accept a reasonable portion of non-commited long-term capacity provided that potential buyers are taking a stake in the project and that the targeted market is deep and liquid (presence of a hub for example).

It is noteworthy that the current "stampede" for mid-stream assets has focused mainly on terminals and ships, disregarding the important storage assets. Many large marketers and wholesalers have concentrated on financial trading of gas to suit their customers' needs and neglected up to now the importance of physical regulation and optimisation of demand.

A finely-tuned optimisation of underground storage provides very effective risk management and LNG can enhance this position. Electricity producers in particular could have access to these newly-deregulated assets together with gas utilities, providing them an extra leverage in their negotiations for LNG supplies.

Recent examples of large-scale shipping orders by both sellers and buyers to secure slots for shipyard capacity by 2006/2008 is also a good example of this stampede. Taking into account the very finely balanced situation in shipping for this period, a number of participants prefer not to take any chances and prefer to risk having some extra shipping capacity in the open market than being caught short later. These conservative orders added to those made by independent ship owners on an uncommited basis will facilitate the development of flexible short and medium-term contracts.

New trading patterns for 2006/2008

The start-up by 2006/2008 of many critical assets to allow smooth flow of LNG into the main markets and the signing of relevant "baseload" contracts, both into developed countries and in new emerging economies such as India and China, will provide a new balance into the market. On average, prices are poised to subside due to the lifting of these constraints, the buyer's market bias and the deconnection from oil prices.

Simultaneously, a number of more flexible assets (toll-based, third party access ) and flexible contracts will emerge. Short term agreements, which are currently generated more by "technical" imbalances, should grow rapidly due to (a) arbitrage positions generated from continuous price differentials among regional markets, and (b) tailor-made solutions demanded increasingly by power plants and new eligible buyers. Such short-term agreements could occupy all the technical spare capacity and third party access capacity of mid-stream assets to reach a total of 15/20% of overall trade (from the current 8/10%).

On the other hand, a new breed of medium term (two to five years) contracts could emerge also as an interesting alternative to long-term contracts, which need adjustments and renegotiations in quantity and price over the span of their life. Medium-term contracts may suit a number of LNG players: (a) the sellers, as a "bridge" to finance mid-stream assets, (b) the buyers connected to hubs, who may gain flexibility of supply, and (c) asset owners, as they are less exposed on their guaranteed throughput capacity to a volatile spot market while retaining an option to be exposed to the market at a later time. This type of contract, based on the equity/tolling portion of assets, could represent up to 10% of the total contracts and mid-stream capacity.

The total of short-term and medium-term trade could therefore represent a total of 25% to 30% of worldwide trade by 2006/2008, a figure equal to the "flexible" part of the overall market. Naturally, this percentage will only be achieved if there are no other unforeseen critical items in the "pipeline", and this could be the case especially for shipping capacity (25% to 30% of trade would represent the equivalent of 50 to 60 ships by 2006/2008 in this flexible trade).

Standard long-term and short-term contracts will facilitate an increasing

number of transactions. This standardisation is already under way, and will concern also medium-term contracts. Price references could vary according to the types of contracts considered. Long-term contracts will reduce their dependence on oil and include a basket of references such as oil, coal, electricity, hub prices, etc, in order to mitigate risks and avoid frequent renegotiations which do not serve the stabilising objective of these contracts. Short-term contracts can be either fixed-price or hub-related. Medium-term contracts have the widest spectrum of possible price references, as they extend within the limits of paper hedging at hub exchanges, the selection of price indexation being the choice of buyers for their tailor-made contracts.

A strong base for future development

The prospects for the period 2006/2008 point to the fact that LNG has now "turned the corner". A "critical mass" of assets is already in the pipeline, which will ensure that LNG's back-bone infrastructure (mid-stream assets) is in place to connect the major sources of supply

to the major hubs and emerging markets worldwide. Cooperative schemes bet-ween buyers and sellers to own and control these assets will ensure that equitable long-term, medium-term and short-term contracts are being put in place to suit different strategies and risk profiles of existing and new players in the market.

The larger market share and influence of LNG in the world markets, whether at major hubs or in emerging markets, will have a price-moderating and stabilising effect in the overall gas markets. As new tolling assets are put in place and deregulated markets provide to new eligible customers the opportunity to participate also in the LNG market, a larger portion of the market will be under flexible short- and medium-term contracts. Persistent price differentials between regional hubs will also attract a growing part of the trade to short-term arbitrage contracts.

LNG markets in 2006/2008 will therefore have gained in weight and influence on gas markets but also will have become a very diversified and flexible proposition, which can be very attractive to a number of new LNG players, who could provide a demand-led second-round of growth beyond 2006/2008.

Max Vauthier is the founder and President of LNG BROKERS SAS, a recently-formed independent Company focused on LNG Commodity brokerage and associated services. The Company's mission is to facilitate LNG transactions and create value for its customers, especially in the emerging short and medium-term transactions and in new LNG projects. Max Vauthier has 25 years experience in the energy industry in trading and business development positions with large groups such as BP and SUEZ, and is familiar with both oil/gas and electricity markets.