lessons for LNG from other commodities

The outlook for the pricing of LNG has become controversial in the past 12 months as gas prices across the globe have diverged and the demand/supply balance in different regions has shifted dramatically. While there is ample research and views on what shifts in demand, supply and costs might mean, I think there is a lot to be gained by comparing the current state of LNG markets to the experience of other commodities.

The predominant pricing mechanism for LNG is for long-dated contracts (~10 years) for a pre-determined quantity each year.  For pricing, this is usually benchmarked to crude oil prices, or to be precise the Japanese Crude Cocktail (JCC). Spot and shorter-term contracts have become more prevalent in recent years, but pricing is again mostly linked to oil prices.  Japan is the largest consumer of LNG and has experienced a big lift in imports in the last few years due to the ongoing impact of the Tohoku disasters on nuclear power.

This form of contract settlement is now relatively unusual amongst most commodities. Base metals and crude oil have for a long time been exchange traded both physically and in futures, with these markets now very deep.

Bulk commodities are a different story, with it only in the last few years that iron ore and met coal have moved towards short-term pricing mechanisms.

Exchange traded gas prices like US Henry Hub price and the UK NBP gas price allow for short and long term hedging within respective domestic markets.  Using these pricing points, however, are not ideal for LNG.

In the case of Henry Hub gas, this is close to the least marginal supply given the shale gas revolution, with low cost supply not defining the marginal supply.  NBP is perhaps more appropriate, but European markets are also heavily affected by pipeline supplies which are controlled by a few suppliers.

A template for the development of the LNG market useful might be seaborne thermal coal.  As the chart on the left shows, the size of marginal supply moved by ship relative to total global consumption is fairly similar for thermal coal and LNG. It is also a market for which demand in Asia plays a dominant role in pricing.

Thermal coal has a number of different pricing mechanisms.  European coal prices are heavily integrated into power, gas and carbon markets with deep futures markets, for which NBP or German gas prices are a comparison point.

Asian markets, however, have numerous different pricing mechanisms.  Japanese buyers buy predominantly on contract terms with fixed pricing, although marginal spot cargoes are usually priced relative to FOB prices in Newcastle in Australia.

Arbitrages between different price points can be traded, by are by no means perfectly efficient, with significant divergences sustained over significant periods.

New pricing points are also being developed for coal, particularly given the increased acceptance of different qualities of coals, which have exhibited varying premiums/discounts.  The market's ability to price different qualities of coal is also a potential issue for LNG given varying energy content.

Development of these pricing mechanisms has taken many years. But moving LNG in this direction perhaps makes more sense then sticking with the current status quo, or adopting current available pricing points.

Perhaps the biggest lesson for LNG that comes from other commodities markets is the transformative power of Chinese demand and supply.

Gas demand in China has been slower to develop than other commodities thanks to the previous abundance of cheap coal and the security of its supply.  But priorities are changing, with diversity of energy supply and environment impact slowly but surely becoming more prominent. As of yet, China has had nowhere near the same impact on gas as it has on other commodity markets.

The huge uplift in Chinese demand in the mid-2000s saw a price rise for just about all metals and bulk commodities, but the latter half of the decade saw diverging fortunes on the supply response within China in particular.

For commodities like aluminium and nickel, we saw producers willing to produce for either very low to no margin, or a change in technology which have bought prices lower.  Copper and iron ore, however, have seen prices remain high due to a lack of quality domestic reserves.

So it seems likely that LNG pricing dynamics will bear little resemblance to the current status quo.  While it makes sense that more relavent price benchmarks are developed for LNG in the Asia Pac region, the ultimate driver may prove to be China, which has had surprisingly little impact on global gas markets compared to other commodities.