UK: What Is The Future Of LNG Pricing?

Is LNG Pricing Linked To Crude Oil An Outdated Model?
Last Updated: 9 September 2019
Article by Simon Collier

In brief

  • The price of liquefied natural gas (LNG) usually reflects the energy market into which it is sold.
  • LNG sold into well-established gas markets, such as Europe, is priced to compete with alternative sources of gas, whereas in Asia it is usually linked to the price of crude oil.
  • An emerging price index in Asia and competition among LNG suppliers is changing the global market.

A reality for the LNG market is that – for import projects to make commercial sense – it has to be shown that LNG can compete on price with other energy sources (including pipeline gas). Even in markets where policy decisions encourage natural gas use, such as China, price differentials matter. This has meant that the price of LNG sold under long-term LNG sales contracts has traditionally reflected the energy economics of the market into which the LNG is being sold. There are marked differences in the way LNG has been priced in the three main LNG markets of Asia, Europe and the US.

In Asia, LNG has typically been indexed against crude oil prices. The price of LNG will be given per million British thermal units (MMBtu). A British thermal unit is a measure of the energy content of an energy source such as gas (more specifically it is the amount of energy required to heat one pound of water from 59°F to 60°F at a pressure of 14.696 psia, i.e. atmospheric pressure at sea level). On average, one MMBtu of natural gas has approximately 17% of the energy content of a barrel of oil. As a result, the price for one MMBtu of LNG in a crude oil-linked LNG pricing formula will be a similar percentage of the price of one barrel of oil using the relevant oil price index. This percentage is known as the price slope.

The pricing formula will index the price of LNG against a benchmark such as Brent crude or, in Japan, against the Japan Customs-cleared Crude (JCC) price (sometimes informally known as the Japanese Crude Cocktail price). The price slope will then be applied to give the price per MMBtu. For example, a price slope of 13% against Brent crude would mean that, at Brent crude prices of USD 70 per barrel, the MMBtu price would be 0.13 x 70 = USD 9.10 per MMBtu. The chosen crude oil benchmark will usually be applied with a three to six month lag so that changes in the LNG price follow changes in the price of crude oil.

In Europe, the gas market has already developed to the extent that LNG must compete directly with pipeline gas. As a result, oil-linked pricing formulae in LNG sales contracts have been replaced by pricing formulae that are set by reference to competing gas prices at gas hubs such as the Dutch Title Transfer Facility (TTF) and the UK's National Balancing Point (NBP).

Following the European model, there is a developing movement towards gas-on-gas pricing in Asia, although oil-linked pricing is likely to remain dominant in the short to medium term. The driver for this change is gas buyers demanding a pricing mechanism that is more representative of the regional gas market that they are subject to. An Asian benchmark price for LNG that is developing in popularity is the Platts Japan Korea Marker (JKM).

Given that the US, like Europe, has a well-established gas market, LNG imports (when they were necessary) were linked to gas prices, most notably the trading price at the Henry Hub, a meeting point in Louisiana for a large number of gas gathering and transmission pipelines. The price of LNG would be, for example, 115% of the Henry Hub price plus a fixed liquefaction fee, to give a price per MMBtu. Although the shale discoveries in the US have now made it an LNG exporter, US producers have also set their export prices against the Henry Hub. The problem with this for LNG buyers is that the price of gas then has no correlation to competing energy sources in their domestic market.

The competition between LNG export projects has, seemingly, forced a change in US export pricing. It has recently been announced that Tellurian will sell LNG to Total from the Driftwood LNG project in Louisiana at prices that are indexed to JKM. It has also been announced that NextDecade will sell LNG to Shell from the Rio Grande LNG export project at prices that are indexed to Brent crude.

The prevailing view in the market is that JKM-linked pricing will continue to grow, and in the coming years LNG contracts will increasingly move away from pricing formulae linked to crude oil and towards gas-on-gas pricing linked to trading prices at gas hubs around the world.

Whichever pricing mechanism is chosen, a long-term LNG sales contract will exist in market conditions that are difficult to predict at the time the contract is signed. Changing market conditions could have a negative impact on either the seller or the buyer, resulting in a situation where the terms of the contract do not reflect the market. One possibility, for example, is that competition in global gas markets leads to reduced gas prices while crude oil prices increase. To deal with this scenario, an LNG pricing mechanism linked to crude oil prices could provide for the price slope to decrease after the benchmark crude oil price reaches a certain point. A price adjustment mechanic such as this, however, is unlikely to be able to suitably accommodate a significant and long-term change in market circumstances.

To address more fundamental market changes, LNG sales contracts will often include price review mechanics, providing for the price to be subject to review if the contract price no longer reflects market conditions (the specific triggers for the application of the price review mechanism will need to be carefully agreed and drafted). Although many existing oil-linked LNG contracts are long-term agreements – suggesting that in the short to medium term oil-linked contracts will continue to predominate – it is possible that we could see price review mechanics in some contracts being used to renegotiate oil-linked LNG pricing to a pricing mechanism that is more representative of a prevailing gas market.

For further information about forces and trends that affect the global LNG market, we invite you to download DLA Piper's Global LNG Report 2019: A review of demand, supply and financing issues, in association with Petroleum Economist, looking at the forces and trends that will shape the global LNG market in 2019.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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