|Vietnam’s self-sufficiency in natural gas is forecast to end in just a few years, Photo: Le Toan |
Changes are happening out of necessity and not out of choice. What always seemed to be formidable obstacles are rapidly deteriorating into historical footnotes. Liquefied natural gas (LNG) industry mainstays like destination clauses, long-term contracts, and oil indexation are morphing into something resembling a modern, fundamental-driven commodity market.
LNG stakeholders face an acute need to reposition themselves, as gas faces competitive threats from all sides. As a result, investors in LNG, once the most staid of businesses, are probing new facets of the energy space in order to create higher demand for an asset that is increasingly stranded.
The cost of moving gas from A to B in any form remains relatively high and problematic, while the number of competitive fuel options are rising within key use sectors for gas. Taking the most expensive form of gas supply (imported LNG) and placing it into the most competitive sector for gas use (power) will be the defining story for gas demand growth in the next decade.
It will require a severe curtailment or complete elimination of oil indexation as the driving force in LNG pricing, and recognition that pricing gas at a competitive level with coal and battery storage is an absolute minimum condition.
Of course, pricing LNG on oil to compete with coal and battery storage is possible, but why would the industry hold onto this legacy when commercially viable alternatives are readily available?
Financing new supply
The supply push coming from oil-centric upstream developments, combined with a narrowing of traditional downstream opportunities, is forcing LNG developers to rethink their strategy for marketing volumes. The problem of how to market LNG is so acute that it is now threatening to curb upstream development for oil.
Price movements for oil and gas have become largely inverted, and pricing the latter based on the former has become highly problematic. In the extreme, higher oil prices in the US have led directly to negative gas prices in regions such as the Permian basin. While these price inversions are eventually solved by additional midstream and downstream build-outs, the problem is a chronic one that is forcing change.
The move further downstream by LNG sellers into import terminals, power generation, and transportation fuels – bunkering and trucking, primarily – comes from increasing pressure tied to upstream realities. Reduced options for creating more gas demand now pose an existential threat to higher oil and liquids production.
Almost every cubic metre of LNG produced over the next two decades will be sourced from wet gas production, where the considerably higher price of oil, natural gas liquids, and condensates will dictate the economics of drilling, completions, and output.
As a result, incremental gas is being produced without a corresponding strategy as to how it will be consumed. The assumption of a wellhead price for gas at close to zero will help with the marketing of the LNG, but also shines a light on the reality that gas and LNG specifically are moving from a downstream, high-margin revenue business to an upstream cost of production.
LNG sellers will respond on several fronts, depending on the nature of their legacy position in the market. The majors and national oil companies are moving ahead with LNG projects regardless of the downstream outlook. Financing has become internalised and core customers are shifting from end users to standalone marketing arms of equity holders in the liquefaction project and to portfolio players populated by trading companies. Signing up long-term deals for large volumes is certainly preferred, but is no longer the central driving force in project development.
The situation for LNG startups like Venture Global, Tellurian, and NextDecade is different. Locking down long-term customers will attract the necessary financing to build to scale. While these projects all tout savings along the entire value chain – ranging from lower gas production costs to harmonised LNG/renewables solutions – securing long-term cash flow through contracts remains the central driving principle.
As a result, the most aggressive forms of pricing are taking place among these projects, as they seek to attract buyers in order to attract capital. If they succeed, it will be proof positive that this type of strategy is financeable.
With supply options building and demand options limited, the financial burden of building more tanker capacity and regasification is shifting from the buyer to the seller. And the shift has a chance of moving beyond the import terminal as well.
LNG demand will only grow if the pricing point can be lowered, and it is the sellers that will need to foot the bill. Shaving down costs on delivery of LNG is necessary for gas to find a sustainable market.
Over the past decade, solar panels and wind turbines have gone from being idle threats to dire threats to gas demand growth in the power generation sector. The gas demand narrative has gone from being “the fuel of the future” to “the fuel of transition” to “the fuel to use four hours a day to stave off intermittency.”
The difference is quite significant between forecasting gas demand growth based on 24 hours a day to forecasting it based on four hours per day, at best. Outside of coastal China, growth prospects for gas have been severely compromised by the introduction of renewables as a base load source for power generation.
A decade ago, most forecasts for power would have been comfortable giving 75-90 per cent of the growth to gas as the generating fuel of choice. Now, gas is lucky to hit 40 per cent and most of the risk is to the downside.
LNG sellers are now moving from seeing renewables as a competitive threat to seeing them as a potential partner in offering environmentally-sustainable solutions in fast-growing economies ravaged by pollution and in need of a pathway to de-carbonisation.
Carving out demand
The larger traditional buyers of LNG are also facing competitive headwinds at home, hence the reluctance to deploy more capital into import terminals and tankers without a clearer view as to what they face. The cost of building out a gas grid remains exorbitant, and outside of markets like coastal China, gas prices established by governments at the burner tip are largely under water compared to import points. Building out residential or commercial use in a country like India is simply not realistic due to the cost. Raise prices, and demand growth is compromised, with what happened to Ukraine a prime example.
Alternatively, keep prices low, and purchases must be subsidised. And if a government needs to subsidise LNG imports, it faces a broader policy choice of preferring to subsidise the build out of renewables. These issues are existential for traditional utilities, which have been the backbone of LNG demand growth over the past 50 years.
For LNG buyers, the call for more flexibility in signing LNG contracts is a way of saying, “We would rather not sign any long-term contracts at all.” Hence the insistence by buyers of securing contracts for lower volumes and fewer years. To some extent, buyers still value security of supply, but they are no longer willing to pay a price premium for it. Volume and length of contract are the truest expressions of security needs among new deals.
Signing low volume, long-term deals certainly has a value. Some buyers are signing up new volumes from the US just to create more leverage for re-signing older volumes at better prices that are near expiration. Roughly 40 per cent of all long-term LNG contracts will be expiring over the next decade. New LNG projects are therefore competing directly with legacy LNG projects to secure market share.
With the number of buyers rapidly diversifying and portfolio players willing to take larger and larger positions in the middle, liquidity in the LNG spot market is rocketing higher. More and more fob lifting of LNG is entering the market in the hands of non-end users, which implies that more spot transactions will occur at market prices. Higher use of the LNG benchmark price assessment of Platts’ Japan Korea Marker is just the latest in a shift to spot indexation as a form of valuing cargoes and short-term trade.
The shift is also on for the use of spot indexation for longer-term contracts. While oil indexation will keep playing a role on legacy deals and even coal indexation is entering the mix, tying the indexation of LNG to gas prices seems like a logical next step in the evolution of pricing. Oil indexation becomes more anachronistic as time passes, given that the fundamentals underpinning of the two commodities are headed in opposite directions.