LNG & Crude Oil: Dissimilar Trading Markets

Should the liquefied natural gas (LNGLF) (LNG) market become much more like crude oil, with deep and liquid futures contracts coupled with unrestricted trade between producers, buyers and traders?

The answer is yes it should, but that is unlikely to happen as there are enough significant differences to make it extremely difficult for LNG to tread closely in oil's footsteps.

In a recent column (LNG producers need to go downstream to build industry), I argued that the LNG industry would find it hard to undertake a new wave of expansion if it persists with its current model.

The present model is for massively expensive projects to be underwritten by long-term sales contracts that effectively tie buyers and sellers together for periods of up to 20 years at prices linked to those of crude oil.

Simply, this way of doing business can't survive in an era where spot LNG in Asia <LNG-AS> is trading at $4.30 per million British thermal units (mmBtu), barely one-fifth of what it was two years ago, and Brent crude is around $40 a barrel, or roughly one-third of what it traded at in June 2014.

Part of the problem for LNG producers is that they need to ensure demand-growth for their fuel, and I argued that moving downstream in customer countries by building, or partnering in, re-gasification terminals, pipelines and end-user applications such as industry and power generation was a sensible option.

But rather than the vertical integration that I suggested, a cogent argument for a different path was made by Craig Pirrong, professor of finance and Energy Markets Director of the Global Energy Management Institute at the Bauer College of Business, University of Houston, in his Streetwise Professor blog (http://streetwiseprofessor.com/?p=9898).

Pirrong argued that LNG is a homogenous commodity that can be shipped anywhere in the world and the increasing numbers of producers and buyers will drive liquidity.

"The silver lining in the current glut of LNG is that it is speeding the development of liquidity. Meaning that Clyde Russell's prescription of vertical integration is the exact wrong response to that glut," he wrote.

"The glut increases liquidity. Liquidity enhances optionality. Optionality creates value. Don't stymie this salutary development. Go with it. It will pay off in both the short term and the long term," Pirrong said.

This argument works in that the shift in the LNG market to a situation of oversupply should allow for considerably more flexibility in how the super-cooled fuel is traded.

LNG pricing should become more flexible and long-term contracts consigned to history.

Similarly destination clauses also impede market development, and their demise would also support the development of a futures market, whether that be a cash-settled contract against a respected index, or, less likely currently, a deliverable contract.

But while freeing up the way LNG is bought and sold would be positive for the development of the market, it doesn't necessarily follow that LNG can quickly come to mimic the crude market.

LNG IS DIFFERENT
LNG, while homogenous, has significant problems when it comes to extended transportation and storage.

LNG boils off, or evaporates, at all stages of its transport, storage and re-gasification and the longer it is in any of these processes, the more that will be lost.

This simply isn't the case with oil, which can be stored for long periods of time and its ability to move vast distances between continents is only limited by the economics of shipping costs.

LNG boils off at about 0.1 to 0.15 percent per day while being transported by ship, and at a lower rate while being stored in tanks.

So even a typical 20-day voyage from Australia to Japan could result in about 3 percent of the cargo being lost.

A much longer journey, for example from the U.S. Gulf coast to China around the Cape of Good Hope, would see a greater loss.

This means that even in a market free of destination clauses and restrictive pricing, LNG will find it harder than crude to move freely around the world.

LNG is also unlikely to be stored for long periods, meaning that contango plays or other trading strategies common to oil aren't feasible for LNG.

The assumption that a more liquid spot LNG market will drive demand-growth is also worth looking at.

LNG demand-growth appears to have peaked in the world's top consumer, Japan, and may even be in structural decline as nuclear power comes back online and coal generation is increased because it is still cheaper than natural gas.

LNG imports into China have disappointed, falling 1 percent in 2015, although they have grown 14.3 percent in the first two months of this year over the same period last year.

But whether China will ever reach an annual LNG demand of about 60 million tonnes, roughly three times its current level, is highly debateable now, even though a couple of years back a forecast like that would have been uncontroversial.

There are positive demand signs elsewhere in Asia, with India a market that can experience growth, assuming prices remain low, as well as the emergence of several other LNG importers such as the Philippines.

But in an environment like the present situation in Asia, where demand growth for LNG is far from assured, a case can still be made for LNG producers to move downstream if they want to develop markets to justify future projects.

After all, Saudi Arabia has long followed this model for oil, developing refineries in customer markets and at home, and is once again considering this path in China.

Virtually every major international oil company owns downstream operations such as refineries and service stations, and in countries like Australia the margins on goods like milk and candy sold at service stations exceed those for the fuel.

The oil industry shows that vertical integration can and does work alongside a robust spot market, and the LNG industry would be doing itself a disservice if it didn't look at every avenue of increasing demand for its product.

By Clyde Russell