LNG Producers Face Unwanted Quandary

Global producers of liquefied natural gas (LNGLF) (LNG) are facing a choice they probably didn't anticipate or want, but their response will likely shape the future of their industry.

The dilemma facing producers is how do they respond to the moves by buyers to effectively scrap the pricing model that has underpinned the development of LNG for the past five decades.

There appear to be increasing moves by major buyers, particularly in Asia, to end long-term, oil-linked price contracts that also feature restrictive destination clauses.

What buyers in countries like Japan, India and China have realised is that global oil companies have bet heavily on LNG and have built new plants in excess of even the most optimistic forecasts of likely demand for the next few years.

The buyers see this as an historic opportunity to not only lower their cost of supply, but also to introduce flexibility into a market that has largely been rigid and dominated by producers.

Japan, the world's top buyer of the super-chilled fuel, is investigating whether destination clauses in LNG contracts are uncompetitive, Bloomberg News reported on July 14, citing unidentified sources.

The investigation by the Japan Fair Trade Commission may be completed by the end of the year, the report said.

If the Japanese government does take action to end destination clauses, it would allow Japanese utilities to offload excess cargoes, given that many have likely overbought LNG, especially given the resurgence of coal-fired power and the possible restart of Japan's nuclear reactors.

India, the fourth-largest LNG importer in Asia, is already taking steps to re-negotiate LNG contracts, with major buyer GAIL India in talks with Russia's Gazprom to delay and re-work a 20-year contract due to start in the 2018-19 financial year, Reuters reported on July 25, citing sources familiar with the matter.

India has also renegotiated a long-term supply deal with Qatar's Rasgas, nearly halving the price, and industry sources say the South Asian nation's biggest LNG importer, Petronet , is also seeking to renegotiate a costly import deal with ExxonMobil for supply from the Gorgon project in Australia. ExxonMobil holds a 25 percent stake in the Chevron (CVX)-operated development.

Buyers in China, Asia's third-biggest LNG importer, are also seeking to renegotiate contracts in order to lower prices and boost flexibility.

DEATH OF THE HOLY TRINITY
The picture that emerges is that momentum is building to end what Deloittte oil and gas director Geoffrey Cann calls the "holy trinity" of the LNG industry, contracts that are long-term, indexed to crude oil prices and prevent re-selling by purchasers.

The question then becomes how do companies like Chevron and Royal Dutch Shell (RYDAF) react to this changing circumstance and protect the tens of billions of dollars invested in building eight new projects in Australia, five in the United States and various others around the globe?

Up until now the companies have largely been focused on successfully building and commissioning the plants.

The eight new LNG projects in Australia were underpinned by long-term contracts, which gave their developers a certain comfort about the return on investment, even as spot Asian LNG <LNG-AS> prices collapsed by about 72 percent from their peak in February 2014 to $5.80 per million British thermal units (mmBtu) in the week to Aug. 5.

But these contracts are the ones now under threat, not only from buyer actions but also from U.S. LNG shipments, which are more generally flexible and priced off U.S. natural gas prices and not crude oil.

The companies can either fight against the changes and try to keep the existing pricing system intact, or they can embrace the changes and try other avenues to compensate for what will likely be lower prices in the short to medium term.

While producers will no doubt be tempted to try and keep what's left of their lucrative contracts, past history with other commodities would suggest this will largely be a futile and quite possibly self-defeating exercise.

Rather, they should concentrate on expanding the market for LNG as fast as they can in order to soak up the current excess supply.

Given that new LNG projects are finding it increasingly hard to get final investment approval because the current low prices cannot justify the massive up front costs, it would seem only a matter of time before the boot moves back to the feet of the producers.

Right now they have to suck up lower prices, largely because the industry as a whole has over-invested in recent years.

This is the price that companies pay for trying to build eight projects simultaneously in Australia, an exercise that merely served to push up costs while adding to the looming glut of the fuel.

But if the industry can weather low prices for the next few years, while at the same time boosting demand among new users, it will be handsomely rewarded for embracing flexibility now.

Assuming demand growth will eventually outrun available supply, producers will benefit from sharply rising prices as spot markets tighten.

Just as long-term contract prices haven't fallen as far as spot prices in the current downturn, it's unlikely they would rise as much once the cycle turns.

The problem for company executives, especially at publicly-traded energy majors, is that they seldom get enough time to implement a change in strategy, especially if it comes at the expense of short-term profits.

But if the LNG producers were able to invest in developing new markets, along trading hubs and storage facilities, it's likely a more liquid and sophisticated market would benefit them in the long term.

By Clyde Russell