- spot and term, Australian supply and Asian demand: indelible links in the LNG market
- LNG term contracts used to be linked to crude oil prices since indexation began as a credible LNG benchmark didn’t exist
- while spot LNG prices fully reflect the fundamentals of LNG markets, crude-linked term contract prices cannot keep up with LNG market fundamentals
- a major concern with crude-linked term contract prices is the broken feedback loop between price and LNG fundamentals
As the LNG market matures, the commodity’s spot price has emerged as the driving force behind prices of all contract types, including long-term contracts. To delve into how today’s perception of LNG markets was formed, it is worth looking at the history of LNG trading. Here’s an article sourced from SP Global.
Pricing basis of term contracts
When LNG started shipping to Japan more than half a century ago, it was a point-to-point shipment system that was essentially a rigid long-term energy security arrangement. Between then and now, the most profound changes are on the pricing basis of term contracts, including from fixed price to indexation.
Contracts linked to oil prices
LNG term contracts used to be linked to crude oil prices since indexation began as a credible LNG benchmark didn’t exist. The benefit of the linkage was evident—buyers and sellers needed a central ground to price their LNG cargoes, and a relatively transparent and well-established price that would not cease to exist in the duration of their LNG contract seemed to be the most appropriate choice.
Own pricing dynamics
LNG trade has since evolved to resemble the modern-day oil trade, where suppliers source cargoes from multiple production points for delivery to multiple buyers. Ironically, through this practice, LNG has developed its own price formation process and its own pricing dynamics that are quite distinct from oil.
Liquid spot market
The market has also reached a point where production and pre-determined demand no longer match perfectly. Some projects are built without 100% matching offtake agreements. Furthermore, when the market enters a period of contract renewal at legacy projects, new contracts are being signed with smaller volumes and shorter tenors. These factors have contributed to the creation of a liquid spot market where producers and end-users connect and resolve supply and demand imbalances.
Spot LNG prices
While spot LNG prices fully reflect the fundamentals of LNG markets, including the portion covered by term contracts, crude-linked term contract prices cannot keep up with LNG market fundamentals. This was not an issue when LNG flows were mostly point-to-point, but it has become problematic as the LNG market continued to develop into an increasingly functional market of its own.
Broken feedback loop
A major concern with crude-linked term contract prices is the broken feedback loop between price and LNG fundamentals. For example, higher crude oil prices encourage LNG producers to produce more, regardless of LNG demand. In this case, an oversupply in the LNG market would fail to affect LNG term contracts linked to crude oil pricing, meaning LNG producers remain indifferent towards such the supply situation, exacerbating the imbalance.
Conclusion
It was exactly this distinctive feature of non-market pricing in the LNG market that contributed to both the oversupply of LNG in 2020, resulting in record-low spot LNG prices, and the tight market seen in most of 2021, resulting in some of the highest spot LNG prices in history.
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Source: SP Global
