Japan s LNG Prices Trending Upwards

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1 Japan s LNG Prices Trending Upwards David Wood David Wood & Associates, Lincoln UK Published in Energy Tribune December 2007 Japan is the world's largest LNG consumer and imported bcm of natural gas as LNG in 2006 (BP Statistical Review, June 2007). This was 2.4 times the quantity imported by South Korea, the second largest LNG importer, and 4.9 times the quantity imported by USA, the fourth largest LNG importer. The world's demand for LNG during the first half of 2007 is estimated at some 115 bcm, which equates to close to a 9% growth on first half of 2006 demand. Deliveries into the East Asia market grew substantially above that rate and continue to do so. Higher prices pulled short-term LNG cargoes into the US from Europe in first half 2007, with more than 12 bcm delivered into the US market. This was the reverse of the situation in first half 2006 when Europe drew the majority of short-term cargoes away from the US. However, the ability of the US to secure short-term LNG cargoes was short-lived as Japan and the East Asian markets have cornered the short-term LNG supply since mid The fickleness of the short-term LNG cargoes in terms of destination is testament to the flexibility of the growing LNG market as more infrastructure and supply capacity becomes available (e.g. new liquefaction capacity has become available in Equatorial Guinea, Qatar and Norway in 2007 and further capacity from Nigeria, Australia, Russia and Yemen is under construction for commissioning in the next two years). However, it was the earthquake in July 2007 leading to the shutdown of Tokyo Electric's 8.2GW Kashiwazaki-Kariwa nuclear complex that pushed Japan s demand for LNG suddenly higher and increased their willingness to outbid US short-term gas prices. Japanese utilities increased their LNG imports dramatically in August to October 2007 taking cargoes from most Atlantic Basin LNG suppliers and paying $2.5/mmbtu more than prevailing Henry Hub prices for delivered cargoes. Notably several of the initial cargoes exported from Equatorial Guinea LNG by BG under its FOB purchase contract have been diverted to the East Asian market. If demand for LNG from Asia and Japan remains strong, and US and EU winters are harsher than average, Japan can be expected to pay in excess of $13/delivered mmbtu in first quarter These recent events in Japan have made the current global LNG market tighter and more competitive than previously expected. LNG spot sales (short-term deals or the sale of one cargo) remain only a minor part of the global LNG market (less than 15%). Nevertheless, it is a lucrative one for those with the flexibility in cargoes, contracts and access to infrastructure to exploit it (e.g. BG Equatorial Guinea). The high short-term LNG prices being paid recently by Japan do not reflect the average LNG prices that Japan has become accustomed to over recent years. In contrast to the US, much of the global LNG market is underpinned by long-term sales contracts, which are needed to secure commitments to build the

2 expensive supply chain infrastructure. The dominance of long-term contracts in which LNG prices are not indexed solely to crude oil prices (e.g. France and Spain) or involve formulas to dampen the impact of oil price increases (e.g. Japan) have helped to secure lower and more stable LNG prices in those countries in the 2005 to 2007 (Figure 1). In contrast, Henry Hub price volatility is reflected in US LNG prices. Figure 1. Average prices (short-term and long-term) paid for LNG in seven important LNG markets in selected months from July 2005 to August However, the relative stability of Japan s LNG prices in recent years may not be sustainable for much longer. The sudden increase in Japan s gas demand coincides with a period of unprecedented high oil prices and a time when several of Japan s long and medium-term LNG supply contracts are coming up for renewal / price renegotiation. The S-curve price formula that prevailed in Japan s last major round of term LNG contract negotiations in 2001 has been successful protecting it to a large extent from the rapid rise in oil prices over the past four years. Indeed LNG prices imported to Japan have remained significantly lower than crude oil (i.e. some 35% lower) on an energy equivalence basis However, suppliers will be wary over renewing supplies on such a formula unless the coefficients are adjusted to secure higher gas prices as and when oil prices increase. The S-curve mechanism is worthy of some consideration as with modifications it should continue to provide Japan with the opportunity to maintain LNG prices and spark spreads competitive with those of other power generation fuels (i.e. coal, oil products and nuclear). The primary objective of the "S-curve" mechanism is to limit the impact on LNG prices of extreme oil price fluctuations. It has certainly been tried and tested in this regard in the past seven years. The formula is generically defined as P $/mmbtu CIF Japan = AX + B + S Where: A, B are constant coefficients

3 X is the crude oil (Japanese Crude Cocktail JCC) CIF price S coefficient or curve is added to the price formula to further flatten or dampen the price curve only when the JCC price, which historically has averaged WTI price less about $1/barrel, lies above or below a preset price range, which in 2001 contracts spanned the range of $15 and $ 35 / barrel. Applying the S-formula established in 2001, term LNG prices change linearly in proportion with crude oil prices in preset price ranges approximately $20/barrel to $40/barrel. That preset range seemed likely to cover all upside oil price eventualities at the time they were negotiated in If the price of crude oil rises or falls outside that preset range, then the rise or fall in LNG prices is further dampened by the additional S coefficient which then becomes effective providing transitional floor and ceiling LNG prices (Figure 2). Figure 2. Changing market conditions are likely to lead to a dilution of the S-curve LNG price formula that has helped to stabilize LNG prices in Japan under some longterm contracts since Relating to the 2001 agreements the price of Qatar LNG sold to Japan was reported to involve a floor price of $3.60/mmbtu CIF-Japan (some $2.50/mmbtu FOB-Ras Laffan) and for the preset price range the A coefficient of the formula was The values of the B and S coefficients and the exact limits of the preset price range have, to the author s knowledge, not been disclosed. In 2003 China and India managed to secure term LNG contracts on similar formula arrangements with a much lower value of A but no S term. Such contracts lead to a lower, flatter and more stable price relationship than Japan s S-curve formula. At the JCC price of $20 / barrel the Guangdong price formula was reported at $3.1/mmbtu CIF, which represents a 20% discount to Japan s price formula. In some of the recently renewed term contracts with Australian suppliers, in order to secure supply, Japanese buyers have had to accept LNG prices linked to crude oil prices on an energy equivalent basis without the dampening effects of the S coefficient. The impact of such changes are likely to result in the average LNG price

4 delivered to Japan will be within 20% of crude oil price on an energy equivalent basis beyond Japan's import prices paid for LNG cargoes, both long-term and shortterm, can therefore be expected to become more volatile in response to oil price movements beyond 2008 (figure 2). Tightness in prevailing global LNG supplies as illustrated by recent short-term LNG cargo redirections, has provided LNG producers the upper hand in recent price negotiations. This is quite different from the prevailing situation in 2001 to 2003 when buyers had the advantage and it was possible to negotiate low prices with gentle indexation formulas (e.g. Guangdong, China, involving supply from NWS Australia). The markets may yet turn again in that direction. Conclusions The majority of global LNG trade is likely to remain based on long-term contracts in the Asian market linked to JCC (and other appropriate benchmark crudes), although on substantially diluted S-curve pricing formula. However, as Asian supply becomes yet more diversified (e.g. the addition of Russia s Sakhalin LNG in 2008, Indonesia s Tangguh in 2009 and new NWS LNG projects in Australia from 2010) together with the opening of LNG import markets along the West Coast of North America (Mexico and US) with the commissioning of the Costa Azul receiving terminal in Baja California in 2009, Japan s LNG pricing is likely to be even more influenced by short-term LNG trades linked to US gas price movements. During periods of high global LNG demand and rising prices, markets should expect LNG cargoes to be diverted to the countries that are most willing to pay the highest prices. More flexible global spot LNG trading could see strong competition between East Asia and US to secure cargoes in the future, which may lead to gas price spikes in both regions from time to time. US gas importers remain reluctant to secure substantial volumes of LNG under long-term contracts, except for some volumes from Nigeria and Trinidad and Tobago. In the future to stabilize prices, and to compete effectively with Japan and other East Asian markets for cargoes, the US may be forced to do so. A number of other factors, over and above the availability and price of short-term LNG cargoes, should also influence East Asian long-run gas and LNG prices: Nuclear and coal contributions to the primary energy mix for power generation Restrictions on gas flaring promoting utilization of stranded associated gas Legislation to restrict carbon and greenhouse gas emissions Competition induced by deregulation, unbundling of infrastructure and more extensive third party access to liberalized markets Investment in new gas supply chain infrastructure, both LNG and pipelines (e.g. Russia to China and Korea) The impact of these factors also influence the ability of the US to attract a greater share of available short-term LNG cargoes.

5 About The Author David Wood is an international energy consultant specializing in the integration of technical, economic, risk and strategic information to aid portfolio evaluation and management decisions. He holds a PhD from Imperial College, London. Research and training concerning a wide range of energy related topics, including project contracts, economics, gas / LNG / GTL, portfolio and risk analysis are key parts of his work. He is based in Lincoln, UK and operates worldwide. Please visit his web site or contact him by at dw@dwasolutions.com