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LNG’s European core

LNG Industry,

This article is from the May/June issue of LNG Industry, subscribers can login here to view the full article. To subscribe to LNG Industry click here.

The global LNG market is entering a period of rapid evolution. Market growth is being driven by a structural shift towards natural gas as a cleaner fuel, as well as an increase in gas import dependence in Asia and Europe. In order to meet this increase in demand, global liquefaction capacity may need to double by 2030, requiring an estimated US$ 1 trillion of new investment. At the same time, pronounced inter-regional price differentials and improvements in gas hub liquidity have been a catalyst for LNG contract re-negotiation and growth in the shorter term trading of cargoes.

Europe will play a central role in shaping this growth phase in the LNG market. In turn, LNG pricing and flows are becoming increasingly important drivers of the European gas market. European gas suppliers are diversifying portfolios of pipeline gas supply to include contracted LNG and access to regasification capacity. As a result, LNG has become a key source of incremental supply into European gas portfolios. LNG import volumes are still low relative to pipeline imports, but they have a disproportionate influence on marginal pricing at European gas hubs.

However, Europe cannot be considered in isolation. In order to understand European LNG dynamics it is important to take a step back and consider Europe in a global gas market context.

European interaction with the global gas market

The global LNG market is still in a stage of relative infancy. Only about 10% of global gas consumption is currently satisfied by LNG, and only a relatively small volume of LNG supply has the contractual flexibility to respond optimally to price dynamics. The constraints around supply flexibility are reflected in the current regional price divergence across Asia (tight market post Fukushima), Europe (broadly tracking oil-indexed contract supply) and the US (awash with unconventional domestic gas production).

Only a decade ago the European gas market existed in relative isolation. But growth in LNG flows and price arbitrage have connected Europe with the gas markets of the US and Asia. At the same time, the divergence of European gas hub prices below oil-indexed contract prices has caused the rapid development of hub liquidity and market price signals. These factors have resulted in gas hub pricing becoming the key driver of commercial decision making across European gas portfolios. This is despite the fact that the majority of gas is still sourced via long-term oil-indexed supply contracts.

Europe lies in close proximity to the key producers in the Middle East and Africa, so it is an attractive destination for LNG sales, given relatively low transport costs. The supply of LNG into Europe is also relatively flexible compared to Asian supply. Location and supply flexibility mean that Europe plays an important role in influencing the marginal pricing of LNG. Liquidity at traded hubs, such as the UK NBP and Dutch TTF, provide key price signals to the global gas market.

For the time being, US gas prices are in a world of their own as robust domestic shale gas production flows into the HH spot market. However, US and European gas prices are re-converging on a forward basis, in anticipation of the ramp up of US LNG exports from the middle of this decade and the potential for US production costs to rise.

Europe’s role in LNG spot and contract markets

LNG delivered to Europe is predominantly sourced under long-term oil-indexed contracts. Contract terms vary by delivery location and seller, but typically feature indexation to either a basket of oil products or crude. Hub indexed contracts have become increasingly common in North West Europe as hub prices have fallen below oil-indexed contract prices and hub liquidity has developed. To date, hub contract indexation has been focused on the UK NBP, but US HH is becoming more important, given that it is the basis for US export contract pricing (as set out in the previous case study).

While long-term oil-indexed contracts still dominate the LNG market, there has been a sharp increase in LNG spot market trading volumes over the last five years.

The spot market for LNG may still be small relative to the contract market, but it is important because prices at the margin drive the behaviour of flexible LNG flows. The interaction between the LNG spot market and the European gas market is well illustrated by the price dynamics over the period from summer 2012 to winter 2013.

Price behaviour over this period illustrates the inelasticity of spot LNG supply. The resulting spot price volatility is caused by a limited volume of flexible cargoes available to respond to spot price signals. Volatility is exacerbated by significant shorter term swings in demand from large buyers with lower levels of contract cover such as China, India, Brazil and Argentina.

The interaction between European gas hub pricing and the spot LNG market can be seen over summer 2012 as European hubs provided a ‘soft floor’ for surplus LNG cargoes in the LNG spot market. At the point that a flexible exporter, such as Qatar, can get a better netback price at European hubs than in Asia, spot LNG flows back into Europe, alleviating downward price pressure. In turn, Asian or South American buyers need to pay a price premium above NBP, plus the relevant transport differential, to attract cargoes away from Europe.

The prospect of having to compete for LNG with Asia and South American buyers is a key concern for European gas suppliers. A gas price squeeze, e.g. from a cold winter or supply disruptions, may drive gas hub prices and volatility sharply higher. This happened in March 2013, where UK NBP prices spiked as LNG became the marginal source of supply.

The business impact of LNG market evolution

Europe is set to play a core role in the evolution of the LNG market as an important incremental source of demand. European hub price signals will also be increasingly important in driving the pricing dynamics and flow of LNG. This environment presents two clear commercial and analytical challenges for businesses with a European LNG market exposure.

The first challenge is to understand the evolution of the dynamics of LNG pricing. The second challenge is understanding how LNG asset value, e.g. a supply contract or re-gas capacity, interacts with the value of other assets in a gas portfolio. These challenges are exacerbated by the scale and pace of change in the LNG market. This has been well illustrated by the events of the last five years, with a progression from commodity supercycle, to gas supply glut, to a post Fukushima world. With little new liquefaction capacity coming online before 2015, demand dynamics are likely to shape the next phase of LNG market evolution. These conditions do not lend themselves to making commercial decisions on the back of LNG market forecasts.

Authors: David Stokes and Oliver Spinks, Timera Energy, UK

This article is from the May/June issue of LNG Industry, subscribers can login here to view the full article. To subscribe to LNG Industry click here.

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