The last nail in the LNG oil-indexation coffin?

Ryan Pereira's picture
Ryan Pereira, Principal Commercial Manager - Global Gas and LNG, Gaffney Cline & Associates
Nicholas Fulford's picture
Nicholas Fulford, Global Head of Gas and LNG, Gaffney Cline & Associates
Comments: 0

It has been a long time coming, but natural gas is finally emerging from beneath the shadow of its big brother, crude oil.  While some of the more traditional participants in the LNG space may still be hanging on to the idea that oil indexation for gas is still a viable way to price it, increasingly their gas marketing attempts are looking like King Canute’s doomed struggle to keep the tide from coming in.

1970s and 1980s: Evolution sparking a revolution? The way in which global gas pricing has evolved can be traced back to the North American reforms of the 1970s and 80s, and the emergence of a wholesale market in natural gas.  The principles governing that market were nothing more than what it cost to drill and produce the gas, and the tariffs in the complex array of pipelines connecting all the major centres of demand. 

While Henry Hub, at the epicentre of that early gas network, became synonymous with US wholesale gas prices, and AECO provided the Canadian equivalent, a thriving market developed at dozens of other hubs around the continent, and it became easy to connect buyers, sellers, and increasingly, gas traders. 

As financial risk became more complex, so a financial market developed alongside the physical market.  As the derivative market became more sophisticated, so the churn rate, the measure of how many times that same therm of gas is bought and sold, started to increase, and the liquid, actively traded market that exists today gradually took shape.

1990s: Reforms laid the foundation for new norms? The reforms in Britain in the mid-1990s heralded the next major price discovery process, whose beginnings can be found in the competition inquiries that forced the unbundling of British Gas’ National Transmission System.  A rapid growth in the number of wholesale players using the system, and an array of complex balancing and cash-out mechanisms, created incentives for the shippers to trade with one another.  Thus the National Balancing Point (NBP) was born, and Europe had its first wholesale price index for gas.

Even then, many of the more traditional players said it would not amount to anything.  How can you finance a North Sea gas development without long-term oil-indexed contracts, they asked?  The answer, of course, was in the same way lenders became comfortable with Henry Hub in the US, they gradually adapted to NBP too, and North Sea developments continued to be financed, without so much as a hiccup.

2000s: Innovation created transformation? With the success of the wholesale market in the UK, the EU adapted the UK’s Network Code and little by little, after three increasingly far-reaching energy directives, Continental gas (and power) markets gradually opened to competition, and as in Britain, gas shippers started to trade first physical gas, and traders stepped in to help them manage risk.

Between 2005 and 2015 we have witnessed a complete reversal of Europe’s 80/20 favouring of oil-indexed contracts, to a similar ratio based on gas-on-gas indices, such as NBP or the Netherlands’ Title Transfer Facility (TTF).  The transformation has not been without some major casualties, with a series of price arbitrations resulting in billions of dollars of value transfer, typically in favour of the customer. 

2020s:  Asian gas price invasion? And so it is in Asia today.  With all the largest gas markets in Asia undergoing some form of unbundling, battle lines are being drawn between the traditional gas and power utilities (many of which are encumbered with long-term inflexible LNG supplies), and emerging gas and power providers (with no such constraints, buying gas short term from the lowest cost source).  In the US, Canada, Britain and Continental Europe, history has shown us that oil indexation does not survive the transition to a competitive market.  It may take a few more years, but Asia’s days as the last bastion of oil-indexed gas must surely be numbered.

Surprise, or just that we looked at it with closed eyes? This movement away from one commodity (gas) priced on the fundamentals of another (oil) should not come as a surprise to anyone, in the sense that as the economics of the gas value chain are so fundamentally different from those of oil, the price will follow a very different trend.  The surprise has been how so few saw it coming, especially those gas producers who failed to notice that their customers were faced with choices.

Register now to attend the Gastech Exhibition and Conference taking place 17-20 September in Barcelona to hear key industry experts discuss the evolving dynamics of contracting, pricing and trading of gas and LNG. 

Image courtesy of Gaffney Cline & Associates