Where will a global LNG price reference emerge?

Lucas Schmitt's picture
Lucas Schmitt, Senior Analyst, EMEARC Gas & LNG, Wood Mackenzie
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The path to establishing an LNG hub is a long one. It has taken more than a decade to build gas hubs in the US and Europe that are liquid enough to generate industry-trusted price discovery for physical and financial transactions. While the amount of pure spot LNG trading is still thin, market conditions are starting to look favourable for greater liquidity. Short-term LNG trade (i.e. up to four years) is close to 30% of global LNG trade. New supply is emerging, with portfolio players having large uncontracted flexible volumes, particularly from the US. Traders are stepping up their game, bringing short-term experience from other highly-traded commodities.

The majority of short-term deals are still done on an oil-indexed basis, with indexations reflecting market conditions. But increasingly, other price indices are gaining momentum, including JKM (a Japan/South Korea price marker published by Platts) European spot prices and a US FOB price. Which of these have the best chance to develop further and become a truly global LNG price reference?

Liquid European gas hubs provide liquidity to LNG trading: With transportation differentials increasingly driving Asia-Europe price spreads, Atlantic traders are using European gas hubs' liquidity and financial instruments to trade arbitrage opportunities between Atlantic and Pacific basins. Effectively, this establishes Europe as a global benchmark for LNG spot prices. Portfolio players and Asian buyers building European positions (through regas capacity, put options and swaps) only reinforces this further.

However, LNG imports to Europe represent less than 20% of global LNG volumes. While shipping differentials provide indications of Pacific basin tightness, local market imbalances remain the driver of price formation in Asia – something that European spot prices fail to capture. Recently, several exchanges have started offering JKM swaps, with transactions increasing exponentially over the last year. Nevertheless, JKM swap liquidity remains small compared to other global or regional energy hub benchmarks. Many question the underlying JKM price movements, as it is based mainly on daily bid-ask spreads, rather than daily trades. What it lacks is a physical market reference for daily liquidity – a physical Asia gas hub.

Can China establish itself as a global LNG hub? Developing a physical hub is complex. It requires government support, market liberalisation, access to infrastructure, many market participants and confidence in transparent price formation. This includes gas-to-gas/LNG competition and demand side responses such as coal/oil switching capabilities with gas.

Japan, the biggest LNG market globally, is pivotal for global LNG price formation. But until now it has failed to develop a domestic framework. Liberalisation is providing momentum for competition, but so far only at the retail level, with limited third-party access to infrastructure to facilitate wholesale gas price competition or fuel competition within local power producers.

China, however, will have a better chance. It is already the largest gas market in Asia and is likely to become the world's largest LNG importer by 2025. Inter-fuel competition in power could gradually establish price floors and ceilings. More importantly, China will also bring pipeline gas-to-LNG competition – something missing elsewhere in Asia. As it develops new domestic pipeline and storage infrastructure, gas will more freely be transported through the country. If market liberalisation proposals are implemented, they will enable more transparent access to infrastructure, boosting the number of players and enabling regional price formation.

All of this will take time to develop, but as and when it does, China will establish itself as the Asia gas hub. It is likely also to be the most prominent LNG hub globally.

Watch out for a US Gulf Coast FOB index to emerge first: For now, though, it is the US Gulf Coast that is emerging as the most important LNG trading point. Unlike European hubs and JKM, it is a supply hub. But it is characterised by growing liquidity and fungibility and is traded in relation to Henry Hub, the most liquid gas hub globally. Exchange-traded instruments recently announced from both the Intercontinental Exchange Inc. (ICE) and Chicago Mercantile Exchange (CME) will facilitate price discovery. It could soon become what the Newcastle FOB price is to the global thermal coal market.

US exports are currently averaging one cargo per day. This could rise to four per day within the next five years, more than 90% of which will be produced in the Gulf Coast. There are many sellers – some 20 or so foundation customers across the four Gulf Coast terminals. Some volumes have already been sold to third parties under long-term contracts, and in other cases are mainly intended for specific markets. But these 'committed' volumes are a small proportion of the total. The rest is fully flexible, de facto spot LNG.

Gulf Coast LNG will be liquid and fungible. The close proximity of the four big terminals in the Gulf Coast means they are practically equidistant to world markets. They are all of the same construction vintages and will all source feedgas from the US grid. From a gas quality standpoint, LNG cargoes from these facilities will be interchangeable.

Flexible volumes are currently being sold in various ways, through short-term tenders as well as intermediaries. By 2020 US LNG will account for a fifth of global LNG trade (with most of that spot traded volumes) and competition to secure spot LNG cargoes will intensify, with traders coalescing around a Gulf Coast FOB price. Increasingly, it will interpret the sentiment of the global LNG market, establishing itself as a global LNG hub.

The LNG market will need to establish globally-trusted LNG hubs to develop as a proper global commodity. Currently, European gas hubs provide liquidity to LNG trading. But the European LNG market remains small compared to Asia and fails to represent the sentiment of the global LNG market. A US Gulf Coast FOB hub is poised to become a global LNG hub post-2020, as exports increase and US LNG provides an unprecedented amount of spot trading availability. JKM swaps are also gaining momentum and might well become a pure paper plus financial price hub. But as and when China develops a domestic traded gas hub, it is likely to be the most prominent LNG hub globally.

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Image courtesy of Wood Mackenzie