The pricing of LNG (Liquefied Natural Gas) contracts reflects the fact that one million British thermal units (MMBtu) of natural gas contains one-sixth (16.67%) of the energy content of an oil barrel, a relationship which is referred to as oil parity. Traditionally, the natural gas trades are dominated by long-established market structures, under which, the LNG has remained indexed, based on the price of crude oil. Now Increasing number of buyers are signing full or partial short-term contracts linked to LNG price indices.
These shifts in the market have come-amid wider changes in the LNG industry. Apart from the large energy groups, such as Shell and Exxon, the independent energy traders are entering the sector, agreeing on relatively short-term deals with new pricing mechanisms. The short-term trades have risen as LNG supply has grown with the launch of new LNG plants, which chill and condense gas, so it can be shipped on tankers overseas.
Energy saving practices and the restart of nuclear plants in certain sections of world (In particular Japan, world’s largest importer), led to a fall in LNG consumption over recent years forcing utilities into traders to resell some long-term supplies. Bulk of long-term contracts due for expiry in next few years, are likely to be replaced with more diverse maturities and flexibility on a destination. Trading volumes of LNG derivatives linked to the benchmark have soared, as more LNG dealers and companies look to hedge their short-term agreements. Spot and short-term trade in 2016 rose 9 per cent to 74.6m tons from the previous year, accounting for 28 per cent of all LNG trades (as per International Group of Liquefied Natural Gas Importers). Volumes in recent monthly contracts cleared through ICE linked to the spot LNG index marker, are reaching a new monthly high, such that after more than quadrupling in 2016, volumes in 2017 overtook that of the previous year in the first five months of the year.
Despite the rise in trading liquidity, the LNG derivatives market is still a small portion of the whole physical market. As more traders are also taking proprietary positions, adding depth and liquidity to the market, LNG markets are witnessing an increased use of futures and derivatives, just like the oil market, where the value of futures contracts is multiple times of value of physical contracts. The natural gas market shift, from long term to short term and physical to financial trades, is bringing a fundamental shift in hedging strategies, which is interesting to watch for.