LNG price sensitivity

04/25/2016 http://www.ogfj.com/articles/print/volume-13/issue-4/features/lng-price-sensitivity.html?eid=318365972&bid=1403842

OIL-LINKED CONTRACTS AND PROXIMITY OF LNG

EXPORT FACILITIES TO THE HENRY HUB IMPACT
ARBITRAGE OPPORTUNITIES
VIKRAM ENJAM, UNIVERSITY OF HOUSTON BAUER COLLEGE OF BUSINESS,
HOUSTON

AMERICANS, ESPECIALLY those involved in the energy industry, will be hearing and
reading a lot about LNG in the coming years. Demand for liquefied natural gas (LNG) is
projected to grow at a 6% compounded annual rate until 2025.

LNG projects are usually built by obtaining project financing. Lenders require long-term
contracts (SPAs) from creditworthy gas buyers to ensure that project revenues will be
sufficient to repay the debt obligation.

Pricing of LNG in 20-year, long-term contracts has always been linked to an energy
index or group of indices, based on the geographic location of the LNG buyer. As the
index price changes, LNG price changes correspondingly.

US LNG liquefaction projects are offering Henry Hub-linked LNG pricing, which is a
relatively new pricing index for buyers. This article is written to suggest an optimal LNG
pricing index to Asian buyers between Henry Hub and the oil index, as Asian buyers
traditionally had LNG purchases linked to the oil index. Pricing mechanisms associated
with Asian buyers are prominent, as Asian countries are the world's largest importers of
LNG.

CHALLENGES FOR PROJECT DEVELOPERS

The recovery of extensive shale gas reserves through horizontal drilling and hydraulic
fracturing has enabled the United States to transition from an importer of natural gas to
an exporter of the product. Coupled with abundant gas resources, the US possesses
robust pipeline connectivity and transparent natural gas hubs ("gas-on-gas"
competition). In addition, proposed US LNG projects have the lowest dollar-per ton
($/TON) capex costs compared to Australian, Canadian, or any other green field
projects that are in development. Several existing LNG import terminals are being
converted to LNG export facilities, where capex costs are much lower due to existing
infrastructure.

About 21.6 MTPA (million tonnes per annum) of US LNG volumes is contracted as
"unspecified." These volumes are purchased by portfolio LNG players such as GDF Suez,
BP, Total, and Gas Natural - and not by end users. This 21.6 MTPA is additional supply
that is available in the market to meet demand from utility companies.

Per Table 1, there is about 70 MTPA of LNG readily available for the buyers from
projects that are either in operation or in the post final investment decision (FID) stage.
These unsold volumes will be a competition to new US LNG project developments that
are in the early stages.
Most LNG buyers are usually inclined towards the supply that is already available in the
market rather than signing a 20-year gas commitment agreement in hopes that the LNG
project sells all of the remaining volumes, achieves project financing, and eventually
FID. These steps are time consuming with challenges associated across each step. LNG
that is available in spot markets will also continue be an attractive option for the buyers
due to the prevailing low oil price environment.

The US may become one of the world's largest producers of LNG by 2025 even if only a
quarter of the proposed capacity gets built. It is evident that project developers need to
develop projects at low costs and offer competitive and flexible gas supply contracts
due to prevailing the buyer's market and peer project competition.

NATURAL GAS PRICES

Unlike crude oil, there are no worldwide uniform gas prices. In high oil price
environments, there could be more than two-fold difference in the price that domestic
consumers in US pay for gas compared to consumers in Asia. Table 2 (Historic
Worldwide LNG Prices) illustrates the impacts and correlation of historical LNG prices
due to falling oil prices. The LNG prices shown in Table 2 are not from LNG shipped
from the US as US LNG liquefaction plants were not operational in 2015 and earlier.
Japan and Korea have most of their LNG contracts linked to the price of oil. Therefore,
as oil prices declined, LNG prices decreased proportionately. The table demonstrates
the linkage to oil prices within these countries:

% Reduction in Nat Gas Price in USA (Jan'13-Oct'15)-33%

% Reduction in Oil Price (Jan'13-Oct'15)-57%
% Reduction in LNG Price Japan (Jan'13-Oct'15)-56%
OIL PRICE-LINKED LNG
Asian LNG contracts are linked to the crude oil price index. Japan, the world's largest
LNG importer, uses contracts with a formula linked to the Japanese Customs Cleared
Price for crude oil and referred to as JCC (Japanese Crude Cocktail). With few
exceptions, a similar structure is used in other Asian markets such as South Korea,
China, and Taiwan. The LNG pricing formula for oil-linked LNG contracts is as follows:

P= C + βX+ S
P is the LNG price ($/MMBtu)
C is the base price ($/MMBtu)
β is the price slope
X is the Oil Price index (JCC in Japan)
S is the Shipment Charges

Asian oil-linked contracts consist of "S-Curves" within the contract structures, and within
the S-Curve, LNG buyers prefer a flatter slope at high oil prices while project developers
prefer a flatter slope at low oil price environments to ensure that project economic
commitments are met.

Typically in an S-Curve-based, oil-linked contract, the price slope is applied around the
$40-to-$100 oil price range, and beyond this range LNG buyers pay a fixed fee in very
high and very low oil price environments.
LNG PRICE SENSITIVITY TO INCREASING OIL AND
HENRY HUB (HH) INDEXED GAS PRICES
LNG price sensitivity analysis examines changes in LNG prices with proportionate
natural gas (Henry Hub) and in increasingly higher oil price environments.

CONCLUSION
HH-linked US LNG arbitrage opportunities are a function of oil prices. In proportionate
price increasing scenarios, between the two indexes, the higher the oil price, the
greater the price spread. HH-based pricing is preferable with a lower risk to the buyer,
in part because it is impacted less by geopolitical risk.

There is a recent shift among Asian LNG buyers to purchase LNG linked to the HH
index. This trend is expected to continue to make US LNG projects attractive. Most
Asian LNG buyers are utility companies (i.e. end-users), and the HH-linked price offers
an extra degree of price protection to the buyers compared to other forms of pricing.
Henry Hub-based pricing structures will physically connect the US gas market with the
Asian and European gas markets, likely making the prices of the three regional markets
become more consistent over a 20-year horizon or longer. In addition, US gas is a
steady and reliable supplier due to abundant shale gas reserves across the country.

Finally, US Gulf Coast LNG projects have the added benefit of their proximity to the
Henry Hub and access to the vast pipeline network around the Hub. All of these factors
play a vital role in influencing a 20-year or longer gas purchase commitment strategy.

DISCLAIMER: The views and opinions expressed in this article are those of
the author and do not reflect the opinions of any other organizations other
than the author himself. Examples of analysis performed within this article
are only examples and should not be utilized in real-world situations as they
are based only on very limited and dated open source information.

ABOUT THE AUTHOR

Vikram Enjam is an MBA candidate with a focus on energy at the University of

Houston's CT Bauer College of Business. He has more than eight years' experience in
the LNG industry. He holds Master of Engineering and Bachelor of Technology degrees
in mechanical engineering from Lamar University (Texas) and JNT University (India),
respectively. The author can be reached at venjam99@gmail.com for additional
questions or clarifications about this article.