An arbitrage is a difference in value for a commodity relative to location. It is something that efficient markets close. Billions of dollars are being invested in the US to take advantage of the price difference between domestic gas and Asian LNG, just as billions were earlier invested in LNG import terminals. In this month’s featured article from Platts Energy Economist, editor in chief Ross McCracken discusses how only time will tell if it proves a good bet either for buyers or sellers.
Arbitrages are common in the oil and gas world. One of the most long-standing was the Brent-WTI arb. In the old days – Before Shale – international marker Dated Brent, then a single crude blend from the North Sea, traded at a discount to the US marker West Texas Intermediate. If the discount proved large enough to compensate for the freight cost, cargoes of Brent would be moved across the Atlantic and into the Gulf Coast.
Taking Brent out of the North Sea tightened the regional market and helped close the arb. The Brent-WTI arbitrage was always a fleeting opportunity, and it is one that has long since gone altogether. WTI has for some years traded at a substantial discount to Dated Brent.
The new arb that traders are chasing is for LNG between the US and Asia. It is large. Based on current prices, the arbitrage – i.e the difference between the delivered price in Asia and the US purchase price, transmission, liquefaction and shipping costs — for notional US Gulf Coast LNG is about $6/MMBtu and for West Coast LNG $8.70/MMBtu.
Asian companies have been keen to agree long-term supply agreements for US LNG because it appears cheap. Their existing LNG contracts are almost all priced off crude oil, while US LNG exporters appear prepared to base their exports on US gas prices.
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As such, both parties are taking a bet that US gas prices will remain cheap, and that delivered LNG prices into Asia will remain high, which for long-term contract cargoes is, by extension, largely a bet that crude oil prices will remain high.
The Asian LNG arb is a relatively recent phenomenon, with complex origins, dating to August 2008. The oil complex as a whole was tumbling from the all-time record peak achieved the previous month, but US gas prices were in a tail spin of their own making.
The US unconventional gas boom had started to produce in ever greater volumes, seemingly regardless of price, and increases in US exports were limited by a lack of export infrastructure and regulation. By third-quarter 2010, the arb was firmly established.
Then, in March 2011, the Fukushima nuclear disaster occurred, an event which within a year would see all of Japan’s nuclear capacity off-line. At the same time, the Arab Spring was in full swing and Libya descended into civil war, creating a large gap in global crude supply. The oil price recovered. Demand for LNG rose strongly.
Japan, already by far the world’s largest market for LNG, turned to thermal generation to compensate for its idle reactors. The Asian LNG market was also seeing the steady addition of new importers, most notably in the form of China and India. Rising demand for LNG in Asia was both immediate and structural.
The Asian LNG arb is thus the result of four main factors: the decoupling of gas production from price in the US market as a result of the unconventional oil and gas boom: restraints, both regulatory and infrastructural, on the US’ ability to export; rising Asian LNG demand; and excess demand from Japan.
Two of these conditions are in reverse. Japan’s nuclear fleet is expected gradually to come back online, and the US is removing its restraints on exports. So far, 6.37 Bcf/d of export capacity has been approved by the government to countries with which the US does not have a Free Trade Agreement. More might be forthcoming.
The other two conditions could be reversed. Cheap gas in the US is provoking a domestic demand response, particularly in the power generation and industrial sectors, the former accelerated by the regulatory headwinds faced by coal. New pipeline capacity to Mexico should be in place by 2016-18. By the time US LNG export projects come on line – also a significant element of new demand — domestic and external demand for US gas could be firing on all fronts.
What direction the supply/demand balance for LNG in Asia takes is uncertain. Opinions are divided. Both liquefaction capacity and Asian demand for gas are growing strongly and, as gas trade depends on infrastructure that takes time to build, it is uncertain where the balance will lie at any particular point in the future. Forecasts for both a tight and slack market abound. Certainly potential demand from China appears almost limitless, but demand means nothing without infrastructure.
At least two parts of this quadratic equation offer US exporters hope. First is that the US gas industry looks more than capable of a supply-side response that meets the additional demands likely to be made upon it. If it can produce a surplus when prices are low, it should be able to produce much more if prices rise. Second is that crude prices, and thus much of the LNG with which the US will compete, should remain high, although this too represents an uncertainty.
In the mist of so many variables, it is perhaps better simply to return to the basic nature of an arbitrage. They are typically fleeting and never permanent. Where they are persistent, it is usually a reflection of inefficient markets and logistical constraints.
The build out of liquefaction plant, of regasification capacity, and the removal of US trade restrictions, will all serve to make the global LNG market more efficient. As such, it is probably safe to predict that, even if it looks unlikely now, the Asian LNG arbitrage will become a fleeting opportunity rather than persistent open window. The tricky part is to say how soon this might occur.