Over the last several months there has been much discussion about the impact of falling crude oil prices on the liquefied natural gas market. The conventional argument goes something like this: lower crude prices are making oil-linked LNG contracts cheaper and are putting pressure on the spot market as these contracts increasingly undercut spot prices.
At first glance, this argument appears quite compelling. On January 14, 2015, the price of Platts-assessed Dated Brent was $45.73/b. For buyers using 14.5% slope to crude, not uncommon in the Asia-Pacific market, that would equate to an LNG price of just $6.63/MMBtu. By comparison, the Platts JKM price (a spot index for the Asian LNG market) was assessed significantly higher at $9.38/MMBtu on the same day.
Taking a deeper look at the market, a more complex picture emerges in which crude prices have had, at best, a minor and mostly psychological impact on the spot market for LNG. In fact, during four of the last five months, the average price of the JKM has undercut the price of oil-linked contracts. The key to this mystery is, of course, in the details of contract-pricing.
For most buyers in Japan and South Korea, the world’s largest LNG consumers, the price of an imported cargo is calculated at a 14.5-15% slope to crude on a lagged “3-0-1” pricing formula. That sounds complicated. However, each of the digits in this formula is simple, signifying, respectively, the number of months used for averaging, the number of months to count back to the end of the lag period, and the number of months being priced.
Accordingly, the contract cost of a January-delivered LNG cargo would be based, at its cheapest, on a 14.5% slope to the average price of Dated Brent during December, November and October.
A look at the data is quite revealing. In January, a Dated Brent-linked contract buyer would pay $11.10/MMBtu for a delivered cargo. By comparison, the average JKM spot price for January was $10.06/MMBtu, calculated during the November 17 – December 15 assessment period. The table below shows the same monthly comparisons going back to September. It may be surprising to notice that only during November was the cost of an oil-linked contract lower than the average spot market price.
Contract Type (prices as $/MMBtu)
Admittedly, the perception of falling crude prices may well have had some psychological impact on the spot market for LNG. This of course would be difficult to quantify. The plunge in crude prices is a sexy topic these days and the media has been contemplating its varying impact on nearly every commodity imaginable.
Regardless, the key to understanding the recent decline in LNG prices hinges on a less timely, less interesting explanation—market fundamentals. Over the last six-months, basic supply and demand factors are almost entirely responsible for the decline in spot LNG prices.
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After hitting a record high price above $20/MMBtu in February 2014, the spot price of Asian LNG has since declined by more than 50% as mild weather, high inventories and growing production have overwhelmed the global market.
Mild temperatures in both Asia and Europe last winter boosted LNG stocks in Japan and South Korea to high levels. During the summer, mild temperatures again put downward pressure on prices. Not only did they hinder the draw-down of stocks, but also zapped demand for marginal cargoes purchased in the spot market. Kogas, the world’s largest LNG buyer, even deferred delivery of as many as 30 cargoes in an effort to stem the influx of additional volumes.
On the supply side, the early start-up of the ExxonMobil-led Papua New Guinea LNG project added an additional 6.9 million mt/year of LNG to an already over-supplied market — that’s the equivalent of more than 100 standard-sized LNG cargoes per year. In the run-up to winter procurement, many traders and portfolio players leveraged low shipping prices to make floating storage plays, which ended up adding unneeded length to the winter market. Most recently, BG Group’s Queensland Curtis LNG project shipped its first cargo to Asia on January 5, promising to add another 8 million mt/year of supply to the market.
If crude prices remain at or below $60/b for an extended period, there’s no question that the impact will filter through to the spot market, most notably from late Q1 onwards. However, looking back at 2014, it’s clear that basic market fundamentals are to blame for low prices in the spot LNG market, not the often-cited crude oil crash.