Building LNG supply chain value24 Sep, 2012
The influence of LNG in Europe is increasing
A slump in Asian LNG prices since June this year has driven a steady flow of spot LNG cargoes back into North West Europe. At the same time, aspiring North American LNG exporters have been aggressively marketing long term LNG contracts to European buyers to underpin the development of new liquefaction capacity. The evolution of European gas hub pricing is set to become increasingly dominated by the dynamics of the global LNG market as global liquefaction capacity is projected to double over the next decade.
European energy company portfolios are exposed to the LNG market in different degrees. As well as the universal influence of the LNG market on European hub pricing, European gas suppliers are increasingly diversifying portfolios of pipeline gas supply to include contracted LNG and access to regasification capacity. Many larger gas players are also targeting ambitious growth in their exposure to multiple elements of the LNG supply chain, including supply contracts, shipping and access to new sources of production.
LNG supply chain characteristics
There are some specific challenges that must be confronted in order to understand value and risk across the LNG supply chain. LNG supply is more complex than pipeline supply in that it incorporates multiple sources of gas production, liquefaction & regasification capacity requirements, cargo shipping and the flexibility to sell gas at multiple locations as illustrated in Diagram 1.
At the core of this complexity are bespoke contract structures that bridge the supply chain to link production and supply. The interaction between LNG contract exposures and the market driven risk factors that act on those exposures, is a key driver of the value associated with LNG portfolios. This interaction is in turn a driver of LNG pricing and flows.
Lifting the hood on LNG portfolio exposures
LNG contracts have historically been priced using crude oil indexation. This originated from the ability of large importers (e.g. Japan and Korea) to substitute oil and gas for industrial and heating purposes. Crude indexed contract pricing remains dominant today, but the influence of gas hub indexation (mainly Henry Hub and NBP) is becoming increasingly prevalent particularly in the Atlantic Basin.
LNG contract price indexation to crude is typically not complex in itself. Contract prices move linearly in relation to the crude benchmark. However LNG contract complexity arises from an unusually high proportion of pricing and locational optionality in contracts. These result in non-linear relationships between contract value and underlying exposures.
Some examples of common sources of LNG contract complexity are set out in the box below.
Price caps and floors: It is common for LNG contracts to have embedded price cap and floor terms that dampen oil indexation linkage at high and low oil prices. This may apply to the whole contract price index or specific components of the index. The end result causes the “S-curve” shape common in LNG contracts.
Producer upside sharing conditions: It is common for LNG purchase contracts to contain provisions for the sharing of any upside created from cargo diversion with the producer. These are typically specified as a formula defining the gross margin as a function of the destination on which upside is calculated. For example, if a cargo is delivered to the US: gross margin = a+ b * HH – cost, if a cargo is delivered to NBP: gross margin = c + d * NBP – cost. As a result of these conditions it is not always the case that it is profitable to divert to the highest priced market.
Marginal tax deltas: It is common for an LNG portfolio to have commercial activities spanning different legal entities and tax jurisdictions. The optimal destination of a cargo can be a function of the legal entity cargo ownership structure based on the margin accrued in each entity and the corporate tax it attracts. There may be a simple marginal tax rate differential across jurisdictions or more complex considerations. For example, a trading and marketing based entity will attract tax based on the difference between the price it receives for a cargo less the price it pays, whereas an E&P entity will generally be charged the difference between the sales price and production costs. Optimising these tax liabilities across an LNG portfolio can be a key value driver.
LNG contracts typically sit within a portfolio of assets spanning other components of the LNG supply chain (e.g. production, shipping and regasfication). Value creation across the LNG portfolio depends on an understanding of how contract exposures interact with physical asset flexibility. Common sources of portfolio flexibility include:
- Options to purchase or sell incremental cargoes
- Options on gas hub delivery via contracted regasification capacity
- The ability to utilise or contract shipping capacity to move gas in response to price spread movements between markets.
This portfolio flexibility also generates non-linear exposures (i.e. value is not linearly related to the underlying exposure) that interact with LNG contract exposures to drive portfolio value.
LNG portfolio interaction with the market
Portfolio exposures are only half the picture. Portfolio value is realised by hedging and optimising exposures from contractual terms and asset flexibility against underlying market risk factors such as oil prices, gas hub prices and exchange rates. The relationship between exposures and risk factors is illustrated in Diagram 2.
The challenge that LNG portfolio managers face is in understanding how a broad set of fundamental market drivers act on exposures to drive value. This is a problem that spans multiple geographies and commodities.
But it is easy to get lost in the detail. Extracting value from an LNG portfolio is essentially a spread game. The intrinsic value of the portfolio can be measured against observable market spreads. The extrinsic value of portfolio flexibility depends on the evolution of the volatility and correlation of these spreads.
However unlike for many other energy assets, it is difficult to effectively manage LNG asset exposures in isolation of the surrounding portfolio. The complex interaction between flexibility across portfolio components means that substantial value may be lost if assets are managed against the market on a standalone basis.
Take for example the opportunity for an Atlantic Basin based LNG portfolio to make a committed sale to an Indian buyer at a premium to European hub prices (adjusted for shipping costs). The deal may be highly profitable on a standalone basis due to the price premium, but the commitment to deliver will reduce overall portfolio flexibility. The loss of the extrinsic value associated with reduced portfolio flexibility should be included in assessment of the deal.
Building LNG portfolio value
Creating value from market price spreads depends on access to interdependent asset flexibility across the LNG supply chain. So the key to building portfolio value is in understanding how an incremental asset investment can unlock value by alleviating portfolio flexibility constraints.
Take a simple example of a company servicing a gas customer base in Europe via a dedicated LNG supply sourced from the Middle East. Buying additional supply from a US exporter indexed at Henry Hub may unlock portfolio value by providing both pricing and locational flexibility. For example it may set up the option to swap Henry Hub sourced gas for Middle East cargoes which can then be delivered to take advantage of an Asian price premium.
There is currently a formidable momentum in growth across the global LNG supply chain. The relatively immature and complex nature of LNG asset exposures makes for a rich environment in which to build portfolio value. But the engine behind value creation is an effective framework to analyse the interaction between portfolio exposures and underlying markets.