Developing a LNG portfolio valuation capability22 Oct, 2012
With global liquefaction capacity set to double over the next decade and Europe becoming increasingly import dependent, many European energy companies are focusing on LNG portfolio growth. The LNG supply chain is characterised by complex physical and contractual flexibility as we have set out previously. This makes analysing LNG portfolio value a challenging task.
The interdependent nature of LNG portfolio flexibility means that an investment decision in a single asset or contract cannot be made without analysing its impact on the overall portfolio value. When it comes to LNG portfolio value, the ‘whole’ does not equal the ‘sum of the parts’. So a portfolio valuation capability forms a key foundation of the management of value and risk from LNG assets and contracts.
In this article we set out a staged approach to developing an LNG portfolio valuation capability based on our own experience analysing LNG portfolio value. This capability is primarily aimed at informing LNG investment decisions rather than shorter term trading and optimisation decisions. To illustrate the application of the capability we present a case study focused on adding a supply contract with a US exporter to a European gas portfolio.
A staged approach
In developing an effective LNG portfolio valuation capability it is critical to maintain a focus on simplicity, adaptability and transparency. The complex nature of the analytical problem lends itself to a staged approach that can evolve as the portfolio grows. The staged approach is represented in Diagram 1 and explained below.
Diagram 1: Staged approach to LNG portfolio valuation capability
Each stage should add value to commercial decision making as it is developed. In other words the capability evolves as a result of commercial requirements to analyse portfolio value (e.g. to assess new supply contracts or upstream investment opportunities). Each stage should also build on the last to reduce the risk of inadvertently overlooking key features of the portfolio or problem.
Stage 1: Source to destination analysis
Price spreads are the key driver of LNG portfolio value. So developing a ‘top down’ analytical view of the value of production and destination pairings is a logical place to start. In order to do this it is useful to build a nodal view of the portfolio. This is illustrated in Diagram 2 which provides a simplified network view of a hypothetical LNG portfolio centred around the Atlantic basin.
Diagram 2: Nodal view of an Atlantic basin LNG portfolio
The nodes represent different production sources and destination markets. Production and demand assets can exist at different nodes and the flow between nodes is constrained by transport capacity (e.g. pipeline or LNG regas). Finally production cost, supply contract terms, hub price signals and retail portfolio pricing characteristics can be overlaid.
The advantage of this approach is that it provides a structured and transparent view of the value of flexibility in moving gas across the portfolio. For a relatively low initial effort the nodal approach can pay big dividends in helping to understand portfolio exposures and how incremental investments may unlock portfolio value. The other great benefit of starting with a nodal view is that the structure provides a solid foundation for developing a more sophisticated portfolio optimisation and valuation model.
Stage 2: Developing a simple portfolio model
The limitation of the Stage 1 nodal source to destination analysis is that it lacks analytical firepower. It does not fully capture how portfolio components interact with each other and the market. Developing this capability is the focus of the second stage.
Typically this will involve developing a model that optimises LNG portfolio flexibility at current market prices (in essence calculating the intrinsic value of the portfolio). As well as providing information on asset value, this also allows calculation of the cost of particular portfolio constraints (e.g. limited supply flexibility or access to shipping capacity). This information is very useful for determining where to prioritise portfolio development and origination activities.
Case study: Buying LNG supply from a US exporter
It is useful to illustrate the application of the portfolio valuation capability in a case study which focuses on a European gas player looking at the value and risks associated with signing an LNG supply contract with a US exporter.
A US export contract provides access to Henry Hub (HH) indexed gas. The contract has the advantage of being a supply source that can be managed (both physically and financially) against a liquid hub and forward market. But contracting gas from a US exporter will typically involve paying a premium to hub prices (e.g. 115% HH). So there is an important value consideration in signing the contract. There is also an important risk consideration since the contract involves buying gas on a different price basis (HH) to end user demand (NBP/TTF) e.g. for power stations and retail load.
Contract value is driven by regional price spreads between the US (HH), Europe (NBP/TTF) and Asia. This is in part a question of the evolution of global gas market fundamentals. For example if the flow of gas from the US to Europe remains constrained by lack of US liquefaction capacity then the NBP/TTF – HH price spread may exceed the transport differential i.e. access to HH gas has intrinsic value. But as well as fundamental considerations there are also specific portfolio value issues.
From the perspective of a European supplier, HH indexation offers a liquid/hedgeable alternative to oil indexed supply which can be attractive if the supplier is constrained in their ability to buy gas indexed to NBP/TTF (i.e. the price basis for sale to end users). A US export contract also adds hedgeable hub based supply flexibility to an LNG portfolio that can unlock portfolio constraints e.g. the HH indexed gas could be swapped within the portfolio with a source of Middle Eastern supply with a destination clause constraint and then sold on to an Asian buyer at a premium.
An LNG portfolio valuation capability provides a structured means of analysing the value impact of all the issues described in the example above.
Stage 3: Developing a full stochastic portfolio model
The final stage of development focuses on capturing the uncertainty around the evolution of market driven risk factors. The key incremental benefit of this stage is to gain a better understanding of the extrinsic value of portfolio flexibility.
Evolving the portfolio valuation model from Stage 2 to 3 involves adding the ability to:
- Simulate the evolution of market prices (e.g. HH, NBP, TTF, crude, exchange rates) incorporating views on market fundamentals (e.g. the evolution of hub price correlations and volatility)
- Allowing the representation of specific portfolio hedging and optimisation strategies (e.g. the rolling intrinsic hedging of portfolio exposures)
- Re-optimise portfolio flexibility and adjust hedge positions in response to changes in market prices and exchange rates.
While there are considerable advantages from being able to capture these factors, there is no need to develop this capability until the LNG portfolio strategy and exposures reach a level of complexity that warrants it. This is typically at the point that a company is developing a portfolio with exposure to multiple supply and demand sources which are linked by access to shipping capacity.
Applying the analytical capability to generate portfolio value
Ultimately developing a portfolio valuation capability is about generating numbers that inform portfolio investment decisions to create value. The capability should capture existing portfolio exposures and quantify associated value and risk. It should facilitate analysis of the impact of changes in market fundamentals on portfolio value. It should also quantify the incremental value of structural portfolio changes such as asset investments, changes in contract terms or changes in hedging/optimisation strategies.
However perhaps the most overlooked benefit of this capability is that it focuses key stakeholders (asset developers, originators, risk managers and traders) on developing a common understanding of the LNG portfolio and indentifying opportunities to create portfolio value.