Liquidity lift-off: the expected increase in the speed of the development of LNG derivatives

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The entry of more financial players, along with a more liquid spot physical market, is expected to speed the development of LNG derivatives in the coming years.

The LNG derivatives market has seen phenomenal growth over the past three years, a trend that seems set to continue given the increasing volume and scope of the physical market.

JKM derivatives volume growth in 2018 stood at 256% year on year, following growth of 295% in 2017. If 2019 and 2020 turn out to be anything like the previous years, strong growth in volumes is in store for the near term, which would significantly enhance the industry’s risk management capabilities and overall liquidity and transparency.

A more liquid derivatives market tends to encourage physical spot trade as market participants feel more comfortable with taking physical positions that are not hedged against an associated commodity, but against LNG itself.

This in turn helps boost price transparency and benchmark robustness as traders seek to participate in the price formation of both financial and physical LNG markets.

An all-time record of 46,349 lots of JKM derivatives, the equivalent of approximately 158 cargoes, changed hands in May 2019, according to exchange and broker data, a far cry from the 201 lots that were traded in the full year 2012.

Looking forward, growth is expected to find support from an increasingly liquid physical market, the rise of LNG-based indexation, greater participation by financial entities and the overall expansion of the sector.

Currently, the total number of active market participants within the JKM derivatives space is around the 45-50 mark, compared with about 40 in 2017.

The combination of fast volume growth and a relatively limited increase in the number of participants is the result of higher hedging activity from physical spot market players that now have greater confidence in the depth and sophistication of the JKM derivatives market, according to broking and trading sources.

Total volumes of JKM derivatives for 2018 amounted to the equivalent of around 36 million mt, just over a third of physical short-term and spot transactions, an indication that there is plenty of growth potential in the JKM Swap as a hedging instrument.

Meanwhile, as the derivatives market matures, more and more financial entities are expected to join traditional players with physical exposure, which could boost the pace of financial LNG growth in the coming years.

Forward curve liquidity deepens

With the increase in liquidity, there has also been a rise in activity further down the curve. In March 2019, trade of long-dated contracts — including Calendar Year 2020 and 2021, Summer 2020, Winter 2019, and the Q4 contract — hit 16,386 lots, or 40% of the trade for the period.

This is a significant rise from a year earlier. In March 2018, long-dated contracts for periods further ahead than Q3 represented 19% of the total trade for the month, or 2,040 lots.

With more physical market participants willing to transact for periods further out, a deeper forward curve will allow more effective risk management, particularly with counterparties seeking JKM exposure on not just the spot, but also within their long-term portfolios.

Most recently, Total and Vitol have signed deals for 15 years of FOB cargoes to the tune of 1.5 million mt/year from Tellurian’s Driftwood project priced against the JKM.

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