Bland LNG contracts need a bit of seasoning

The LNG market has clung tenaciously to traditional contracting structures, but so many of the justifications – the rationale for oil indexation, limited LNG supply, and lack of spot gas trade or benchmark – no longer pass the sniff test in 2020 and beyond.

The LNG market needs different options. Sellers still need some long-term commitments to provide financial security to shareholders, and buyers still need some security of supply to assuage regulatory concerns regarding economic vulnerability. That said, the tropes that define each of these concepts for buyers and sellers desperately need to evolve, and now is the perfect time to move on.

Shifting the focus from “how much” and “how long” to “when” and “what period of the year” provides a better solution to what currently ails the market for LNG contracts. Taking the LNG contract to the next level involves better defining when – more specifically what time of the year – having an LNG contract is an absolute necessity, and when it is more of an option.

Here’s where the introduction of seasonal LNG contracts come into focus. This new type of LNG contract supports the goals of both buyers and sellers, while also simultaneously reducing mutual risks. In a seasonal LNG contract, a long-term deal will be struck, where both sides agree to a specific period of the year when the LNG is most and least valued.

For most buyers in the northern hemisphere, this period of time would be during the fourth and first quarters, when weather can increase consumption by two to three times the annual average. Fine tuning the starting and stopping point of the seasonal LNG contract would depend on individual markets, with different criteria used such as heating and cooling degree day profiles or population weighting relative to total gas use.

Seasonal differences in contracts are not unprecedented. Some Asian buyers previously negotiated for highly seasonal annualized volume at a 60-40 or 70-30 ratio towards the winter (Korea) or the summer (Taiwan), which also involved swapping arrangements for lifting LNG out of season. However, the contracts still required lifting volumes 12 months per year, whereas what is being suggested here is that the contract will only exist for a fixed period of the year, with no commitment to lift at other times.

Seasonal weightings on an annualized contract were a nice option in the past, but it is now more of an underexploited opportunity, as it’s also easier to offload volumes in the spot market when they are not needed for prompt use. It was not long ago that spot markets were not an option, and nor was access to European LNG import terminals or underground storage.

A new spice: pricing the flexibility

Seasonal contracts will also necessitate seasonal alterations in the pricing of the LNG. At the broadest level, sellers would seek premiums from buyers in the fourth and first quarters and offer discounts in the second and third quarters to mirror the nature of the seasonal demand curve. Buyers do want perennial security of supply, it’s just that they only want it when a threat of insecurity actually exists.

In Asia, buyers would pay premium pricing during their winter, which could be broken down in many ways to align with the relative level of supply insecurity. In this case, a Chinese or Japanese buyer could pay JKM plus X for October, JKM plus Y for November and December and JKM plus Z for the first quarter. The premium paid would essentially guarantee the buyer a baseload volume at a time when competitive risks are the greatest.

Prices could also correspond with the actual volume at risk, as the profile is very different when serving residential and commercial buyers than when serving high-load industrial users or power generators that need to be sensitive to switching economics.

During the second and third quarters, one of two things would need to happen: either the buyer takes no volume and it’s not part of the contract at all, or the buyer takes volume that is discounted versus the benchmark. Here’s where JKM comes in as a novel wrinkle because it allows sellers the opportunity to attract buyers with a guaranteed re-sale margin.

Would it be better for the sellers just to tender themselves? Perhaps, but it would not offload some of the building volume risk they face. Through discounting the sale at JKM minus Z, the goal of the seller here would be to entice investments in underlying demand growth and lay off supply risk during a lower demand period. Buyers essentially are guaranteed an arbitrage at JKM (or TTF) minus Z in the spot market that would allow them to claw back some of the premium paid during the winter months.

Portfolio LNG players provide regional Flavor

The seasonal LNG contract works particularly well in the ever-expanding market of portfolio LNG volumes, where free on board lifters have accumulated substantial long positions not yet matched with end user offtake agreements. Signing seasonal LNG contracts would allow portfolio players to lay off some of this risk in a manner that aligns well with their broader optimization strategies.

Providing this type of flexibility and security to buyers would be a logical next step in their role in LNG trade. Portfolio buying was central to the eruption in new LNG supply projects over the past decade. Now portfolio players can offer a similar service to end users, while also deflating the sizable exposure to the spot market they face each year.

For all sellers, these types of contracts offer a partial hedge against the greatest threat they face: insecurity of demand. The insecurity stems from a massive expiration of roughly 30% of all long-term LNG contracts by 2030 and 50% by 2035. These contracts were signed when security of supply outweighed security of demand as a central driving force in the market place. Now, finding a long-term buyer is harder than eve

Read our recent blog on COVID-19's impact on the LNG value chain