Global Trading
Significant new developments have been taking place in the global
Liquefied Natural Gas (LNG) market over the past two years. For
example, BP and Shell have placed orders for new LNG ships without
specifying for which trade markets the ships will be used. BP has
contracted to sell LNG to AES without identifying the source. BG,
El Paso, Enron and Shell have purchased quantities of LNG for sale
into the US market with no conventional long-term buyer. Finally,
this same group of companies, with Tractebel, has secured all the
LNG terminal capacity into the US market and is sponsoring
virtually all the proposed new terminals to serve the US market.
These developments suggest the emergence of a new LNG market participant ? the Global Merchant ? which could have a profound impact on LNG developments in the Gulf with its traditional reliance on sales to the Far East. The causes and conditions giving rise to these new LNG players are examined below.
Traditionally small spot LNG market
The LNG market is, predominantly, a term market, with spot sales accounting for less than 5% of global LNG sales (see Chart A).
In the past, spot sales have tended to increase as major new LNG projects ? whose output capacity has been contracted long-term to a limited number of buyers ? come on stream: buyers are unable to absorb the entire capacity. Sales then decline as the dedicated markets grow and absorb the new plant capacity. Consequently, despite much conjecture within industry circles about potential growth in the spot market for LNG, this market remains confined to a small fraction of the overall LNG market.
There are a number of reasons for the failure of a spot LNG sales market to develop. First is the lack of enthusiasm amongst the Asian buyers that make up some 75% of the LNG buyer's market -- for Asian buyers, security of supply has been paramount. Second, there has not been a clear market clearing mechanism for the spot sales of LNG. Sellers have typically negotiated spot sales directly with a buyer but have had no certainty in advance that a given spot cargo could find a market.
Changes in LNG economics
But in the last few years, two key developments in the LNG industry have combined to permit the emergence of a new merchant LNG market. These are:
Reduced Costs
There has been a steady decrease over the last 10 years in capital costs of both liquefaction facilities (see Chart B) and of LNG ships (Chart C). These costs have fallen as a result of improved engineering and more competitive market conditions. According to a study by McKinsey & Co., these trends have contributed to a reduction in the cost of LNG landed in the East Coast of the US by as much as $0.75/MMbtu, compared to price levels during the 1980s.
Increased US gas prices
Gas prices in the US have seen a sharp rise this year. A number of market participants believe that this is a long-term structural change, marking the end of the gas ?bubble? era and the start of a sustained period of higher prices, with gas trading at thermal parity with oil. This view is currently reflected in the forward markets. Chart D below shows SG's estimate for the landed cost of re-gasified LNG into the US from a range of potential new projects. Superimposed is the forward price for gas at Henry Hub, together with the latest CERA forecast, typical of a more conservative view.
Chart D illustrates SG's view that, under the more conservative projection of $2.50-$3.00/MMBtu gas prices, it is viable to ship LNG into the US market from projects in the Atlantic Basin, including the Mediterranean, but probably not from those in the Middle East. By contrast ? under the more optimistic scenario of $3.50/MMBtu or more ? it is economic to ship LNG into the US market from any project in the world. At present, gas prices in this higher range can be locked-in using derivative contracts for a period of ten years or more and thus the economics of a Gulf-based LNG project could be secured on the basis of sales into the US market.
The liquidity of the US gas market is such that an LNG buyer with access to ships and LNG terminal capacity can ? for the first time in many years ? be confident of being able to sell LNG cargo without the benefit of a long-term contract.
Thus, while for a Gulf-based project, the US might not necessarily be the most profitable market ? given the shipping distance ? since long term contracts are not required, the sponsors will have the option to replace the US offtake with markets that offer a higher netback as the opportunities arise.
This new market clearing mechanism is what is giving rise to a new group of players in the LNG market -- the Global Merchants. These companies, with their own dedicated shipping and terminal access into the US market, are buying tranches of LNG from new projects on a medium- to long-term basis, underwritten by their ability to sell into the US market. The Global Merchants will then sell LNG to a number of different buyers, offering much more flexible terms than previously available. Such sales can be in the form of spot sales, medium-term contracts, or contracts to meet specific seasonal or short-term volume requirements.
This new model of merchant trading will bring new features with enormous benefits to the LNG market:
New feature Consequence
Shorter Buyers will no longer be required to
Contracts commit to 20-year contracts. This will encourage new buyers into the market that do not perceive a long-term need for LNG e.g. where pipeline supplies are anticipated in the medium-term.
Increased Global Merchants will be able to offer the
Flexibility seasonal and shorter-term volume flexibility required by buyers (especially in South Korea).
Reduction of The intermediation of the Global
Credit Risk Merchant, combined with a guaranteed market of last resort, could permit the financing of new LNG projects where countries with weaker credit ratings are the primary markets.
Selling into US key for merchants
SG foresees neither the development of a deeper spot market than exists for crude oil ? a market that is almost 30 times larger than LNG ? nor the emergence of pure merchant LNG plants, for many years to come.
The key to the success of the merchant LNG business model is the ability of the Global Merchants to sell LNG, as a last resort, into the US market. In terms of volume, doing so should not present a problem. Even with the new terminal capacity additions, LNG imports are unlikely to exceed 5% of the total US gas market in the near term. More important, the underlying trade into the US market must be economic in the long-term, if only marginally.
This will only be the case, for the more remote supply sources, if US gas prices remain in the $3.00?3.50 range. A number of the new Global Merchants have, unsurprisingly, expressed bullish views about future US gas prices. While there is much uncertainty about the range of future US gas prices, it is currently possible to hedge future gas prices at levels above the $3.00-3.50 range for up to 10 years, which should be sufficient to underpin the financing of a new project on this model.
As noted above, a Global Merchant will need to have ships and terminal capacity in the US. With BG's recent acquisition of the remaining capacity in the Lake Charles, Louisiana terminal, the available capacity has now been secured by the relatively small emerging Global Merchants club that includes: BG, BP, El Paso, Enron, Shell and Tractebel. Nearly all the new LNG terminals proposed to serve the US market have been sponsored by members of this small group.
Assuming that the Global Merchants sign long-term off-take contracts with LNG sellers with pricing indexed to Henry Hub, financing of the new LNG plants and ships should be reasonably available. The leverage obtainable for projects more remote from the US, however, is likely to be lower than the 70-75% typically achieved for grass-roots project financings of liquefaction plants in the past. Given the high costs of liquefaction and delivery to the US, together with the volatility of US gas prices, financing structures for remote projects may be more akin to those of petrochemical projects with similarly lower debt leverage. Should sponsors choose to hedge the price of gas ? not typically done in previous LNG projects but easier if the LNG price were indexed to Henry Hub ? higher levels of debt should be achievable.
Conclusion
While a substantial part of the LNG market will continue to consist of long-term bilateral arrangements and undoubtedly most Gulf-based LNG projects will continue to serve the Far Eastern markets, there are fundamental changes afoot. A small club of Global Merchants is emerging ? companies which will use the newly robust US gas market and the new trading model described above to underpin the expansion of the LNG market, not only in the US but world-wide. They will be able to provide much more flexible terms to existing customers and develop new markets previously considered unsuited to LNG. These and other factors ? the liberalisation of the gas market in Europe, together with the emergence of Zeebrugge as a second market-clearing centre, which due to its greater proximity to the Gulf will be of greater long term significance for the Gulf LNG producers ? will accelerate the process of establishing a new, much more sophisticated, global LNG market.
These developments suggest the emergence of a new LNG market participant ? the Global Merchant ? which could have a profound impact on LNG developments in the Gulf with its traditional reliance on sales to the Far East. The causes and conditions giving rise to these new LNG players are examined below.
Traditionally small spot LNG market
The LNG market is, predominantly, a term market, with spot sales accounting for less than 5% of global LNG sales (see Chart A).
In the past, spot sales have tended to increase as major new LNG projects ? whose output capacity has been contracted long-term to a limited number of buyers ? come on stream: buyers are unable to absorb the entire capacity. Sales then decline as the dedicated markets grow and absorb the new plant capacity. Consequently, despite much conjecture within industry circles about potential growth in the spot market for LNG, this market remains confined to a small fraction of the overall LNG market.
There are a number of reasons for the failure of a spot LNG sales market to develop. First is the lack of enthusiasm amongst the Asian buyers that make up some 75% of the LNG buyer's market -- for Asian buyers, security of supply has been paramount. Second, there has not been a clear market clearing mechanism for the spot sales of LNG. Sellers have typically negotiated spot sales directly with a buyer but have had no certainty in advance that a given spot cargo could find a market.
Changes in LNG economics
But in the last few years, two key developments in the LNG industry have combined to permit the emergence of a new merchant LNG market. These are:
Reduced Costs
There has been a steady decrease over the last 10 years in capital costs of both liquefaction facilities (see Chart B) and of LNG ships (Chart C). These costs have fallen as a result of improved engineering and more competitive market conditions. According to a study by McKinsey & Co., these trends have contributed to a reduction in the cost of LNG landed in the East Coast of the US by as much as $0.75/MMbtu, compared to price levels during the 1980s.
Increased US gas prices
Gas prices in the US have seen a sharp rise this year. A number of market participants believe that this is a long-term structural change, marking the end of the gas ?bubble? era and the start of a sustained period of higher prices, with gas trading at thermal parity with oil. This view is currently reflected in the forward markets. Chart D below shows SG's estimate for the landed cost of re-gasified LNG into the US from a range of potential new projects. Superimposed is the forward price for gas at Henry Hub, together with the latest CERA forecast, typical of a more conservative view.
Chart D illustrates SG's view that, under the more conservative projection of $2.50-$3.00/MMBtu gas prices, it is viable to ship LNG into the US market from projects in the Atlantic Basin, including the Mediterranean, but probably not from those in the Middle East. By contrast ? under the more optimistic scenario of $3.50/MMBtu or more ? it is economic to ship LNG into the US market from any project in the world. At present, gas prices in this higher range can be locked-in using derivative contracts for a period of ten years or more and thus the economics of a Gulf-based LNG project could be secured on the basis of sales into the US market.
The liquidity of the US gas market is such that an LNG buyer with access to ships and LNG terminal capacity can ? for the first time in many years ? be confident of being able to sell LNG cargo without the benefit of a long-term contract.
Thus, while for a Gulf-based project, the US might not necessarily be the most profitable market ? given the shipping distance ? since long term contracts are not required, the sponsors will have the option to replace the US offtake with markets that offer a higher netback as the opportunities arise.
This new market clearing mechanism is what is giving rise to a new group of players in the LNG market -- the Global Merchants. These companies, with their own dedicated shipping and terminal access into the US market, are buying tranches of LNG from new projects on a medium- to long-term basis, underwritten by their ability to sell into the US market. The Global Merchants will then sell LNG to a number of different buyers, offering much more flexible terms than previously available. Such sales can be in the form of spot sales, medium-term contracts, or contracts to meet specific seasonal or short-term volume requirements.
This new model of merchant trading will bring new features with enormous benefits to the LNG market:
New feature Consequence
Shorter Buyers will no longer be required to
Contracts commit to 20-year contracts. This will encourage new buyers into the market that do not perceive a long-term need for LNG e.g. where pipeline supplies are anticipated in the medium-term.
Increased Global Merchants will be able to offer the
Flexibility seasonal and shorter-term volume flexibility required by buyers (especially in South Korea).
Reduction of The intermediation of the Global
Credit Risk Merchant, combined with a guaranteed market of last resort, could permit the financing of new LNG projects where countries with weaker credit ratings are the primary markets.
Selling into US key for merchants
SG foresees neither the development of a deeper spot market than exists for crude oil ? a market that is almost 30 times larger than LNG ? nor the emergence of pure merchant LNG plants, for many years to come.
The key to the success of the merchant LNG business model is the ability of the Global Merchants to sell LNG, as a last resort, into the US market. In terms of volume, doing so should not present a problem. Even with the new terminal capacity additions, LNG imports are unlikely to exceed 5% of the total US gas market in the near term. More important, the underlying trade into the US market must be economic in the long-term, if only marginally.
This will only be the case, for the more remote supply sources, if US gas prices remain in the $3.00?3.50 range. A number of the new Global Merchants have, unsurprisingly, expressed bullish views about future US gas prices. While there is much uncertainty about the range of future US gas prices, it is currently possible to hedge future gas prices at levels above the $3.00-3.50 range for up to 10 years, which should be sufficient to underpin the financing of a new project on this model.
As noted above, a Global Merchant will need to have ships and terminal capacity in the US. With BG's recent acquisition of the remaining capacity in the Lake Charles, Louisiana terminal, the available capacity has now been secured by the relatively small emerging Global Merchants club that includes: BG, BP, El Paso, Enron, Shell and Tractebel. Nearly all the new LNG terminals proposed to serve the US market have been sponsored by members of this small group.
Assuming that the Global Merchants sign long-term off-take contracts with LNG sellers with pricing indexed to Henry Hub, financing of the new LNG plants and ships should be reasonably available. The leverage obtainable for projects more remote from the US, however, is likely to be lower than the 70-75% typically achieved for grass-roots project financings of liquefaction plants in the past. Given the high costs of liquefaction and delivery to the US, together with the volatility of US gas prices, financing structures for remote projects may be more akin to those of petrochemical projects with similarly lower debt leverage. Should sponsors choose to hedge the price of gas ? not typically done in previous LNG projects but easier if the LNG price were indexed to Henry Hub ? higher levels of debt should be achievable.
Conclusion
While a substantial part of the LNG market will continue to consist of long-term bilateral arrangements and undoubtedly most Gulf-based LNG projects will continue to serve the Far Eastern markets, there are fundamental changes afoot. A small club of Global Merchants is emerging ? companies which will use the newly robust US gas market and the new trading model described above to underpin the expansion of the LNG market, not only in the US but world-wide. They will be able to provide much more flexible terms to existing customers and develop new markets previously considered unsuited to LNG. These and other factors ? the liberalisation of the gas market in Europe, together with the emergence of Zeebrugge as a second market-clearing centre, which due to its greater proximity to the Gulf will be of greater long term significance for the Gulf LNG producers ? will accelerate the process of establishing a new, much more sophisticated, global LNG market.
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