Cooking with Gas As the LNG Market Grows, Exchanges See Opportunity for New Products
June 8, 2017By Bennett Voyles
Several exchanges are looking at ways to capitalize on the structural changes in the global market for liquified natural gas.
Liquefied natural gas is coming of age as a globally traded commodity, and the world’s futures exchanges have taken note.
Over the last 12 months, Intercontinental Exchange has seen a surge in the volume of LNG futures cleared at its London clearinghouse, and it has introduced a new contract tied to prices in the U.S. The Tokyo Commodity Exchange has launched a set of LNG contracts aimed at the Asian market, with clearing provided by CME Group, and the Singapore Exchange has rolled out its third LNG index.
Why the sudden flurry of interest? The exchanges are responding to far-reaching changes in the way LNG is bought and sold that are paving the way for the emergence of a global spot market. The trend is still in its early stages, but the exchanges see the potential for LNG to follow the same evolutionary path as other commodities such as coal and iron ore. As buyers and sellers move to market-based pricing mechanisms for LNG, they will need tools such as futures and swaps to manage their price risk.
Growth of a Spot Market
On the supply side, the shale revolution has dramatically increased U.S. production of natural gas and introducing new supply into the global market. The first export from the lower 48 states took place in February 2016 and by the year 2020 the U.S. is expected to become the third largest exporter of LNG in the world after Australia and Qatar.
Within the U.S. natural gas is mainly transported as a gas through pipelines, but LNG is far more portable and therefore better suited for exports to Europe and Asia. The routine is simple: natural gas is super-cooled to -260 degrees Fahrenheit (-162 degrees Celsius) and reduced to a liquid that is 600 times smaller than its original volume. The liquid is transported on specialized tankers to a destination port, where it is warmed up and expanded into a gas once more. Energy experts predict that by 2040, more than half of the world’s gas will be delivered to market as LNG, with countries in the Asia-Pacific region being the primary destinations.
Equally important are changes on the demand side. More and more buyers are moving away from the traditional pricing model, whereby they signed long-term contracts pegged to the price of oil. Significant amounts of LNG are now bought and sold on a short term basis, with pricing based on established natural gas benchmarks such as Henry Hub or NBP or on newer benchmarks that specifically track LNG prices in the spot market.
The most important of these benchmarks is the Japan-Korea Marker published by Platts, which tracks spot prices for LNG cargoes delivered into Japan, Korea, China and Taiwan. Asia consumes 75% of the world’s LNG and the JKM benchmark has become a key reference for pricing shipments of LNG to that region.
Another factor is increasing flexibility in contractual arrangements. Traditionally most shipments were locked in a specific destination. Now, more contracts permit LNG cargoes to be sent to alternate destinations, or, if the price dynamics aren’t right, the gas can even be left in the ground until the market improves, according to Marc Howson, a senior managing editor for S&P Global Platts in Singapore.
Increased Need for Hedging
The increased flexibility and greater use of short-term contracts have created demand for hedging, and the JKM contracts listed on ICE Futures Europe have been the beneficiary. Volume rose from a few hundred contracts per month in 2015 to more than a thousand contracts per month from September 2016 onwards, and hit a peak of more than 2,800 contracts in March.
“Momentum in our JKM LNG futures contract has been building since the second half of 2016 in terms of trades, volumes and the number of market participants,” said Gordon Bennett, managing director of utility markets at ICE Futures Europe. “In the last eight months the contract has seen five monthly volume records and in the first five months of 2017 we’ve already exceeded the total number of trades seen in 2016 for the contract.”
Commodity trading companies such as Glencore, Trafigura and Vitol are actively using these derivatives to support their growing involvement in the LNG market. With their expertise in trading oil and other energy commodities, they are well positioned to trade around imbalances in LNG supply and demand, buying cargoes in one region and selling into another. Trafigura, for example, now has LNG trading desks in Geneva, Houston and Singapore. The company says its trading volume in 2016 was 53% higher than the year before and it expects this to continue to rise.
“The industry stands at the brink of an inflection point that will likely see a rapid transition to flexible market-based pricing mechanisms and the reliance on markets and trading to secure supply and demand and manage price risks,” wrote Craig Pirrong, a professor at the University of Houston, in a 2014 white paper commissioned by Trafigura.
As the world's largest importer of LNG, Japan has a keen interest in promoting a domestic market for LNG derivatives. Some existing derivatives contracts could serve this purposes, such as futures on crude oil and natural gas that are traded on exchanges in Europe and the U.S. But these contracts introduce basis risk, and the Tokyo Commodity Exchange is working on plans to develop a domestic market for LNG derivatives.
In April 2016, the Tokyo Commodity Exchange took full ownership of Japan OTC Exchange, a trading platform aimed at supporting over-the-counter trading in oil and natural gas. In April 2017, Tocom launched four LNG contracts on the JOE platform. Two of the contracts are spot contracts with physical delivery, and two of the contracts are cash-settled swaps based on the Platts JKM benchmark and a Japan-specific benchmark published by Rim Intelligence, a Japanese company that specializes in producing energy-related prices and market information.
In an unusual twist, the two swaps will be cleared by CME Group through its Clearport facility. That facility is widely used among brokers and other participants in energy markets as a way to move OTC contracts into clearing.
Gaining traction is always tough for new contracts, but there are several reasons why Tocom's plan may succeed. Platt's Howson noted that the ongoing deregulation of the Japanese gas and power sectors means Japanese LNG buyers will likely become increasingly efficient with their LNG procurement and pricing.
There is also potential for arbitrage between U.S. and Japanese LNG prices. Kosuke Araki, a senior manager at Tocom, said that the flow of LNG cargoes from North America to Asia will stimulate arbitrage between Henry Hub, the main North American benchmark for natural gas, and JKM. He added that the partnership with CME could support this arbitrage. “By collaborating with CME, we could exploit such an opportunity for both exchanges’ participants by facilitating the access to each market’s participants.”
Thirty-three customers have signed up for the new facility, seven from outside Japan. They include three gas companies, nine electric power companies, four oil and gas companies, eight trading houses, and two financial institutions, according to Araki.
Araki noted that JKM swaps are currently traded mostly by European traders in European market hours. "I think there is a niche market to be exploited for Asian players in Asian trading hours, because JKM is an Asian spot index,” he said.
Gulf Coast Anchor
Building on its success with JKM futures, ICE launched a U.S. LNG futures contract in May. The contract is cash-settled against the Platts’ LNG Gulf Coast Marker price and clears through ICE Clear Europe. The contract has not attracted much trading volume yet, but ICE officials are patient. The first JKM swap cleared at ICE was in 2012, and it took almost four years before that market started to take off.
The new contract is designed to support the emerging wave of LNG exports from the U.S. Gulf Coast, which has a high concentration of liquefaction plans and export terminals. One export terminal is already operational—the Sabine Pass terminal on the border between Texas and Louisiana—and several more are under construction.
The LNG exported from the Gulf Coast will have an especially important impact on global LNG prices because of its destination flexibility, according to BP. In its 2017 annual energy outlook, the company explained that LNG cargoes from these terminals can be redirected to different parts of the world in response to regional fluctuations in demand and supply. As a result, U.S. exports will provide the "marginal source" for gas in Europe, Asia and Latin America, and U.S. gas prices "are likely to play a key role in anchoring gas prices in a globally integrated market."
"We have already witnessed exponential growth in Asia-based LNG swaps over the past couple of years and counterparties are demanding that the new flexible supply from the U.S. is underpinned by both price transparency and the means to hedge," commented Shelley Kerr, global director of LNG at S&P Global Platts, when the new contract was announced.
In March, Singapore Exchange launched an index that tracks spot prices for LNG in Dubai, Kuwait and India. This is the third LNG index that SGX has introduced as part of its plans to develop Singapore into a major hub for LNG trading.
The goal is to give regional buyers of LNG a set of indices that track local supply and demand. That is important because the supply dynamics of gas and LNG in the U.S., Europe, and Asia are very different, according to Platts’ Howson. Hurricane risks on the Gulf Coast may affect gas prices in the U.S. but not LNG prices in Asia, while a disruptive event in Asia, such as the recurring shutdowns of the Gorgon LNG plant in Australia, will not have an immediate ripple in the U.S. gas market.
The other two indices published by SGX are the Singapore Sling, launched in October 2015, which serves as a reference point for the South-East Asian market, and the North Asia Sling introduced in September 2016, which competes with the JKM index published by Platts.
For the new index, SGX worked with Tullett Prebon, a leading broker of physical LNG, to develop a reference point based on spot prices for LNG shipments to ports in India, Kuwait and Dubai. The index is based on weekly assessments from more than 20 physical LNG players, including producers, consumers and trading companies.
“We see the development of a trusted and transparent price for the Middle East and India region crucial in helping LNG participants mark-to-market trading exposure," said Melissa Lindsay, global head of LNG at Tullett Prebon. "SGX and the methodology behind the Sling indexes are already highly regarded by the industry, so we think this is the ideal partnership for establishing a credible regional price. This can subsequently be used as an underlying index in physical and financial trades.”