A Formula for LNG Pricing

May 2006

Disclaimer: While the contents of this report have been prepared with due care and diligence and presented in good faith, no liability is accepted for any inaccuracy, loss or damage suffered by any party that may result from the use of any of the contents of this report.

This report presents a formula (or formulae) for LNG pricing. Background information is presented to explain the past and (conjectured) future for this type of pricing (method). Some uncertainties and NZ specific issues are also discussed.

Pricing of LNG in the world varies by region:

• (East) Asia imports are based on formulae linked to oil prices, specifically, linked to a basket of crudes referred to as the Japanese Crude Cocktail (JCC).¹ Except for China where LNG imports have just commenced, imports do not face competition from either indigenous supplies of natural gas or imports via pipeline.
• LNG imports into Europe are also generally linked to oil prices (Brent) but prices are more diverse as they have to compete with pipeline imports and indigenous supplies in many countries.
• The USA is a (re-)emerging market for LNG as stable to falling supplies of indigenous natural gas and imports from Canada along with increasing demand need to be supplemented by imports of LNG. The USA has the most dynamic natural gas markets in the world. Most of the LNG imported is being sourced through spot and short-term contracts and are priced accordingly.

The Asia (imports) pricing basis is the one that is relevant to NZ. However, awareness of the other markets is useful for understanding how pricing methods may develop or change over time.

The general form of the Asian formula is:

P(LNG) = ax + b (1)

where x is the price of a basket of crudes imported into Japan, the JCC. Although not as easy to follow as other benchmark crudes such as WTI or Brent, it is a public domain price. More conveniently,

US$JCC ~ US$WTI – US$1.00 per barrel (2)

a and b are negotiated slope and intercept respectively, specific to each contract.²

There are usually less linear tails in a formula, resulting in an "S" curve to mitigate for price extremes, effectively providing for floors and caps on the price. There are also specific "meet & discuss" clauses in any contract to take account of unusual or unanticipated conditions or situations.

China's first LNG project in Guangdong province is generally regarded as having obtained a precedent-setting pricing basis in 2002.³ The formula provides for lower prices and a weaker linkage to oil prices than in previous contracts. An estimate of the pricing formula is:

P(LNG_cif) = 0.052JCC + 2.1133⁴ per mmBTU⁵ (3)

This is in contrast to a more "traditional" formula (4) that is applicable to most of Japan's imports, a pricing basis that can be assumed to be broadly applicable to contracts in Asia signed prior to 2002.

P(LNG_cif) = 0.1226JCC + 1.2367⁶ per mmBTU (4)

(3) and (4) are illustrated in the Figure 1 below.

Figure 1: LNG Pricing Formulae – fitted

Source: Asia-Pacific Energy Research Centre, 2005. China data estimated by PetroStrategies; Japan LNG prices from IEA Energy Prices and Taxes, JCC prices from EDMC, Institute of Energy Economics of Japan.

Not surprisingly, neither contract formulae nor specific contract prices are generally available in the public domain.

Figure 2 below extends the formulae beyond the data that was used to fit the regressions. Importantly, incorporating a range of oil prices that have prevailed in the last year or so.

One recent set of contracts for which there was a range of prices disclosed was for South Korea. For a tranche of 5 million tonnes pa (~250 PJ, around 3.5% of world LNG consumption and 23% of current Korean consumption), a price range of US$197 – 217 per tonne (US$3.79 – 4.17 per mmBTU, US$3.59 – 3.95 per GJ) at an oil price of US$40 per barrel was agreed upon. This is significantly lower than the US$322 per tonne price under their existing contracts.⁷

Both the old and new prices reported for South Korea are well within the range that can be derived from the two above formulae, as is shown (by the 3 markers) in Figure 2 below.

Figure 2: LNG Pricing Formulae – extrapolated values

The above analysis uses a CIF⁸ pricing basis, as this has historically been the most common arrangement. The CIF component of (3) is possibly in the region of US$0.40.

Assuming that NZ will source its LNG from Australia (not a certainty), shipping distances are not too different than for China's Guangdong project which is sourcing its LNG from the North-West Shelf. That is, (3) is a reasonable formula for New Zealand on a CIF basis.

Points to Note:

• The assessment is that LNG markets have moved from a recent small window of a buyers' market back towards more of a sellers' market. Hence, the "new" formula probably represents a sensible lower bound.
• The "old" formula would appear to be an upper bound under any circumstances.
• Importantly, the "new" formula⁹ applies for contracts that have just or are yet to come into force, with Guangdong having just received its first shipment¹⁰ and the new Korean contracts not due to begin supply until 2008. Although average contract lengths are declining, these contracts are typically for terms of 10-20 years.
• The above analysis assumes a "conventional" contract for supply should NZ import LNG. There seems no reason to suggest otherwise even though there are often more complex arrangements in other markets.
• LNG contracts are becoming more diverse, flexible and generally more attuned to the needs of the customer. For example, destination clauses,¹¹ that are part of CIF contracts, are becoming less common.
• Accordingly, FoB¹² contracts are becoming more common. With a FoB contract, the buyer takes ownership of a cargo once it is loaded, effectively allowing the cargo to be redirected or resold should that suit the circumstances of the buyer.
• The 2004 study by the Centre for Advanced Engineering (CAE),¹³ partly sponsored by MED, suggested a minimum illustrative project size of around 1.6 million tonnes pa (~80 PJ). Contact Energy who along with Genesis Energy has been investigating LNG importation issues assume a project size of 60 PJ pa.¹⁴ These figures are around 1% of world LNG consumption.
• Should NZ proceed to import LNG, it will be the only importer in the southern hemisphere. Albeit inconsequentially small, NZ's thermal fuels load is counterseasonal to the northern hemisphere. There is increased accommodation of LNG buyers' demand seasonality. This means that it may be possible for New Zealand to access excess production and shipping capacity for the seasonal part of its load, possibly at lower prices than in any core contract.¹⁵
• In addition to the counterseasonality aspect, liquefaction trains and LNG tankers are being constructed without being fully contracted, increasing the possibility of offtake along non-traditional lines, that is, gas may be obtained from the secondary, spot or short-term markets.
• Albeit small at around 10%of the overall market, the share of the spot market vis-à-vis the long contracted market is increasing. LNG markets will become more liquid and commoditised into the future. However, this will not be to the extent of oil markets.

A Pricing Formula for New Zealand

Converting equation (3) to a gigajoule (GJ) basis, that is dividing the right-hand-side by 1.055, substituting for JCC with (2) and adjusting for exchange rates gives

P_NZ$(LNG) = (2.003 + 0.0493 * (WTI – 1)) * NZ$:US$ per GJ (5)

Incorporating a New Zealand storage and regasification tariff of US$1.25¹⁶ adjusted for the NZ$:US$ exchange rate applicable for building the storage terminal, NZ$:US$(0), gives

P_NZ$(LNG) = (2.003 + 0.0493 * (WTI – 1)) * NZ$:US$ + 1.25 * NZ$:US$(0) per GJ (6).

where 1.25 * NZ$:US$(0) is the New Zealand storage and regasification tariff, essentially invariant to exchange rates once it is built.

Example

Assume that the WTI price is US$60, the current exchange rate is 0.55 and that the average exchange rate for the construction of the storage and regasification terminal is 0.60. Then

P_NZ$(LNG) = ( 2.003 + 0.0493 * (60 – 1) ) * 1/0.55 + 1.25 * 1/0.6 per GJ (7).

= (2.003 + 2.9087) * 1.8182 + 2.0833

= NZ$ 11.0138 per GJ

Recommendation

It is recommended that (6) be used to derive the cost of LNG

This site uses cookies to track and analyse usage.