A Formula for LNG Pricing

November 2008

Disclaimer: Every attempt has been made and continues to be made to ensure that the information contained in this report is accurate. However, the Author and MED do not:

• warrant the accuracy or completeness, for any particular purpose, of the information contained in this report in paper or electronic form.
• accept any liability for any loss or damage however caused from the reliance on or use of the information contained in this report or arising from the absence of information in this report in paper or electronic form.

Forward looking statements and data, such as contained in this report, are inherently uncertain and due care and expertise should be exercised in using such information.

In an earlier report, "A Formula for LNG Pricing", May 2006, the author presented and discussed a formula relating LNG contract prices in the Asia-Pacific region to oil prices. Since that document was written, both the oil and LNG markets have experienced significant changes. This report briefly discusses recent market developments and their impacts on LNG contracting practices. Based on these market developments, it also presents a proposed update to the earlier formula and provides recommendations as to what LNG price assumptions MED should use in its energy modelling.

LNG projects require substantial capital investments in liquefaction trains and other supply infrastructure, which the parties involved must have assurance that they can recover. Therefore most LNG is traded under long-term contracts, typically of 10-20 years duration. Spot trading in LNG remains relatively modest, so some basis other than spot LNG prices must be found for setting LNG prices under these contracts. Although LNG (and natural gas generally) competes with both oil and coal in the electricity generation and direct-use markets, LNG is usually viewed as a premium fuel, like oil, due to its relative cleanliness, ease of use and ability to be transported by sea over long distances. For these reasons, and the fact that Japan initially imported LNG partly to substitute for oil-based fuels, oil prices have historically been used as the basis for setting the price of LNG in the Asia-Pacific region under long-term contracts.

Some of the key developments of the last 2-3 years are discussed below.

• Oil prices have continued to be high and volatile. Earlier this year (11 July) the West Texas Intermediate (WTI) marker peaked at US$147/bbl. Partly due to the effects of the credit crisis, prices have since dropped to around US$60/bbl at the time of this writing.
• At this oil price level, LNG prices are around US$10/mmBTU, still high by historical standards
• Infrastructure projects, including oil and gas extraction and processing plants, have faced rapidly escalating costs, for both materials and personnel. Greenfield LNG liquefaction capacity installation costs have increased from around $500/t/year or less 3-4 years ago to over $1000/t/year today.
• In broad terms, the uncertainty of rising infrastructure development costs and other factors such as resource or environmental issues, have meant that few LNG liquefaction plants have achieved final investment decision (FID) status since 2005. In 2007, there were over 10 projects awaiting FID yet only two, Pluto in Australia and Angola LNG achieved that status¹. Even for plants that have achieved FID, construction periods have stretched from around 3 years duration to longer than 4 years. Hence any plant approved now is not likely to enter into production until 2012 at the earliest.
• The credit crisis and slowing global economic growth, combined with retreating oil and gas prices, are resulting in a very uncertain environment for financing additional LNG capacity
• As a result of increasing demand not being fully met by increased supply, higher prices may be expected in the long-term in both oil and LNG (and to some extent pipeline natural gas) markets.

Historical LNG Pricing Formulae

LNG pricing in Asian markets, which comprised around 65% of world consumption in 2007, has historically taken the form of an "S-curve" based on a formula of the form:

P(LNG) = ax + b (1)

where x is the price of a basket of crudes imported into Japan, the Japanese Crude Cocktail (JCC). Although not as easy to follow as other benchmark crudes such as WTI or Brent, it is a public domain price². More conveniently,

US$JCC ~ US$WTI – US$1.00 ³ per barrel. (2)

The values of a and b are negotiated individually in each contract⁴.

There are often floors and caps on the LNG price set by (1) These floors and caps also vary with the price of oil, but with a lower slope than (1) resulting in an "S" curve. A "floor" price may effectively protect the producer's investment whereas a price "cap" provides a quid pro quo for the LNG buyer. There are also specific "meet & discuss" clauses in any contract to take account of unusual or unanticipated conditions or situations. For example, Woodside Petroleum (Australia) and three Japanese customers have recently agreed a provisional "out of range" price rise for contracts agreed before 2006⁵. The same supplier has, so far, failed to re-negotiate the now very low prices being paid by Guangdong LNG (as provided by (3) below).

At issue, is (i) the slope, a, of the curve, a reflection of the correlation of LNG prices to oil prices, and (ii) the inflexion points at which the correlation is weaker than a. A pricing formula is conceptually illustrated in Figure 1.

Figure 1: Conceptual "S" formula

The pricing formula recommended in the May 2006 report, often referred to as the "Guangdong formula", was of the form:

P(LNGcif) = 0.052JCC + 2.1133 ⁶ per mmBTU (3)

Or

P(LNGcif) = 0.0493JCC + 2.003 per GJ ⁷ (4)

This was in contrast to the more prevalent

P(LNGcif) = 0.1226JCC + 1.2367 ⁸ per mmBTU (5)

which had evolved from when Japan began large scale LNG importation in 1969 – hence the origin of the JCC.

It can be seen from (3) and (5) that the latter has a stronger link to oil prices. (3) had been negotiated in 2002 by CNOOC of China with Australia's North West Shelf project for China's first LNG imports. Shipments of LNG into the Guangdong terminal started in 2006.

At the time, (3) was considered a precedent-setting pricing basis with a (much) weaker link to oil prices than had historically been the case. Even LNG suppliers considered that the formula was set during a "buyers' market" window of opportunity. However, the window proved to be very short-lived, and only a small number of contracts were agreed with formulae similar to (3). Most of them were by Indonesia's Tangguh project with supply contracts to the recently commissioned⁹ Fujian Province's Putian terminal in China and a number of (South) Korean buyers, all due to start receiving supplies in early 2009.

It is important to note that the oil prices at which the floors and ceilings take effect in these contracts are very low by today's oil price levels. This is because prevailing and anticipated oil prices were much lower at the time these contracts were negotiated.

Pricing Developments, Oil Price Parity and a New Formula.

The demand for LNG has continued to grow strongly, partly as a result of historically attractive prices, and partly due to the increasing appeal of natural gas as a low carbon emitting form of energy. Rapidly developing and expanding economies such as China and India are also resource, and in particular, energy hungry. In the short term, events such as the (temporary) closure of nuclear electricity generation plants in Japan have put pressure on demand, bidding up the price of the fuel. Spot prices were as high as US$15-18/mmBTU in late 2007. Although lower than this peak, spot prices are still over US$10/mmBTU at the time of this writing. The (Henry Hub) price for pipeline natural gas in the USA has also come off its recent highs and is currently around US$7/mmBTU.

Consistent with the run-up in oil, energy and other commodity prices in the last few years, the price of natural gas and LNG has risen and continues to rise. This is illustrated in Figure 2.

Figure 2: Natural Gas Prices

Source: BP Statistical Review of World Energy 2008

→ Full size version of Figure 2 [10 kB GIF]

LNG markets have continued to evolve in other ways, as well. The share of trade taken by the spot market has continued to increase albeit partly driven by short-term events. For a number of years, there has been the contention that the three regional markets, Asia-Pacific, Europe and North America, which have somewhat different pricing methods, will converge. There is now some evidence of this happening, for example, the "S-curve" being superseded by a near oil price parity (straight line) basis.

Between 2002 and 2007, total world trade in LNG has increased from 168.8 billion m3 to 226.4 billion m3, a rate of increase of 6% per annum. Increases in demand are likely to exceed increases in supply in the next few years. In the face of rising demand not being fully met by increased production, the LNG market has turned rapidly into a sellers' market.

Accordingly, sellers have been seeking higher prices and a better pricing basis to reflect resource scarcity, market power and to provide a return on large, high risk, and increasingly costly supply investments. Increased development costs mean that a higher floor price is required to underwrite the investment. A number of suppliers, notably Qatar, which is now the world's largest LNG supplier, have sought pricing parity with oil. With much higher oil prices, the inflexion points have obviously also moved up.

Oil parity implies an "a" coefficient of around 0.17¹⁰. In reality, this may be hard to justify, particularly when inter-fuel competition with fuel oils and coal are considered. The "going rate" now appears to be around 0.145 (around 85% parity with oil) or even slightly above. Thus:

P(LNGcif) = 0.145JCC + 1.0 per mmBTU (6)

An "S-curve" based on (6) would have a lower inflexion point in the region of US$50-60/bbl and the upper inflexion point in the region of US$80-100/bbl. A pessimistic outlook, from the buyer's perspective, would suggest removing the inflexion points altogether.

The range of pricing curves is summarised in Figure 3.

Figure 3: LNG Pricing Formulae

→ Full size version of Figure 3 [24 kB GIF]

A Pricing Formula for New Zealand

Converting equation (6) to a gigajoule (GJ) basis, that is dividing the right-hand-side by 1.055, substituting for JCC with West Texas Intermediate (WTI), as per (2) and adjusting for exchange rates gives

PNZ$(LNG) = ( 0.1374 * (WTI – 1) + 0.94787) * NZ$:US$ per GJ (7).

Incorporating a New Zealand storage and regasification tariff of US$1.50¹¹ adjusted for the NZ$:US$ exchange rate applicable for building the storage terminal, NZ$:US$(0), gives

PNZ$(LNG) = ( 0.1374 * (WTI – 1) + 0.94787) * NZ$:US$ + 1.50 * Z$:US$(0) per GJ (8).

where 1.50 * 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$70, the long term average exchange rate is 0.65 and that the average exchange rate for the construction of the storage and regasification terminal is 0.7. Then

PNZ$(LNG) = ( 0.1374 * (70 – 1) + 0.94787) * 1/0.65 + 1.5 * 1/0.7 per GJ (9).

= (9.4806 + 0.94787) * 1.5385 + 2.1428

= NZ$18.187 per GJ

for an oil price of US$70/bbl.

It is worth noting that this gas price is considerably higher than would result from the recommended "Guangdong formula" (6) in the May 2006 paper:

PNZ$(LNG) = ( 0.0493 * (70 – 1) + 2.003) * 1/0.65 + 1.25 * 1/0.7 per GJ (10).

= (3.4017 + 2.003) * 1.5385 + 1,7857

= NZ$10.1008

This difference reflects the new (and updated) market conditions in LNG discussed in this paper.

Recommendations

1. It is recommended that (8) be used to derive the cost of importing into LNG into New Zealand. The formula should be applied at least within an oil price range of US$50-100/bbl. A floor price based on $50/bbl is likely to be justifiable. Given how short the experience has been so far with oil prices over US$100/bbl the applicable ceiling price is more problematic. For the moment, given the sellers' market for LNG, an interim assumption of no ceiling is justifiable.
2. Should the MED wish to consider a more optimistic view of future LNG prices, for example, for scenario purposes, the traditional formula (5), converted from mmBTU into GJ energy units and adjusted for the NZ$:US$ exchange rate provides a convenient and justifiable lower bound for LNG prices.

This site uses cookies to track and analyse usage.