Highlights
  • Gas trading hubs in Japan and China are not mutually exclusive.
  • Both price benchmark changes and contract flexibility improvements are beneficial.
  • The “Asian Premium” is not caused by destination restriction.
  • Destination flexibility is much more important than hub indexation in East Asia except China.
  • Hub indexation is as important as destination flexibility in China due to pipeline imports.

Introduction

East Asia is gearing to change its dominant oil indexed long term contracts to more flexible spot indexed contracts for its LNG and gas imports at regional hubs. Most LNG to East Asia was traded under oil indexed contracts despite LNG to the East Asian region coming from various countries. However, the oil indexed pricing mechanisms face many criticisms in terms of structure, duration and the substantial gaps in prices between North America, Europe, and Asia. It is thus of East Asia’s interest to create its own regional gas trading hubs that can generate more transparent price index reflecting the region’s own supply and demand fundamentals for its gas trade, move away from oil indexation to the hub indexation, and improve contact flexibility.

Given the significance of East Asia in the world’s LNG market, considering the impact of East Asia’s contract changes is also important for the regional and global gas markets. The Asian natural gas market is the fastest growing gas market worldwide. Due to its geographic reach and flexibility of supply, LNG is expected to continue play a leading role in the East Asia’s gas market and the International Energy Agency predicts that Asia may absorb 80% of the incremental LNG imports over the medium term, among which, China alone will absorb 30%.

The discussions on East Asia’s gas trading hubs, hub indexation and contract flexibility are limited to a few recent studies due to the nascent changes in region’s gas market. Only a few recent studies (Rogers and Stern, 2014 and Stern, 2014) have paid attention to the gas trading hubs, hub indexation pricing mechanism and destination clauses in East Asia. Shi and Variam (2015) is the only study that quantified the impact of adoption of the Shanghai hub price in China’s gas imports on China-Australia LNG trade. However, no existing study has examined the impact of those changes in price benchmarks and removal of destination clauses on the gas markets at East Asian regional level. A paper published by Shi and Variam (2016) in Energy Policy extended the early work by quantifying the impact of East Asia’s changes in gas pricing benchmark, removal of destination clauses and creation of gas trading hubs and is the basis of this post.

Asian LNG hub imports
Total imports of LNG to Asia

Asian hubs, pricing and flexibility

Trade of natural gas, in particular, LNG, is facing challenge on pricing benchmark. The oil indexed pricing mechanisms for LNG in Asia markets, although successful until 1990s’, currently faces few major criticisms. Firstly, oil is no long a major competitor to gas in the end use market; indexation to oil will allow supply/demand factors in oil markets, and not in the gas market, to set the wholesale prices of natural gas and thus is no longer appropriate. Secondly, as the European case shows, the competition between gas and coal in power generation has become more important. Thirdly, the oil indexation also results in relatively higher prices in Asia than hub-indexed gas prices in the USA and Europe during a period of high oil prices. The “Asia premium” leads to concerns that Asia’s economies will lose competitiveness. Lastly, the gas pricing that is realised through regional gas to gas competition in Europe and North America will not reflect Asia’s market fundamentals since gas market is more regional than global.

These criticisms, and the development in the European continental gas markets, has fuelled the debate on how to create gas trading hubs in East Asia and how to price natural gas according to the region’s own supply and demand fundamentals. An Asian hub based price is also needed, because practically, without a local competitive spot market for natural gas, there is little incentive to change current oil indexation practices, especially from the suppliers’ perspective.

LNG Spot prices (2010-2015)
LNG Spot prices (2010-2015)

Gas hubs and regional competition

Many East Asian importers have started to create its own regional gas pricing benchmark through the establishment of gas trading hubs. Currently, Singapore, Japan and China are leading the hub initiatives in East Asia. While it is generally believed that Asian hubs can bring benefits such as enhanced flexibility and transparency of the gas markets, such benefits could be diversified among countries. National policymakers need to understand the impact of such a change of price benchmark to make their decisions.

So far Singapore has led the way. Given its advantages of liberalised electricity and gas markets, good reputation of legal, fiscal and financial regimes, and experience in developing an oil trading hub. In June 2015, Singapore Exchange (SGX) launched an Asian spot LNG index, that is, FOB Singapore SGX LNG Index Group.

To create a competitive market that supports the hub, China has also unveiled its gas market reform strategy, including removal of administrative monopoly, liberalisation of prices, and fair playground for both state and private companies, and unbundling. China has also made concrete progress and plans to create a China spot gas price.

Japan is in the process of developing its Tokyo LNG hub and LNG benchmark prices, as well as gas and electricity market liberalisation. The first Japan OTC Exchange (JOE)-facilitated LNG non-deliverable forward deal was made on July 31, 2015.

There is a concern that the hub initiatives among the three leading countries are mutually exclusive in offering a benchmark price for the region. The competition among East Asian countries for regional gas trading hubs and pricing benchmarks is therefore emerging as important policy issues and therefore need to be addressed. If there is no significant difference among various benchmark prices, the creation of gas trading hubs could be compatible while not exclusive.

LNG destination flexibility

Relaxation of destination restrictions has also been under debate in East Asia. Natural gas, in particular LNG, are often traded under rigid long term contacts with destination restrictions. These clauses are introduced for reasons such as securing supply and investment. However, these restrictions will cause inefficiency in the gas market. A study of real option valuation of free destinations in long-term LNG supplies argues that free destinations are highly likely to improve between 6% and 43% of the value of long-term LNG supplies.

The current market conditions also favour free destinations. The LNG business practice is changing rapidly with increasing medium-term or short-term (spot market) contracts and a shift from DES (Delivered Ex Ship) to FOB (freight-on-board or free-on-board) for a number of reasons, including more competition from gas market liberalisation and the emergence of competitive regulations also prevents the contractors from having any destination clauses in their sales and purchase agreements.

LNG and the growth in Asian hubs

East Asia faces significant opportunities in the development its own hubs and spot prices. Firstly, the well functional spot and futures natural gas markets, Henry Hub in the USA, National Balancing Point (NBP) and Title Transfer Facilities (TTF) in Europe, provide a leading example for East Asia. Secondly, some projects in Indonesia, Guinea, Nigeria and Qatar have started to offer HH-Indexed prices for LNG supply to Asia. Thirdly, the US LNG exports, priced based on Henry Hub and without destination restriction, raise the hope that liquidity in the East Asian spot markets will increase and could provide a trigger to open discussions with other suppliers on developing new pricing formulas and removing destination clauses. Lastly, the coming of a buyers’ market in the global LNG market makes the changing of pricing mechanism towards competitive prices feasible for East Asia.

hubs
2016-2015 Year on Year changes in Asian LNG imports

The results of change to hub indexation imply that the world would benefit from low procurement costs and thus cooperation among various stakeholders is possible. The results of change to hub indexation also imply that in a geographically close regional market in equilibrium, the choice of different benchmark hub prices will not make significant differences in trade patterns and regional prices. An IEA study concluded that given the large size of East Asian gas markets, over the long term, East Asia could host a few different markets and associated trading hubs, each of which can capture differences between markets.

Market implications

The latest research demonstrates that change of gas pricing benchmark and removal of destination clause in the four East Asian importers will have significant benefits for the East Asia and the world.

However, the impact on different stakeholders are different. Although some LNG exporters will lose their market in China, their exports could be directed to other East Asian importers. The reduction of total gas procurement costs indicates that the exporters could benefit from the policy changes as well. Furthermore, whether Shanghai or Tokyo hub price is adopted as the benchmark price for the four East Asian gas imports will not make significant difference. This suggests that multiple hubs initiatives are not mutually exclusive and there is likely to have more than one regional hub that offers different benchmark prices.

Thus, given the existence of common benefits and a lack of competition among hubs, the East Asian importers, and the exporters, should cooperate with each other to facilitate the East Asian market transition. While removal of destination clauses should be given priority in other East Asian importers due to large benefits and less difficult implementation, hub creation should be give equal consideration in China due to large benefit of switch to hub indexation for pipeline import.

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References
  • Gas and LNG trading hubs, hub indexation and destination flexibility in East Asia – Shi, Xunpeng
    Padinjare Variam, Hari Malamakkavu – Energy Policy – 2016:96:P587-596
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  • http://www.lngworldnews.com/wp-content/uploads/2016/08/EIA-Five-Asian-countries-show-slight-increase-in-LNG-imports.png

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