What do Asian liquefied natural gas (LNG) buyers want? The short answer is lower-priced LNG imports. Easy to say. Not so easy to get.
In January, Tokyo Electric Power Company (TEPCO), the company at the centre of the Fukushima Daiichi nuclear accident, had its "new comprehensive business plan" approved by the Japanese government. If the report had a subtitle, it would be "Desperate times call for desperate measures."
This was the sixth plan to be filed by the company in less than three years. But despite the additional paperwork, problems at the Fukushima facility continue. On January 18, the company released a statement on its website admitting to yet another radioactive water leak.
Unable to turn its nuclear fleet back on until it gets a clean bill of health from Japan's new nuclear safety authority, TEPCO has been forced to spend billions buying spot market cargoes of oil, coal and LNG. In 2012, it posted a net loss of 685 billion yen (US$7 billion). The numbers for 2013 are not likely to be better.
With no end to the nation's nuclear moratorium in sight, TEPCO is building fossil fuel-fired facilities. In December, the company announced it will build an integrated gasification combined cycle (IGCC) plant in Fukushima with a consortium of Mitsubishi-owned firms. IGCC plants are the world's most fuel-efficient coal-fired plants. TEPCO also has several new LNG facilities on the books.
TEPCO is not alone. Japan's electricity market is dominated by 10 utility companies, each a monopoly within its own operating region. Because of the additional cost of importing fuel, they collectively lost over US$30 billion in 2011 and 2012.
And fuel import costs aren't problems exclusive to utility companies. They are also problems for the Japanese government. The government logged its third straight deficit in 2013. At 11.47 trillion yen (US$112 billion), it was the worst on record.
In November, the Diet (Japan's legislature) passed a new law that will bring wide-ranging reform to the electricity sector, including breaking up generation and transmission monopolies and eliminating price controls. The government is also urging utilities to find ways to reduce the cost of imported fuels. If successful, these reforms might be the first steps down the road to a deregulated natural gas market in Asia – a market that looks more like that of the natural gas markets of North America and the United Kingdom.
But, if history is any guide, it will be a long road and there will be many pitfalls along the way.
The British Columbia government focuses on high Asian spot prices as the future for LNG. But as the Japanese story illustrates, those prices are a symptom of a market in distress (or, as economists like to say, in transition). And markets in distress don't stay that way.
First, a caveat: Asia is not a monolith. Japan has different energy needs than South Korea, China and India. But Japan is by far the largest importer and will remain so for the foreseeable future (see graph). And regardless of their differences, Asian countries have all been brought together by their common quest to reduce the price they pay for LNG.
In their desire for lower-priced LNG, Asian buyers have called for many things: more diversified supply, a break from oil-linked pricing, more flexible contracts and new technologies – including those that facilitated the development of shale and tight gas resources in North America – to be deployed around the world.
But these in and of themselves are just first steps, and Asian buyers will need to move beyond them to get full gas-on-gas competition and hub-based pricing. And if they do that, they will get not only what they want, but also what they need.
A brief history of natural gas and LNG pricing
Three things characterize the natural gas market in Asia: long-term contracts, oil-linked price formulas and little room for negotiation if something goes awry. What is sometimes forgotten is that these were characteristics of the North American natural gas market in its early days, too.
In the early days, natural gas was a direct substitute for oil in heating and electricity generation infrastructure. Eventually, oil was no competition at all. Instead there was gas-on-gas competition among different supply basins and, in the electricity market, competition among coal-fired, nuclear, hydro and renewable energy.
Infrastructure expanded. Vast pipeline transmission and distribution pipelines were built to connect supply and demand regions. Then concerns about anti-competitive behaviour encouraged governments to step in, first with price controls and then later with market liberalization. Over many decades, competition slowly extended (for the most part) from wellhead to burner tip. These trends moved from North America to the United Kingdom and, in recent years, to continental Europe.
Now gas-on-gas competition is moving to Asia, but according to Jonathan Stern, chairman and senior research fellow of the natural gas research program at the Oxford Institute for Energy Studies, the transition will be slow.
Slow demise of oil-linked pricing
Stern said the standard oil-linked pricing formula – linked to the price of Japanese crude oil imports – doesn't make sense anymore. Each country has unique characteristics. Some kind of oil-linked price might make sense in China and India, where natural gas is still replacing oil, but that price will be a Chinese or Indian price, not one linked to Japanese oil imports. In Japan, South Korea, Singapore and Taiwan, natural gas stands alone and, therefore, some kind of market or hub or spot price or mechanism would be more appropriate.
"You need to look at this on a country-by-country basis," Stern said.
And that is exactly what some countries are starting to do.
Lauded by the Paris-based International Energy Agency as "the candidate best suited to develop a trading hub in the medium term," Singapore is expanding its LNG storage and reloading facilities, hoping to capitalize on its position as a gateway between demand centres in Japan, South Korea and China and supply centres in Malaysia, Indonesia, Australia and Qatar to develop a spot market for LNG. Enticed by a low tax regime, many international trading companies and producers have set up trading desks in the city state.
In China, the government is also experimenting with benchmark pricing by indexing regional gas prices to the price of gas at the Shanghai city gate.
"At Shanghai city gate, what we see is gas coming in from Chinese domestic producers, LNG imports, pipeline gas imports, also oil products, some coal and eventually we will see nuclear," Stern said. "We are going to see a composite price at this city gate, and they are going to base the whole rest of the country on that price."
Importers, then, will have to compete with the Shanghai city gate price, and that price will be revised every three to six months, depending on how the supply mix changes.
The Japanese government is also laying the groundwork for an LNG futures market with the establishment of a spot reference price and a joint venture with the Singapore hub to kick-start over-the-counter traded derivatives, but Stern is skeptical about whether the underlying physical market has evolved enough to support it.
"If you look at the 2012 spot cargoes [the most recent year for which there is data], if you average them out over a year, they average to something like 1.2 cargoes a day. It is very difficult to create a competitive market on something that is only trading one cargo a day."
A deepening of the spot market isn't likely to come about soon. Most Asian long-term, oil-price-linked natural gas and LNG contracts are still in their early days. Some of these are for Australian projects that will start up in the next two or three years. These legacy contracts were negotiated under the old rules, with oil-linked pricing and little or no ability to renegotiate.
The dawn of a new era
Meanwhile, there is little Asian buyers can do to mitigate short-term pain.
"Nobody anticipated Fukushima. Nobody anticipated oil prices going up over US$100 a barrel and staying there," Stern said. "If they had, they wouldn't have signed these contracts in the way that they did."
Short-term relief may result from lower oil prices, but it would be temporary and the structural problems will remain.
As Asian buyers struggle through short- and long-term systemic change, what is a Canadian exporter to do? Stern offered some sage advice.
"Firstly, don't attempt to set price on the basis of old world. It's not going to be possible. The maximum you are going to get, in this period, is something pegged to some form of oil price, probably not crude, and unless you are selling into Japan, probably not [linked to crude imports to] Japan."
Buyers can't afford to increase their oil price exposure and, given the difficulty in predicting what the natural gas market will look like four to six years from now (or more), they need to find another way.
Stern believes the only path forward is one that would allow buyers and sellers to agree to some basis for LNG pricing, but then also agree to sit down six months before plant startup to make sure that basis still applies.
He knows that lawyers and bankers will hate such an approach, but he cannot see any other arrangement that will allow buyers to proceed.
"It would be commercial suicide to agree to something in the current market."
Stern also believes LNG project developers need to get over the fallacy that natural gas and LNG markets are "special."
"What I say to gas people is if you were building a refinery, you would have to take a position on the price of oil before the refinery was built. If you were building a car plant, same thing. These are also multibillion-dollar installations. People in the gas industry have gotten used to having these wonderful long-term contracts [that] transfer the risk downstream. Well, that era is probably over."
With knowledge of the market, and far-sightedness and determined bargaining, perhaps a new era is about to begin. •
This is the second instalment in a three-part series examining Canada's future role in the global LNG industry prepared by Oilweek contributor Leah Lawrence. Part 1 ("Pressing Canada's global gas pedal") appeared in BIV issue 1267; February 11–17). In part 3, Lawrence will examine the strategies Canadian governments and LNG suppliers might adopt to ensure Canada's ability to access global LNG markets is optimized.
