Morten Frisch Gasex 2010 Paper 14 November 2010

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The paper Gas market dynamics and the future pricing of spot LNG presented to Plenary – Panel Discussion I: Energy Supply Security at GASEX 2010 Conference in Taipei. Taiwan on 24 November 2010 and published electronically by the GASEX 2010 Conference.

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Morten Frisch Gasex 2010 Paper 14 November 2010

  1. 1. Version 2, updated 14 November 2010 GAS MARKET DYNAMICS AND THE FUTURE PRICING OF SPOT LNG To be presented at Plenary – Panel Discussion I: Energy Supply Security GASEX 2010 CONFERENCE Taipei, Taiwan Wednesday, 24 November 2010 Morten Frisch Senior Partner Morten Frisch Consulting Morten Frisch Consulting 6 Holmwood Close East Horsley Surrey KT24 6SS United Kingdom Tel: +44-1483-284248 Fax: +44-1483-285099 Email: office@mfcgas.com Web: www.mfcgas.comMorten Frisch Consulting accepts no liability for commercial decisions based on the content of this paper. Although the paper is copyright ofMorten Frisch Consulting, quotes from the paper are permitted, provided full references to the paper and Morten Frisch Consulting are made.Onward transmission or copying of the paper is allowed in its original form only.
  2. 2. Gas Market Dynamics And The Future Pricing Of Spot LNG, Morten Frisch, GASEX 2010 ContentsAbout the Author .................................................................................................................................... 3Abbreviations .......................................................................................................................................... 4Executive Summary................................................................................................................................. 5Causes of the LNG Surplus....................................................................................................................... 6 a) Unconventional Gas a Challenge for LNG .................................................................................. 6 b) World-wide Liquefaction Capacity Developments ....................................................................... 7 c) Uncontracted LNG Availability .................................................................................................. 8 d) Recession Impact on Gas Demand ........................................................................................... 9LNG Spot and Short-term Trading ...........................................................................................................10Commercial Model for Spot and Short-term Trading .................................................................................15 TablesTable 1: Projected Incremental LNG Availability ........................................................................................ 7Table 2: Flexible LNG Sales as Percentage of Total LNG Exports ................................................................ 8Table 3: Asia LNG Demand Q1-Q3 2010 ..................................................................................................10 FiguresFigure 1: Spot and Short-Term LNG Exports ............................................................................................. 8Figure 2: Interrelations of LNG Markets ...................................................................................................11Figure 3: Relationship Between Henry Hub and NBP Prices .......................................................................11Figure 4: Price Relationship between HH, NBP, BAFA and Japan LNG Import Prices....................................13Figure 5: Current LNG Spot Price Dynamics (schematic) ...........................................................................13Figure 6: Japanese DES Spot Prices Potential Range ................................................................................14Keywords: 1. Gas Markets. 2. LNG Markets. 3. LNG Supply. 4. LNG Pricing. 5. Spot LNG. 6. LNG Trading.7. LNG Price Benchmarks. 8. LNG Short-term Sales. 9. Platform-based LNG Trading. 10. Market-based LNGPrice Discovery. 11. US LNG Imports. 12. European Gas Market. 13. LNG Trade Routes. 14. Shale Gas.15. Unconventional Gas.© 2010 Morten Frisch Consulting 2
  3. 3. Gas Market Dynamics And The Future Pricing Of Spot LNG, Morten Frisch, GASEX 2010 About the AuthorMorten Frisch, Senior Partner, Morten Frisch Consulting (MFC)Morten Frisch’s career developed in parallel with the gas industry in his home country of Norway. He hasmore than 35 years of hands-on experience addressing strategic, commercial and operational issues alongthe entire value chain for LNG and pipeline gas. This experience stems from work for the NorwegianGovernment, multinational oil companies and as a consultant since 1990.The first time Morten Frisch led a gas sale negotiation was in 1976, the year his first dealings with LNGreceiving terminals (Everett and Cove Point terminals, USA) also took place. His first LNG marketing workwas conducted in 1980 (for the then Phillips Petroleum’s Bonny LNG project in Nigeria).In 1977 as part of gas price indexation formulae design work, Morten Frisch was instrumental in thedevelopment and drafting of the Norwegian and Swiss law Price Review and Price Re-opener clauses, nowuniversally used in long - term gas sales and purchase contracts for the supply of gas to Continental Europe.In 1993 together with Freshfields solicitors in London he converted this language to English and New Yorklaw. The resulting Price Review and Price Re-opener clauses are now commonly used in long term AtlanticBasin LNG supply agreements.Since 1990 Morten Frisch has conducted extensive work related to natural gas in the Middle East, Iran,Russia, and Central and Western Europe. He has also provided consulting services to clients or projects inNorth and West Africa, Japan, Australia and New Zealand. He is familiar with gas developments in NorthAmerica and has monitored and analysed unconventional gas developments for more than ten years.Morten Frisch and MFC’s consulting practice deals with a variety of gas issues, with a high number ofassignments addressing gas pricing issues, commercial optimisation, risk mitigation strategies and methodsfor operations in rapidly changing gas market environments. He has been called upon as an expert witnessin arbitrations and court cases dealing with gas contract related issues, particularly in disputes involving pricereview/price re-opener clauses.Morten Frisch has acted as a lead negotiator in gas sales and purchase negotiations for clients. In the pasthe has also advised governments on international gas issues. He also advises clients on the organisationalstructure and staffing of gas-related projects, and he has acted as a mentor for their novice commercial gasstaff. He is an established professional in the field of gas training.Since 2007 Morten Frisch has been supporting clients in the development of a more transparent and reliableway to establish gas market-based pricing of spot and short-term LNG sales.Morten Frisch is a chartered engineer (Sivil Ingeniør) in his home country of Norway and an economist(degrees from University of Newcastle upon Tyne, UK and Massachusetts Institute of Technology (MIT),Mass., USA). He is a member of the Society of Petroleum Engineers (SPE) (since 1975), the InternationalAssociation of Energy Economics (IAEE), the British Institute of Energy Economics (BIEE) and a foundingmember of the Norwegian Petroleum Society (NPF). He has published a number of articles addressingstrategic and commercial gas issues. He is frequently invited to give presentations at major international gasand energy conferences and appears regularly as a guest on major TV stations’ business programmes.© 2010 Morten Frisch Consulting 3
  4. 4. Gas Market Dynamics And The Future Pricing Of Spot LNG, Morten Frisch, GASEX 2010 AbbreviationsBAFA = Bundesamt für Wirtschaft und Ausfuhrkontrolle is the name for the German Federal Office ofEconomics and Export Control. Monthly average unit cost of imported natural gas across all border points ispublished by this Federal Office on a monthly basis in €/TJ.Bcm = Billion cubic meters (106).CEGH = the Central European Gas Hub at Baumgarten, established by OMV Gas & Power GmbH. OMV andGazprom have recently signed a Cooperation Agreement to jointly develop the hub with the aim of itbecoming the largest trading platform in Continental Europe (Press Release of 25 January 2010)DES = Delivered Ex Ship.GASPOOL = joint company which operates the market area cooperation of DONG Energy Pipelines GmbH,Gasunie Deutschland Transport Services GmbH, ONTRAS – VNG Gastransport GmbH and WINGASTRANSPORT GmbH & Co. KG.Henry Hub (HH) = Henry Hub is the pricing point for natural gas futures contracts traded on the New YorkMercantile Exchange (NYMEX). It is also a physical point on the natural gas pipeline system in Erath,Louisiana.Mmbtu = Million British Thermal UnitsMtpa = million tonnes per annum.NBP = the virtual National Balancing Point in the United Kingdom’s network of pipelines forming the nationalgas transmission system and the hub in Europe with the largest trade volumes and the greatest tradingdepth.NCG/EGT = a joint company which operates the market area cooperation of Bayernets GmbH, Eni GasTransport Deutschland S.p.A., E.ON Gastransport GmbH, GRTgaz Deutschland GmbH, GVS Netz GmbH.After its most recent expansion, it is now referred to as simply NCG (Net Connect Germany). In 2010 itbecame the largest trading hub after TTF in Continental Europe.PEG-Nord = the virtual trading point in the North of France, created in 2009 when the three zones (PEGOUEST, PEG EST, PEG NORD) merged into one.PSV = Punto di Scambio Virtuale, is the name of the Italian Virtual Trading Point established by Snam ReteGas.Sm3 = a cubic meter of pipeline-quality gas at standard conditions with gross calorific value of 39 MJ.TTF = the Title Transfer Facility, the virtual national balancing point in the Dutch pipeline network and in2010 the largest trading hub in Continental Europe.ZEE Hub = Physical gas trading hub at Zeebrugge which was the first major gas trading hub in ContinentalEurope.© 2010 Morten Frisch Consulting 4
  5. 5. Gas Market Dynamics And The Future Pricing Of Spot LNG, Morten Frisch, GASEX 2010 Executive SummaryA world wide LNG surplus started developing in late 2008. This paper examines the causes of the surplusand the changes the international LNG industry should adopt to address it.The advent of unconventional gas and shale gas in particular has changed the North American gas scenebeyond recognition. Neither the USA nor Canada needs to import LNG on a regular basis and both countriescould before 2020 become exporters of domestically produced gas in the form of LNG from new liquefactionfacilities planned for the US Gulf coast and the west coast of Canada. The Lower 48 States of the USAalready re-export LNG by ocean going tankers from two Gulf Coast terminals. North American shale gasexploration trends and developments are now being transferred to countries in other parts of the world.A number of new liquefaction plants currently under construction will come on stream in the period to 2015.Although some major players in the LNG liquefaction industry are suffering from serious feedgas problemswhich will limit product availability from a number of existing plants, the industry’s liquefaction capacity islikely to see more than a 50 per cent addition of operational production capacity before the end of 2014. Alarge part of the additional liquefaction capacity which was originally destined for the US and Canadianmarkets is now no longer required to supply these markets. The quantities of LNG sold in the flexible spotand short term markets are predicted to increase substantially over the next 3 to 4 years as a result. Theycould be more than double the 2009 observed levels.Gas demand in US and Canada as well as Europe although improving, is still weak after the recession. Bothmarket regions are currently more than adequately supplied and as a result experience depressed gas prices.The Asian LNG market on the other hand has come out of recession much faster and is now showing strongdemand growth and firming spot and short term prices.International LNG trade routes have been changed as a result of the North American gas supply situation.The UK National Balancing Point (NBP) has become the dominant trading hub for the pricing of spot andflexible LNG supplies, since Henry Hub and the North American gas market have price-wise become isolatedfrom gas markets in Asia, Europe and South America. Russia’s Gazprom which has lost market share inEurope due to inflexible oil-indexed gas pricing could be the international LNG industry’s wildcard. Shouldthe company start discounting gas prices towards the lower European hub prices, then this is likely to reduceEurope’s attractiveness to LNG suppliers. If the current balance between LNG supply and demand isdisturbed in such a way that North American gas prices are no longer isolated from prices in otherinternational gas markets, then such a development would likely also have a major impact on theinternational pricing of LNG.The Asian market in general and the traditional markets of Japan, South Korea and Taiwan in particular, arelikely to remain the highest priced LNG markets also in the future and should be in a position over the nextfive years, and likely beyond, to attract sufficient LNG supplies for their needs.The current gas market environment has demonstrated how the traditionally used model for commercial LNGoperations can no longer deliver optimum utilisation of available product. This situation is now beingmagnified as a result of a high number of new industry participants. Energy industry publishing houses andmajor commodity brokers have recognised that the LNG industry needs better market and pricingtransparency as well as the development of screen-based LNG market data systems and trading tools whichshould lead to proper market-based pricing of spot LNG and improved optimisation of LNG chain activities.© 2010 Morten Frisch Consulting 5
  6. 6. Gas Market Dynamics And The Future Pricing Of Spot LNG, Morten Frisch, GASEX 2010 Causes of the LNG Surplus a) Unconventional Gas a Challenge for LNGUnconventional gas, meaning tight gas, shale gas and coal bed methane, has during the last 10 years playeda large and increasing role in the supply of gas to the Lower 48 States of the USA in particular, but also inCanada. This development has been accelerated by advances in drilling and production techniques of shalegas, advances that started becoming significant around 2006. Shale gas production has since this yeardeveloped from being a relatively small source of gas to one that has changed US gas supply in a substantialway. The “shale gas revolution”, now spreading throughout the North American continent, has led to asituation where the region already today can be perceived to be self-sufficient in natural gas on an averageannual basis. Domestic production together with underground gas storage should also provide sufficientcapacity to meet peak gas demand during most periods of the year.Unconventional gas, shale gas in particular, has not yet reached its full potential in North America.Technological advances in shale production are now made on a continuous basis improving shale gaseconomics in a substantial way. For example, after only a year of experimentation with flowing wellpressure modifications, it has been possible to increase expected ultimate recovery (EUR) of gas per well bysome 30 per cent in some of the major shale gas plays.Moreover, many of the new shale gas producing areas still lack the necessary gas gathering, processing andtransmission infrastructure required for large scale commercial production and transportation of sales gas tomarkets. These needs for infrastructure have been made more acute by the fact that many of the shaleplays in addition to dry gas also produce substantial quantities of natural gas liquids (NGLs) in particular andalso light crude oils. New producing areas such as the Marcellus Basin in the North East USA and Eagle Fordin South West Texas should by 2015 have the necessary infrastructure in place to change gas flow patternsand, therefore, change gas pricing along the Atlantic seaboard of the USA and Canada. All US and CanadianLNG import terminals are located on this coast.The prolific Marcellus Basin producing area in addition to serving the currently high-priced gas markets ofNew England, will also supply gas to Canada further north and to markets bordering the Gulf of Mexico.Marcellus gas will be flowing from the North East USA towards Henry Hub in Louisiana, the world’s largestgas trading hub, likely resulting in excess gas supplies and in keeping Henry Hub gas prices low. Thisdevelopment has already lead to soft gas price signals throughout the international gas industry.With unconventional gas flowing into the domestic market, traditional price signals in the US can no longeron their own reflect the economic potential of new reserves and their likely production growth. In fact,despite soft Henry Hub prices currently rendering in many areas gas resources uneconomic, wells keep beingdrilled and production from these is brought to the market. The significant margin producers receive fromthe extraction of NGL and light oils means the gas coming out of these wells is becoming a by-product of theliquids production. Moreover, in many cases, producers, bound by the strict terms of expensive acreagelease agreements, are forced to drill for gas and complete wells for production, irrespective of market pricesignals. As a result, a sustainably strong gas supply keeps market prices low, a situation exacerbated by theabsence of a counter-balancing strong demand. With total gas demand weak in the US for some time, smallincreases mainly from the power generation fuel market have been unable to reverse the downward trend ofgas market price signals. Based on the latest gas demand forecast from the US Department of Energy’sEnergy Information Administration, US gas demand will remain relatively stable in the short to medium termand unable to fully absorb all new sales gas production made available to the market.Allegedly the practice of drilling long horizontal wells and the hydraulic fracturing of these in order to obtainmaximum gas production from shale deposits have resulted in environmental concerns, particularly related towater management issues including claims of water table contaminations. It is not known that the latter hasbeen proved.However, international oil and gas companies with proved “green” credentials, good technology and peopleare now becoming increasingly involved in North American shale gas exploration and production operations.These large and resourceful companies should be able to operate to new and more environmentally friendlystandards regarding drilling and hydraulic fracturing of wells, a situation which should correct perceivedmistakes made in the past by pioneering small independent companies.© 2010 Morten Frisch Consulting 6
  7. 7. Gas Market Dynamics And The Future Pricing Of Spot LNG, Morten Frisch, GASEX 2010The advent of unconventional gas and shale gas in particular has changed gas demand planning in NorthAmerica beyond recognition. As an example, as late as 2007 US Authorities projected an LNG importrequirement of some 55 mtpa (80 bcm of pipeline quality gas) to balance its gas markets in 2015 and afurther increase in imported LNG requirements was predicted in 2020. Only a small part if any of this LNGimport volume will now be required in the US and a similar situation is developing in Canada. As a result ofdeveloping gas surpluses both the Lower 48 States of the USA and Canada could become exporters of LNGproduced from domestic feedgas before 2020. The US State of Alaska is currently a net exporter of LNG.North American shale gas exploration trends and developments are being now transferred to countries likeAustralia, China and India. In the future this will also be the case in Indonesia, South Africa, Jordan andeven Russia. These countries will likely all have substantial shale gas production in ten years time. Althoughshale gas exploration has also started within European Union countries, the future shale gas productionlevels in Western and Central Europe are likely to be more uncertain. b) World-wide Liquefaction Capacity DevelopmentsIn parallel with unconventional gas developments in North America, substantial new projects for LNGliquefaction have been developed and are in the process of being brought to the market around the world.The most recent major projects are located in Qatar, Sakhalin in Russia, Tangguh in Indonesia, EquatorialGuinea, Yemen, Peru, Western Australia, Angola and Algeria. A large part of the capacity of these LNGliquefaction projects was meant to supply the US, in particular, and also Canada. Now, the operators ofthese projects have to re-direct supply towards Asian and European markets in particular, but also to new“counter-seasonal” markets in South America and in the Arabian Gulf area.Table 1 entitled “Projected Incremental LNG Availability” shows a projection of total anticipated new LNGliquefaction capacity coming on stream between the beginning of 2008 and end 2014. Table 1: Projected Incremental LNG AvailabilityLNG expressed as bcm of pipeline quality gas per year 2008 2009 2010 2011 2012 2013 2014Total anticipated additional LNG capacity [1] 11.5 33.9 80.0 114.6 134.7 144.4 146.7Reduction in LNG production due to feedgas problems [2] 0.0 40.5 37.7 43.5 48.8 52.8 54.4Anticipated incremental LNG availability [3] 11.5 -6.7 42.3 71.1 85.9 91.6 92.2Source: MFC estimates, updated 14 November 2010[3]=[1]-[2]A number of traditional LNG suppliers, notably Indonesia, Nigeria, Algeria, Egypt, Oman and Malaysia, tomention the most important, have over the recent years experienced problems in securing adequate feedgassupplies for their LNG liquefaction plants. Some of these feedgas problems are the result of competition forgas supplies between domestic market requirements and export projects. This is an increasing problem inmany LNG producing countries. The inadequate feedgas supply in total represented a reduction in LNGproduction of some 28 mtpa (40.5 bcm) in 2009 when compared to nameplate capacity. As shown in Table1 these reductions have been projected to increase to some 37.5 mtpa (54.4 bcm) in 2014.Among the existing liquefaction plants Nigeria LNG presents a major uncertainty due to disruptions tofeedgas supplies caused by insurrection in the gas producing area. In 2008 the company produced at only65% of nameplate capacity, a number which fell to 51% in 2009. The company also experienced substantialreductions in deliveries during the first half of 2010, a situation that appears to have been corrected for thelast months of the year. In Table 1 it has been assumed that Nigeria in future years will be able to produceat 85 per cent of nameplate capacity, a normal annual operating level for the industry.In 2009 the combined effect of delayed start-up of new liquefaction capacity and the reduction in LNGproduction due to feedgas problems resulted in a reduction in LNG availability of 4.6 mtpa (6.7 bcm) whencompared to previously anticipated LNG availability based on nameplate capacities. However, overallworldwide LNG production did increase by 9.6 mtpa (13.9 bcm) or 5.66 per cent to 179.1 mtpa (259.7 bcm)in 2009 when compared to 2008.© 2010 Morten Frisch Consulting 7
  8. 8. Gas Market Dynamics And The Future Pricing Of Spot LNG, Morten Frisch, GASEX 2010Anticipated incremental LNG availability when using end 2007 capacity as a base and adjusting for reductionin LNG production due to feedgas problems is forecasted to increase from 29.2 mtpa (42.3 bcm) in 2010 to63.6 mtpa (92.2 bcm) in 2014. c) Uncontracted LNG AvailabilityUncontracted LNG availability is product sold under spot and short-term sales arrangements. Spot andshort-term LNG exports or sales are understood to be sales of duration of up to 4 years. Such spot andshort-term sales are also referred to as “flexible” sales in the text below. Figure 1: Spot and Short-Term LNG Exports 35 30 Middle East/Africa/Europe Americas 25 Australasia Others 20 Mtpa Total 15 10 5 0 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Source: GIIGNLFigure 1 entitled “Spot and Short-term LNG Exports” shows the development of flexible LNG sales since1999. There has been a marked increase in such sales since 2005. The major source of such sales havebeen the Middle East, Africa and Europe, the latter being cargoes diverted from European destinations suchas Spain and France to the USA in 2005/06 and mainly to Asian markets thereafter. Since 2008 flexible salesfrom the Americas (Trinidad and Tobago) and Australasia (mainly Sakhalin in Russia and Tangguh inIndonesia) have increased due to diversion of cargoes originally destined for the USA.Table 2 entitled “Flexible LNG Sales as Percentage of Total LNG Exports” shows that flexible LNG salespeaked at 21 per cent of total exports in 2007. The comparable figure for 2009 was some 16 per cent or29.3 mtpa (42.5 bcm) out of the 179.1 mtpa (259.7 bcm) total LNG production in the year. This figure isexpected to increase to above 20 per cent again in the time period 2010 – 2014 when a number of newliquefaction projects which were originally meant to supply the US and Canadian markets come on stream. Table 2: Flexible LNG Sales as Percentage of Total LNG Exports LNG spot and short-term sales Assessment of total exports 2005 15% 2006 17% 2007 21% 2008 19% 2009 16% Source: MFC estimates.© 2010 Morten Frisch Consulting 8
  9. 9. Gas Market Dynamics And The Future Pricing Of Spot LNG, Morten Frisch, GASEX 2010Arabian Peninsula-based LNG sellers are likely to provide large quantities of product for flexible sales by theend of 2011, when all plants being constructed at Ras Laffan in Qatar should have reached full production.In addition to the availability of flexible LNG product, there is another industry development which may actas a catalyst for LNG producers to sell into the flexible markets. This is the emergence of a high number ofenergy and commodity trading houses as active players in the LNG market. These companies appear to bein a position to offer higher prices for product than traditional buyers. However, new entrants to the LNGmarket that do not have equity production or long-term supply contracts which include arrangements forLNG tanker transportation, face a serious industry bottleneck. Shipping availability is an important hurdle.About 80 per cent of the current LNG fleet is assigned to production projects. Of the remaining LNG tankerssome 80 per cent are controlled by the international oil and gas companies leaving only some 4 per cent ofthe current fleet available for independent charter on a regular basis1. It has been observed that traders andcommodity trading houses have failed to secure cargoes due to the lack of acceptable LNG tankers.An interesting case of a company which for some time directed all of its uncontracted LNG supply to the LNGspot and short-term market is Algeria’s Sonatrach. Algeria’s marketing decisions during the period 2006-2008 were based on the assumption that spot sales were sustainably more attractive than long-term contractsales. During this period LNG volumes that had previously been delivered to Belgium and Spain under long-term contracts, were released to the spot market by purposely not renewing the expiring contracts. Duringthe same period Sonatrach decided to construct the Skikda rebuild and Arzew 3/Gassi Touil plants withoutlong-term sales agreements. These two plants are expected to bring up to 9.2 mtpa of additional product tothe market when they both have reached full production capacity after a gradual build up during the period2012 to 2015.However, Sonatrach’s strategy ultimately proved to be unsustainable as the recession changed theinternational LNG markets from the late 2008. Amidst softening prices and the absence of long-termcontracts for their under construction plants Sonatrach senior management started to realise that themarketing decisions of the past were no longer viable. Such realisation is reflected in a statement of the thenAlgerian Energy Minister, Dr. Chakib Khelil at the Gas Exporting Countries Forum (GECF) in April 2010. Dr.Khelil urged member countries to reduce spot selling in order to boost gas prices2. His statement likelyheralded Algeria’s future selling strategy. In fact, the sharp reduction observed in Algerian LNG sales overthe past six months of 2010 could possibly, at least in part, be a conscious effort to boost price levels byholding back product from the market. d) Recession Impact on Gas DemandUnder a) above we discussed the soft gas demand in the USA. Both Canada and the USA are still sufferingfrom the effect of the recession with reduced industrial and commercial activity. Persistent high levels ofunemployment are also likely to exert a downward pressure on domestic gas demand in North America.Key European gas markets such as Germany experienced reduced gas demand due to demand destructionalready in 2007. Starting in the fourth quarter 2008, this development was magnified on a Europe-widebasis by the onset of the recession. In 2009 the 25 European Union countries that consume natural gasexperienced a fall in consumption of 6.4 per cent compared to the level in 2008. This was the case despitethe fact the winter of 2009/10 was in many countries the coldest in 30 years. Industrial and feedstocksectors saw in 2009 particularly large reductions in gas demand. Although these energy demand sectorshave experienced some improvements, their 2010 gas demand is expected to remain below historical levels.In the case of the German gas market utilities are expecting total gas demand in 2010 to return to 2008levels of some 85 bcm against a total demand of 92.8 bcm in 2006.In spite of the negative market development in 2009 and part of 2010, LNG producers have managed tomake substantial inroads in European markets with new or expanded LNG terminal facilities such as in theUK, Belgium and Italy. This has been at the expense of the traditional pipeline suppliers, Russia’s Gazpromand Algeria’s Sonatrach, which to a large extent have failed to adapt to Continental Europe’s new two-tier1 New LNG Trading Players to challenge Old Guard, by Edward McAllister, Reuters, 12 August 2010.2 GECF Falls Short of Spot Sales Deal, article in the World Gas Intelligence, 21 April 2010, p.1© 2010 Morten Frisch Consulting 9
  10. 10. Gas Market Dynamics And The Future Pricing Of Spot LNG, Morten Frisch, GASEX 2010price system3. These two suppliers have as a result seen sharp declines in their gas exports to EuropeanUnion countries, while Qatar in particular but also Norway have increased their market shares.In contrast to North American and European gas demand, gas consumption in the main Asian LNG importingcountries has increased very noticeably during the first six months of 2010 compared to the same period in2009. This development has continued in third quarter 2010 as a result of increased industrial activity andunusual warm weather in some of the key markets. Table 3 below entitled “Asia LNG Demand Q1-Q3 2010”presents LNG import developments for Japan, South Korea, Taiwan, China and India. In the case of IndiaLNG imports have fallen in 2010 due to the start up of new domestic gas production.Based on current trends in economic development with the shift in activity from North America and Europeto Asian economies, energy demand including LNG is likely to continue showing healthy growth in Asia withthe possible exception of Japan. This will in turn create additional demand for flexible LNG supplies as wellas new long term LNG supply arrangements. Table 3: Asia LNG Demand Q1-Q3 2010 2010 2009 Volume (000 tons) Jan-Sep Jan-Sep change % change Japan 52,712 48,027 4,685 9.75% South Korea 23,039 17,388 5,651 32.50% Taiwan 8,478 6,695 1,783 26.62% China 6,708 3,959 2,748 69.42% India 6,589 7,285 - 696 -9.55% Total 97,526 83,356 14,171 17.00% Source:Customs data. LNG Spot and Short-term TradingThe LNG industry is increasingly becoming a global business. The three traditional main LNG consumingmarkets have been interlinked through LNG trade as shown in Figure 2 entitled “Interrelations of LNGMarkets”. In this diagram the North American market is represented by Henry Hub, the main price-settinggas trading hub on the continent. Europe has been split between Spain and Portugal, which together havehistorically been the largest LNG importers in Europe, and the other European countries further north, mainlydue to inadequate gas pipeline connections between Spain and France. Of the European gas trading hubsshown, the UK’s National Balancing Point or NBP is normally the price-setter in North West Europe.3 Current European Gas Pricing Problems: Solutions Based on Price-Review and Price-Re-opener Provisions, MortenFrisch, Centre for Energy, Petroleum and Mineral Law and Policy, Dundee University, Working Research Paper Series2010/03.© 2010 Morten Frisch Consulting 10
  11. 11. Gas Market Dynamics And The Future Pricing Of Spot LNG, Morten Frisch, GASEX 2010 Figure 2: Interrelations of LNG MarketsThe price relationship between Henry Hub in the USA and NBP in the UK for the period from July 2009 isshown in Figure 3 entitled “Relationship between Henry Hub and NBP Prices”. In the past these two pricecurves have normally moved in parallel during periods of Atlantic Basin LNG supply surpluses. Thisrelationship appears to have come to an end at least temporarily starting in the spring of 2010. The likelyexplanation for this is that the Atlantic Basin LNG price link has been broken with US imports staying low,and mainly coming from Trinidad and Tobago under long-term contracts, while the UK has seen rapidlyincreasing LNG import volumes. By far the largest supplier of LNG to the UK in 2009 and 2010 has beenQatar. Qatar with its large LNG exports also to East Asian markets therefore connects the LNG markets ofAsia and Europe. Figure 3: Relationship Between Henry Hub and NBP Prices 8 7 HH MA NBP MA $/mmbtu 6 5 4 3 Jul-09 Sep-09 Nov-09 Jan-10 Mar-10 May-10 Jul-10 Sep-10 Nov-10© 2010 Morten Frisch Consulting 11
  12. 12. Gas Market Dynamics And The Future Pricing Of Spot LNG, Morten Frisch, GASEX 2010The view that the LNG based Henry Hub and NBP price link has been broken, is supported by the fact thatLNG spot prices delivered to North West European and Mediterranean destinations have been priced inrelation to NBP. The same has reportedly been the case for spot sales of LNG into East Asian markets4.Although Henry Hub is no longer used as a benchmark for LNG sales into European and Asian markets,Mexican Caribbean coast imports still use Henry Hub-based pricing. It is also understood that product out ofPeru LNG has been priced and sold on the basis of Henry Hub.Referring back to Figure 3 above an important question for the international gas industry is: How stable isthe current LNG market situation in which the North American market in effect is isolated from gas marketsin Asia, Europe and South America? The market forces controlling this situation are dictated by a) the totalamount of spot or flexible LNG product available in the market in relation to global LNG demand, b) theavailability of receiving terminal capacity in North American markets and c) the availability of shipping toserve North American demand, should the need re-emerge.North America has under-utilised LNG receiving capacity due to a large and increasing unconventional gasproduction together with a flat gas demand as discussed under section a). The LNG shipping fleet has beendeveloped to serve the North American gas market and a number of vessels in this fleet are today either idleor being used partly loaded. Supply-demand dynamics in the global LNG market is the determining factor.As outlined under section b) above the LNG producing industry will in the period to 2014 be in a position tosupply increasing volumes of flexible or spot LNG to the market, if it so wishes.When Dr. Khelil requested that GECF member countries should refrain from spot selling of gas in April 2010,it looked as if his request had fallen on deaf ears. The developments on the part of LNG producers since thisdate might indicate that this may not have been the case. The future availability of flexible or spot LNGcould easily change the current relationship between Henry Hub and NBP gas prices and, therefore, thepricing of LNG on a global basis5.Figure 4 entitled “Price Relationship between HH, NBP, BAFA (Germany) and Japan LNG Import Prices”shows the link between Henry Hub, NBP, BAFA representing average German gas import prices and theaverage Japanese LNG import price. The Japanese LNG import price, which is the highest of the four pricesshown, is mainly priced off the Japanese Customs Cleared average crude oil price (JCC), although Japaneseprices based on other crudes such as Brent and Indonesian blends also exist. Until the end of 2008 theGerman BAFA price reflected mainly the price under long-term oil-indexed gas import contracts. However,after the emergence of a two-tier gas price system in Continental Europe, which resulted in the import ofincreased volumes of hub priced gas, together with subsequent price renegotiations of long-term contracts,the BAFA reported price has now been increasingly reflecting European hub prices linked to NBP. Europeanoil-indexed gas prices that have not yet been modified were in August 2010 some US$1.6/mmbtu above thereported BAFA- average German gas import price for the same month.In today’s North West European gas market environment it can be assumed that Continental European hubprices will be at a level between NBP and BAFA reported prices provided that the pipeline systems linking theUK and Continental European markets are fully operational. LNG landing in the UK would normally have aDES price of NBP less terminal costs and UK gas transmission systems entry costs. During the third quarterof 2010 typically this represented a price obtained by applying a discount of some 5 per cent to the NBPprice. This pricing system will under normal operating conditions make the UK DES LNG spot based price thelowest DES LNG price in North West Europe. During the third quarter 2010 Mediterranean6 DES spot LNGprices have also been at a premium to NBP.4 Heren Global LNG Markets, 17 September 20105 The linkage of prices in the US and UK gas markets was addressed in a paper entitled “Price linkage between US andUK Gas markets. The role of LNG. Can the Markets be de-linked again?” presented by Bjorn Brochmann of Point Carbonat the 11th European IAEE conference in Vilnius, 25-28 of August, 2010 and published in the Conference Proceedings atwww.IAEE.org.6 By Mediterranean is meant Turkey, Greece, Italy, French Med terminals, Spain and Portugal.© 2010 Morten Frisch Consulting 12
  13. 13. Gas Market Dynamics And The Future Pricing Of Spot LNG, Morten Frisch, GASEX 2010 Figure 4: Price Relationship between HH, NBP, BAFA and Japan LNG Import Prices 18 16 14 12 $/mmbtu 10 8 6 Henry Hub Month Ahead 4 NBP Month Ahead BAFA (German) Import 2 Japan LNG Import 0 Feb-08 Jun-08 Oct-08 Feb-09 Jun-09 Oct-09 Feb-10 Jun-10 Oct-10This relationship is demonstrated in Figure 5 entitled “Current LNG Spot Price Dynamics (schematic)”. EastAsian DES spot LNG prices are today reportedly referenced to NBP. This is because the Japanese mainlyJCC-benchmarked price is at a level allowing shipping differentials to be absorbed by Japanese buyers. Thesame applies to spot LNG cargoes delivered on a DES basis to South Korea and Taiwanese buyers. Chinaand India have in the past also purchased cargoes based on such pricing. Figure 5: Current LNG Spot Price Dynamics (schematic)In the LNG Spot and Short-term Trading section it was discussed that North American gas markets are todayeffectively isolated, price-wise, from gas markets in other parts of the world. Should available LNG productincrease to such a level that North American gas markets stop being isolated from gas markets in Asia,© 2010 Morten Frisch Consulting 13
  14. 14. Gas Market Dynamics And The Future Pricing Of Spot LNG, Morten Frisch, GASEX 2010Europe and South America, then such an LNG supply situation would likely lead to rapid gas pricedevelopments in most international markets. The answer to how the available LNG product would increaseto such a critical level could very well lie in Gazprom’s future marketing strategy for Europe and its desire toregain market share for its pipeline gas supplies.Both Russia and Algeria, as mentioned under section d) above, have seen their sales of gas to EuropeanUnion countries decline as a result of inflexible pricing in an oversupplied gas market. Both countries havelost market share in Europe. Russia in 2009 exported 142 bcm of pipeline gas to European countries andhad planned to increase such exports to 160 bcm in 2010. However, based on the latest gas export datacoming out of Moscow, the country will most likely export only some 140 bcm in 20107, even a decreasecompared to 2009. Reportedly, a number of Gazprom’s main gas customers claim they are still facingserious difficulties with the pricing of Russian gas supplies and have demanded additional unscheduled pricerenegotiations. Should Gazprom start discounting gas sales prices under long-term gas sales contracts, it isthought this could have serious implications first of all for European LNG imports. As stated above, Russia inthe short term would like to export an additional 20 bcm of pipeline gas, equivalent to some 13.8 mtpa ofLNG product.If Russian prices were to be lowered sufficiently to reflect Continental European hub prices, then Russiansupplies would increase sharply and potentially achieve the above pipeline gas export ambition. This wouldhave an immediate impact on LNG import levels in Italy, France and Turkey with secondary effects onBelgium, the Netherlands, Germany and Austria. This would in turn result in increased imports of pipelinegas to the UK and hence impact on NBP pricing. Such a development would be reflected in the value ofLNG imported into the UK. The value of NBP pricing used as a benchmark for East Asian spot DES saleswould be lowered under this scenario at the same time as LNG volumes directed towards East Asian marketswould increase and lower the price range for spot LNG deliveries to this region. In the current European gasmarket environment Gazprom could, therefore, well be the wild card for the pricing of spot LNG sales first ofall to Europe and then to East Asian markets. Figure 6: Japanese DES Spot Prices Potential Range 18 Japan LNG Import Price 16 NBP MA Spot Japan LNG Import Forward NBP Forward Curve 14 NBP + 1.50 $/mmbtu NBP + 2.00 $/mmbtu 12$/mmbtu 10 8 6 4 2 0 Feb-08 May-08 Aug-08 Nov-08 Feb-09 May-09 Aug-09 Nov-09 Feb-10 May-10 Aug-10 Nov-10 Feb-11 May-117 Netherlands, Denmark ask for more gas from Gazprom, article in RIA Novosti, 29 October 2010© 2010 Morten Frisch Consulting 14
  15. 15. Gas Market Dynamics And The Future Pricing Of Spot LNG, Morten Frisch, GASEX 2010Furthermore, under such a scenario where a) Europe becomes less attractive to LNG producers, b) additionalvolume of LNG is directed to Asian Buyers and c) new seasonal markets in South America and the ArabianGulf area are unable to absorb all the volumes otherwise destined for Europe, there seems to be only oneother market for the surplus LNG product, should this continue to be produced: All surplus LNG, which couldnot be absorbed in Asian, European and South American markets, would then find its way to the US andCanada, with North America becoming the market of last resort. If this should happen, it would lead to adownward pressure on prices for spot LNG in international markets potentially forcing LNG spot prices tospiral down to levels again set by Henry Hub as benchmark. Russia could well hold the large internationalgas price wild card.Of course, on the other hand, should there be a combination of increased Asian LNG demand and apersistent reduced availability of installed LNG liquefaction capacity, there could in the short to medium termbe a shortage of LNG in Asian markets. Under this scenario it appears that the traditional Japanese, SouthKorean and Taiwanese buyers can outbid their European counterparts without much difficulty. Based onmarket information these buyers in September appeared to be prepared to pay at least US$2.5/mmbtu morethan the highest long-term contract prices currently serving the German market, a contract price levelEuropean gas importers today have great difficulties in passing on to their end consumers. In tight LNGsupply situations Japanese buyers have in the past been observed to pay DES prices well in excess ofUS$20/mmbtu.Figure 7 entitled “Japanese DES Spot Prices Potential Range” presents a comparison of the NBP monthahead price with the Japanese average reported import price from Qatar for corresponding delivery months.Based on forward curves for crude oils, the forward curve of the average Qatari price has been estimated.This estimate is shown together with the forward relationship between the NBP month ahead price curve andJapanese DES LNG spot price ranges and such price ranges relationship with the NBP curve, all observedduring the early part of November 2010. Figure 6 confirms the strength of Japan’s LNG purchasing power inrelation to that of European gas buyers both historically and during the first half of 2011. Commercial Model for Spot and Short-term TradingThe 29.3 mtpa (42.5 bcm) of spot and short-term LNG trade recorded in 2009 was at a substantially lowerlevel than what the industry had expected. Section b) above discussed anticipated incremental LNGavailability, using end 2007 capacity as a base, which was projected to be 29.2 mtpa (42.3 bcm) in 2010increasing to 63.6 mtpa (92.2 bcm) in 2014. A large proportion, probably more than half, of thesequantities, if they are produced, are likely to be sold in the spot and short term markets, increasing flexiblesales from the current level of some 30 mtpa (43.5 bcm) to in excess of 60 mtpa (87 bcm) by the end of2014. This quantity of LNG represents a gas demand which exceeds the total demand of most nationalmarkets. Furthermore, it will be sourced from an increasing number of liquefaction trains and producersaround the world at the same time as the number of LNG regasification terminals, both permanentinstallations and ship-based units, is growing rapidly.In addition to an increasing number of market players with access to LNG production and receivinginfrastructure, there are in November 2010 at least ten energy traders and commodity houses activelyparticipating in the commercial LNG market8. With increased availability of flexible LNG quantities it can beassumed that the number of independent LNG traders in the near term will increase further. Even some ofthe very conservative Japanese Utilities are now moving into LNG trading in order to optimise their fuelsupply portfolios.The industry which supplies energy trading activities and energy market operators with data has understoodthe increasing need for transparency and improved market data. A number of industry newsletters are nowpublishing indicative DES spot prices for major LNG market areas such as; South East Asia normallyrepresented by Japan; North West Europe represented by the UK; and the Mediterranean represented bySpain.8 Factbox – New Trading Players in the LNG Market, Reuters, 10 August 2010© 2010 Morten Frisch Consulting 15
  16. 16. Gas Market Dynamics And The Future Pricing Of Spot LNG, Morten Frisch, GASEX 2010The maturing of the LNG spot market is also evident by the increasing acceptance of LNG brokers in cargotransactions. Tullett Prebon, an inter-dealer brokering house was the first to launch an LNG brokering deskat the end of 2007, and is now operating from London and Singapore, signalling business is growing. UKcommodity house, Spectron has since followed suit. Tullett Prebon LNG brokered its first cargo within a yearof being set up and has since been involved in over 10 LNG cargo deals including options and deals forregasified LNG.The company launched in early 2010 the first online screen for advertising LNG cargoes and buying interest.They state that this LNG screen-based service has been designed for fast communication of spot tradeinterests among their clients and to meet a growing need for greater price transparency. Advocating markettransparency and to help its clients get the best possible understanding of LNG trade movements, TullettPrebon LNG has also launched vessel tracking data services, both on its own and in collaboration with Lloyd’sList Intelligence.The amount of detail and the accuracy of the Tullett Prebon screen-based LNG service are unverified,however it is understood that over 100 market participants now have access to these services.The Spectron Group in its turn launched in September 2010 a screen-based LNG Indices service used torecord indicative price levels for spot LNG cargoes to be delivered to East Asia, Mediterranean and NorthWest Europe in 30 and 60 days from the data of the entry date. The recorded LNG price data should,therefore, correspond to the front month (M+1) and the front second month (M+2) in the forward gasmarket.The Spectron LNG Indices service, just like the publishing houses now also providing indicative LNG spotprices, is based on assessments and reported data that has not necessarily been confirmed by trades.It is hoped that these latest LNG market activities will develop into an Over-The-Counter physical market(OTC market) for LNG and that such a move will ultimately result in deals for string cargoes being recordedand a physical forward price curve starting to develop.One thing can be certain of these analyses and screen-based developments: The traditionally usedcommercial model for LNG is no longer adequate for an optimum operation of the LNG industry. Electronictrading platforms have long been used to set up commodity exchanges for flexible products such as crudeoil, oil products and coal. Financial products developed from the electronic trading of crude oil and oilproducts are today frequently used by LNG buyers and sellers to hedge their market positions. The LNGindustry is as a result becoming increasingly familiar with electronic trading operations and the benefits theycan provide. Thus while a credible LNG Index and swap market has yet to establish itself, this would be anatural evolution of the market.The development of electronic market tools for LNG would be very welcome to an increasing number ofbuyers and sellers of LNG on an international scale. It can be expected that traders in addition to brokerswill take the lead in developing such tools as the LNG spot and short term market becomes more liquid inthe period to 2015. It is observed that the latest market developments already have increased LNG traders’appetite for physical risk. In addition to sourcing LNG and trading cargoes of product on board LNG tankersthey are also entering into spot and long term LNG tanker charters and contracts for firm capacity at LNGreceiving and regasification terminals. Traders are today increasingly operating along the entire LNG chain:hence the need for more sophisticated tools to control and minimise risk.The development and use of transparent and reliable online trading services will lead to proper market-basedprice discovery for spot or flexible LNG, meaning the discovery of an optimum price for LNG in the variousgeographic regions in which the product is used on a regular basis. This price will be the direct result ofmarket trading and not based on the cost of fuel alternatives which are used as price benchmarks. It will beprimarily dependent upon the demand and supply forces of the underlying fuel with the addition of ashipping differential and any other destination-specific costs. This price will be an accurate reflection of asingle market’s activity and/or the interrelations of activities in systems of markets, as demonstrated by thecurrently observed link between NBP gas prices and the DES price for spot LNG in East Asia.Price discovery tools will have positive consequences not only for buyers and sellers in the LNG industry butalso for participants in LNG - dependent industries such as shipping. By monitoring LNG tanker trafficthrough the Suez Canal during the month of July 2010, it was observed that a total of 36 laden LNG carriersmade the voyage through the Canal; 32 sailed from East to West while 4 travelled from West to East. Mostof the west-bound cargoes came from Qatar while it is believed that up to 3 of 4 laden eastward transits© 2010 Morten Frisch Consulting 16
  17. 17. Gas Market Dynamics And The Future Pricing Of Spot LNG, Morten Frisch, GASEX 2010may have been delivered to Kuwait and, therefore, sailed past Ras Laffan where the Qatari tankers sailing inthe opposite direction had been loaded9. A market-based price discovery process for spot LNG will surelylead over time to a reduction of all such non-optimal shipping flows and shipping routes. One thing thatcould potentially hamper this development is the fact the LNG shipping fleet does not have the sameflexibility as the ocean going fleets for crude oil, petroleum products and dry bulk commodities.It can not be disputed that market based pricing and price discovery will lead to the optimisation ofcommercial operations and portfolio flows of both LNG suppliers and consumers. On a trading level, ifapplied to LNG, market based pricing and price discovery would allow for direct, non-benchmark based useof all pricing and hedging possibilities available to traders of other commodities in today’s increasinglysophisticated markets.Looking at history, both gas markets in the USA and UK were modernised and saw the introduction oftransparent gas trading systems based on which financial products could be developed, as a result of gasoversupply caused by structural market changes. The combination of the recession, the large increase inLNG supply and further regulatory changes are now driving a similar development in Continental Europe.Only time will tell to what extent the influx of LNG, which is forecast to become available before 2015without long-term contracts, will cause a similar development in the international LNG industry.Morten Frisch Consulting accepts no liability for commercial decisions based on the content of this paper. Although the paper iscopyright of Morten Frisch Consulting, quotes from the paper are permitted, provided full references to the paper and Morten FrischConsulting are made. Onward transmission or copying of the paper is allowed in its original form only.9 Suez Canal LNG Traffic Surges in July, LNG World News, 23 August 2010© 2010 Morten Frisch Consulting 17

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