A new report released today by Ernst & Young, looks at the evolving market dynamics for global LNG – which could challenge pricing status quo.
The “Global LNG report – Will new demand and new supply mean new pricing” indicates the near-consensus view of strong LNG demand growth over the next 10-20 years, but with a growing role for more price-sensitive buyers who are likely to be less willing to pay supply security premiums. On the supply side, a massive amount of new LNG capacity has been proposed, which if all were built, would more than double current capacity by 2025.
Even with reasonably strong demand growth, this implies growing supply-side competition and upward pressures on development costs and downward pressures on natural gas prices. Nevertheless, the very positive longer-term outlook for natural gas is driving investment decisions, both in terms of buyers’ willingness to sign long-term contracts and sellers’ willingness to commit capital to develop the needed projects.
Over the industry’s last five decades, there has been a progressive broadening of the LNG supply base, with three waves of suppliers. The first wave was dominated by Algeria, Malaysia and Indonesia, while the second wave has been dominated by Qatar and Australia. The third wave could come from as many as 25 other countries, many of which currently have little or no capacity; but by 2020, these countries could provide as much as 30% of the world’s LNG capacity.
LNG project proposals are growing faster than industry’s capabilities to develop them. Generally at the high-end of the cost curve, with development bottlenecks and spiraling construction costs, Australian projects are typically under the most pressure. Sanctioned projects are generally less significantly impacted, but projects still seeking contracted off-take are at substantial risk.
In contrast, “brownfield” projects which include expansions to existing operations and those that will build on existing LNG import infrastructure, such as in the US, will have distinct cost advantages. Similarly, merchant LNG projects that don’t include the upstream costs of gas supply development, again as is the case for most of the proposed US LNG export projects, will enjoy distinct cost advantages over the integrated projects.
But the supply/demand magnitudes and dynamics aside, the biggest potential impacts are on LNG pricing: namely, will oil-price linkages continue to dominate global LNG contract pricing; will there be room for spot-gas-price linkages; and will divergent regional gas prices show signs of convergence?
The advent of diverse new supply sources is challenging the LNG status quo, with Asian buyers presumably looking to modify or possibly replace their long-standing and relatively expensive pricing model of gas prices tied explicitly to oil prices. High LNG development costs will require iron-clad long-term off-take agreements. However, more recently, the market is witnessing the inherent conflict of increasingly-more-expensive projects trying to sell to increasingly-more-price-sensitive buyers.
From the global supply side, oil is becoming somewhat scarcer while gas is more plentiful. As a result, there is the inherent conflict of persistently-high oil prices and a growing surplus of natural gas, with strict oil indexation becoming less tenable. Oil indexation of gas contracts will become more difficult with greater competition between sellers, more price-sensitive buyers, increasing energy deregulation, increasing gas-on-gas competition from new pipeline infrastructure, increasing spot market liquidity, and most importantly, increasing availability of spot- price-based LNG exports. In short, high-cost projects will find it harder to find shelter in bi-lateral contracts and high-cost sellers will struggle to preserve pricing power.
Among the new wave of potential LNG exporters, most important to the issue of pricing are those in the US and Western Canada, where the source gas is likely to be priced on a spot basis, unlike gas elsewhere in the world which is generally priced (wholly or partially) on an oil-linked basis. Critically, the possibility of spot gas-linked contracts for North American LNG could upset the traditional LNG pricing structure. The proposed North American LNG export projects are particularly well-positioned, even though the US Gulf Coast projects will give up some of their Free On Board (FOB) cost advantage with higher shipping costs. As substantial volumes of lower-cost LNG move into Asian markets, projects at the high end of the supply curve – namely, many of the Australian projects – will become increasingly vulnerable.
Going forward over the medium-to-longer-term, Ernst & Young expects to see a gradual but partial migration away from oil-linked pricing to more spot or hub-based pricing. LNG sellers are reluctantly facing realities and are offering concessions in order to remain competitive. Dale Nijoka, Ernst & Young’s Global Oil & Gas Leader concludes, “LNG prices are unlikely to collapse, simply because the cost to supply is high and incentives to develop new capacity must be maintained.”