US LNG exports: A move toward gas market price convergence

OREANDA-NEWS. June 23, 2015. Much has been written in recent years about the potential impact of upcoming US LNG exports. Market analysts have pondered the likely effect on domestic US natural gas prices, gas production rates, domestic employment, GDP and even consumption by related petrochemical and agricultural industries. On the global stage, many expect that at current price levels US gas could flood the European and South American markets, pushing Atlantic Basin gas prices to new lows.

In a recent article, Bloomberg Business predicted that US exports will expand the spot market for LNG to almost 50% of total trade by 2020, up from its current level at 29%. Destination flexibility, built in to US supply and purchase agreements, will “turn consumers into traders” they say. The authors describe a future LNG market characterized by greater flexibility and liquidity.

However, the authors stop short of a deeper analysis, perhaps missing the broader significance of their bold prediction. If correct, what the authors foresee is nothing short of a paradigm shift in the global natural gas trade — one that will push regional markets toward price convergence.

In economics, price convergence is defined by the law of one price. It states that the same good will sell for the same price in any location. The theory is based on the assumption that differences in price will be eliminated by arbitrage opportunities. Of course, being a theory, the law doesn’t operate perfectly, since transportation costs and other barriers can obstruct the free flow of goods across markets.

However, as markets become more liquid and barriers are removed, product prices do tend to converge. This has already happened in the case of oil markets. Consider the variation in crude oil prices between North Sea Brent, Middle East and US benchmarks shown below.

The variance of the price data is 3.02, indicating a relatively narrow spread between these global benchmark crude values.  Now consider the variance of a similar grouping of natural gas benchmark prices from the US, the UK and Asia.

The variance of this price data is 4.15, indicating a wider spread between global benchmark natural gas values, that those of crude. If the predicted increase in global LNG spot trade does occur, it would have two related effects on the market leading to greater gas-market price convergence.

First, natural gas prices unconstrained by crude linkage will be more dynamic. Instead of reflecting the underlying fundamentals of crude markets, LNG will trade at a negotiated price dictated by actual supply and demand for natural gas. With the majority of Asian LNG contracts still linked to the Japan customs-cleared crude (JCC), there still remains a wide divergence between contract- and market-determined pricing. Consider, for example, the March JCC price for LNG, which settled at \\$12.32/MMBtu. By comparison, the spot market price for LNG delivered in March, as measured by the Platts JKM™, was nearly 40% lower, averaging just \\$7.44/MMBtu.

Second, greater spot market liquidity also means fewer destination-restricted vessels. For years, such restrictions have cramped the LNG market’s ability to respond to changing market conditions. In Japan, for instance, mild weather over the last two winter seasons has pushed LNG inventories to record levels. In March Japanese gas utilities held 1.85 million mt of LNG in storage, a 47% increase over average March storage levels in 2012, 2013 and 2014. With greater destination flexibility, Japanese buyers would likely have reduced imports, diverting unneeded vessels to the highest-paying market.

As the LNG spot market becomes more liquid, the market as a whole is destined to become more efficient. Market forces will determine price and vessel movements, which will increasingly reflect real supply and demand fundamentals in the global gas market. As that happens, increasing arbitrage opportunities will reduce regional differences in price. If the spot trade for LNG does reach 50% of total market size, what the future holds is not just a market change, but a paradigm shift toward regional gas price convergence.