2019 was another dynamic year for the global LNG market. The market saw some demand growth, although not as much as expected, particularly in Asia, driven largely by China. There has also been sustained pressure on prices, with spot prices dipping to new lows in Asia in the latter half of the year, which has continued into 2020. Portfolio players have gone from strength to strength, cementing their place as key drivers of current market trends, and we have seen a number of traders taking steps to broaden their activities and firm up their place as a portfolio player.
These dynamics have informed the trends in LNG procurement and marketing over the past year. This article explores some of the key themes we have seen in our work advising LNG buyers and sellers on LNG sale and purchase agreements (LNG SPAs) in 2019, and some trends we expect to see continuing into 2020 and beyond.
Increased focus on flexibility
We saw the focus on flexibility in LNG contracting ramp up even more in 2019 than in previous years. This trend is principally driven by buyers, who seek flexibility to help manage their downstream commitments and address fluctuations in downstream demand.
Buyers are requesting increased levels of buyer downward quantity flexibility (DQT) (i.e., a right to reduce the annual contract quantity and therefore the Buyer’s take or pay obligation). Sellers are increasingly willing to accept greater buyer DQT rights, in the form of higher annual and cumulative caps on the exercise of DQT (typically expressed as a percentage of the annual contract quantity or, in some cases, as a number of cargoes).
In some cases, we have seen paid cancellation rights being agreed (i.e., a right for the buyer to request to “cancel” the delivery of a cargo, and reduce its take or pay commitment, in exchange for payment of a fixed fee). Cancellation rights have been a feature of the LNG SPAs for offtake from some US projects which adopt a tolling model which, coupled with relatively flexible upstream feed gas supply, means that cargoes can be cancelled at shorter notice. The cancellation fee for those projects is typically equal to the liquefaction fee component of the price formula. However, we are seeing cancellation rights more broadly in the market recently, including in the LNG SPAs from portfolio suppliers in particular. We are also starting to see these rights being exercised by buyers (for example, Singapore’s Pavilion Energy reportedly elected, in November 2019, to cancel the scheduled lifting of a cargo from the Cameron LNG project in the United States1).
Destination flexibility continued to be a focus in 2019, as in previous years, following the publication of the Japan Fair Trade Commission’s Survey on LNG Trades in 20172 .
Although the JFTC’s findings related principally to contracts with Japanese buyers, buyers across the market are calling destination restrictions into question and requiring greater destination flexibility. This is particularly the case for new buyers in emerging markets, who may use destination flexibility as an alternative method to manage downstream demand fluctuations in their domestic market, in addition to quantity flexibility rights, and from established buyers who are increasingly taking a role as portfolio players.
In our experience, a degree of flexibility in terms of destinations is now a “given”, certainly for contracts for delivery on an FOB basis, but also for contracts for delivery on a DES basis.
In terms of intra-year flexibility under DES contracts, destination flexibility in the form of diversions remain subject to conditions. Reasonable conditions would typically include notice of the diversion having been given sufficiently in advance (although the notice periods agreed are becoming shorter), the buyer agreeing to reimburse the seller for incremental shipping costs incurred in delivering a cargo to an alternative terminal, and there being no material impact of the diversion on the seller’s shipping schedule (i.e., the subsequent delivery of other cargoes scheduled for delivery to seller’s other customers).
Importance of flexibility for new buyers
Flexibility can be particularly important for new buyers. As LNG demand grows in Asia, and particularly while spot prices remain low, more emerging economies are seeking to import LNG for the first time (or to increase its share in their fuel mix). New buyers in emerging markets face the challenges of developing an LNG value chain for the first time, which can include uncertainty in initial downstream demand. On this basis, while established buyers might request some additional flexibility, new buyers typically require increased levels of flexibility in order to support the development of the value chain and underpin their entry into the market.
Portfolio sellers are often best placed to offer the levels of flexibility required by new buyers, and can find value for their own portfolios through greater flexibility, allowing opportunities for portfolio optimisation and trade.
Decline of long-term contracting?
Although more of a commercial trend, a third key area in relation to which we have seen buyers seeking flexibility is the term of LNG sale and purchase arrangements. Short-term and spot trading has caught the market’s attention in recent years, with the number of short-term and spot trades on an annual basis increasing (although as a percentage of global trade, it has hovered around the 30 per cent mark for several years, reaching 32 per cent in 20183). This has been combined with falling spot prices, particularly in Asia.
A number of established buyers in particular are looking to replace long-term contracts with a mix of term LNG SPA contract durations (supplemented by spot trading) to allow a more flexible portfolio.
In contrast, most new buyers will typically seek longer term LNG supply arrangements (to match the term of their LNG infrastructure commitments, which may require long-term commitment to capacity or the financing of new LNG terminals). However, new buyers in emerging markets are often particularly price sensitive (more so than established LNG buyers), and some are choosing to supplement mid to long-term LNG supply arrangements with LNG purchased on a spot basis, given the current low spot price environment (although this strategy may be more difficult to implement when the market inevitably tightens and the current oversupply conditions have ended).
Despite the focus on short-term and spot trading, 2019 saw a number of long-term LNG SPAs executed, showing that there is still a place for them in the market (particularly where supply is sourced from greenfield LNG projects, where limited recourse project financing typically requires firm, long-term offtake commitments). However, we are also seeing a number of instances where project sponsors (or their trading affiliates) have agreed to purchase their percentage share of offtake from their equity projects in order to secure the offtake required for FID and financing (if required), rather than marketing on a long-term basis directly to end-user customers. These volumes form part of the global portfolios of the relevant sponsors, and are in many cases finding their way to the increasingly liquid short-term and spot market.
Role of traders
While portfolio sellers appear to be becoming more active in short-term and spot trading than has traditionally been the case, we are seeing the reverse from traders, a number of which have contracted to purchase LNG on a long-term basis, including as a foundation customer from greenfield LNG projects.
For example, in late 2018, Vitol agreed to purchase 0.8 MTPA from Petronas, to be supplied from the LNG Canada project over a 15 year term, commencing in 2024 and in late 2019, signed a 10 year deal for offtake from Trains 1 to 3 of the Nigeria LNG project, with supply commencing in October 20214. In 2019, Gunvor agreed to purchase a total of 3 MTPA from the Commonwealth LNG project in the United States, as well as taking on a marketing role, helping the project secure binding LNG offtake and gas supply agreements for the full capacity of the facility (8.4 MTPA5)6 .While it has historically been less common to see traders involved in long-term LNG sale and purchase transactions, traders necessarily need to procure volumes to trade and, assuming that they are confident in their forward view of the market and their ability to on-sell those volumes as part of their trading activities, this can include purchase on a mid-term or long-term basis.
One of the potential factors behind the decision by traders to take long-term offtake from greenfield projects may be the ability to obtain relatively favourable terms as a foundation customer of the project. The traders may also hold the view that the market for supply will have tightened by the time for commencement of supply from the relevant projects commences, and so these transactions may be driven by a desire to lock in supply from that time, on today’s terms, in order to support their trading activities over the longer term.
According to information compiled by Bloomberg, Trafigura, Gunvor and Vitol (the top three commodity trading houses active in LNG) increased their delivered volumes by more than double over 2017 – 2018 (equivalent to almost 9 percent of global LNG trade in 20187). This trend continued into 20198. Over the last few years, we have also seen these traders and others more actively taking steps to broaden their industry participation beyond trading, such as investment in LNG regasification terminals.
We expect to see this trend continue, with the scope of the traders’ roles potentially broadening further in light of the risk profiles that they may be able to accept (compared to the portfolio suppliers and dedicated single-source suppliers marketing greenfield project volumes).
Price and price reviews
Price reviews ramping up
Price review clauses have long been a feature of mid-to-long term LNG sale and purchase agreements, but changing market dynamics and recent price pressure has placed additional focus on these clauses.
Price review clauses in new LNG SPAs are increasingly heavily negotiated and detailed, with the parties seeking to outline the objective, scope and process for any future price review as clearly as possible, to avoid some of the uncertainties associated with a price review, including price review arbitration.
A number of price reviews were initiated under long-term LNG SPAs in 2018 – 2019, and we expect more to come in 2020 as long-term contracts entered into earlier in the decade reach their agreed contractual price review periods.
One question we are often asked is, in light of the “buyers’ market” conditions which are persisting, whether we have seen buyers attempting to renegotiate prices outside of the agreed price review mechanism timing, to take advantage of the favourable market conditions. This is not something we see emerging as a trend, in large part because there would be no legal basis under an English-law governed LNG SPA for a buyer to initiate a renegotiation of the price outside of a formal price review process which is outlined in the LNG SPA. Any such renegotiation would require the agreement of the seller, which we think is unlikely in the current price environment (except where that renegotiation is part of a broader deal, such as a commitment to additional volumes). However, we expect that the current market conditions will contribute to a greater number of buyers initiating the price review processes under their existing LNG SPAs when they become due, and taking an assertive stance in price review negotiations. In Asia in particular, the more traditional, non-adversarial attitudes to formal price review processes are shifting in line with the underlying market dynamics.
A new approach to price review that we saw emerging through 2018, and which continued into 2019, is parties opting to include a termination right which is exercisable by either party if they are unable to agree on a revised LNG price after a defined period of good faith price review negotiations, rather than allowing for the matter to be referred to arbitration to be resolved. Parties may prefer this for various reasons (such as to avoid committing the significant time and internal resources, and incurring the costs, associated with conducting and managing a price review arbitration, and to avoid passing control over the outcome to a third party, such as an arbitral tribunal). However, we also see a number of potential issues with this approach, including:
- reduced incentive for the parties to reach a negotiated outcome;
- potential for “gaming” by the parties (i.e., using the price review termination right to bring the contract to an end on a “no fault” basis, for reasons other than price review); and
- changing the nature of the LNG SPA from long-term to potentially short-term, which may have an impact on the risk allocation the parties are willing to agree to at the time of entering the LNG SPA. Buyers may also find themselves in a more difficult position if the market has tightened by the time the price review is initiated, and be required to agree to a higher price through the price review process in order to ensure supply.
It is too early to say whether this emerging trend will become a consistent feature of price review clauses in long-term LNG SPAs over coming years, but we expect that the outcomes of the price reviews that occur, and particularly those where formal dispute resolution process are initiated, during 2020 will influence this trend.
Developments in pricing
We have also seen a number of developments in LNG pricing over 2019. There are still hopes for the development of an Asian gas price index, but it is not clear yet where this will be developed, and whether any such index will be able to gain a foothold in the Asian market, where pricing is still dominated by oil-linked indices (e.g., Brent).
After just under four years, Singapore ceased publication of the SGX LNG Index Group spot price index (known as the “Sling” index) in 2019, citing low participation in the index. By contrast, the Japan Korea Marker (known as “JKM”), which has been published by Platts for over ten years, is edging out competition as an alternative to oil-indexed pricing and we expect to see more contracts priced on this basis over coming years.
2019 also saw further innovation in LNG pricing, with Tokyo Gas and Shell entering into an LNG sale and purchase heads of agreement pursuant to which Shell will sell up to 500,000 tonnes of LNG a year to Tokyo Gas over a ten year term, with pricing partly using a coal-linked pricing formula, with the remaining portion linked to oil and gas price indices. This twist on “hybrid pricing” may be a step towards helping LNG and natural gas compete more effectively with coal, which is still a main competitor for gas in the Asian power sector.
Transparency and standardisation
During 2019, BP published its DES and FOB master sale and purchase agreement (MSPA) templates, which it says are intended to contribute to the broader discussion around transparency and standardisation in the LNG market9.
Although template MSPAs (and term LNG SPAs) are available in the market, these have typically been published by industry bodies, such as GIIGNL10 and AIPN11. BP is the first of its international oil company peers to publish its own template form MSPA (although we note that Trafigura published its template MSPA in 2017).
One particular barrier to the development of a more liquid global LNG market is a lack of transparency in contracting terms. Particularly if other portfolio sellers and traders follow BP’s lead, the publication of standard form MSPAs by market players (rather than industry bodies) could be helpful in this regard. Notably, BP’s template is developed on the basis that BP may be either the buyer or the seller under any confirmation notice issued.
Although the general terms set out in MSPAs are increasingly converging (with certain issues are addressed similarly across MSPA forms), standardization for spot trading across the industry is potentially still some way off (if at all). One issue that we see is that portfolio sellers and traders often have their own preferred template form of MSPA, which they prefer to use to maintain consistency across their portfolio, and sellers marketing spot cargoes from a particular project use template forms to ensure the MSPA terms are consistent with the specific requirements of the project. A number of major, well-established LNG buyers also have their own preferred template. Accordingly, some LNG buyers may still find themselves having signed a range of different MSPAs with different sellers.
The general terms of a template MSPA can also be varied through the “confirmation notices” which are executed by the parties when a trade is agreed, and which contain the special conditions applicable to that particular trade, meaning there is always potential for individual trades to deviate from standardized terms.
Whether this will assist in transparency or standardisation is yet to be seen, and we will be watching closely in 2020 to see if any other international oil companies follow suit.
Author: Jessica Ham, Counsel
3. GIIGNL Annual Report 2019.
10. The International Group of Liquefied Natural Gas Importers.
11. The Association of International Petroleum Negotiators.