19 April 2024
Swing state: Flexible US LNG squeezed out to save the market
Publication date: 02 June 2020
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Unheralded pricing dynamics
European gas prices have suffered further routs over the past week as oversupply, limited demand response and storage limitations continue to wreak havoc on markets. At the time of writing, European hub prices are well below [1] Henry Hub with Asian LNG prices trading at a miniscule premium to US prices. As recently as last year, this dynamic may have been viewed as extremely improbable, but not only are market participants living in this reality, it seems as if this situation is here to stay for the at least the remainder of the year and potentially longer.
[2]Source: Gas Strategies, Reuters
New mechanisms for market balancing
Times of oversupply are nothing new for LNG with investment in liquefaction capacity showing cyclical tendencies, as periods of over and under investment have led to alternating times of rapid and stagnant growth of the market. However, in the past the market has always balanced for three principal reasons: the majority of volumes sold by projects were underpinned by long-term contracts with end-market third parties, the growth trajectory of the LNG market consistently exceeded expectations, and, as last resort, liquidity of gas hubs in north west Europe allowed participants to ‘sink’ cargoes.
In the current reality of abundant supply and considerable volume length sitting on the books of portfolio players, not all production has a pre-determined ‘end market’ and European markets in their saturated state have struggled to economically absorb all excess volumes. With this failing to balance the market, current pricing dynamics have caused supply to be effectively shut-in on projects with the highest short-run marginal costs. This phenomenon is particularly impacting US liquefaction facilities where the offtake model enables buyers to “cancel” cargoes. This buyer-enforced supply side response to the global glut of LNG will help alleviate oversupply but the scale of losses facing those forced to cancel cargoes is enormous, with the reported 45 cargoes cancelled in July 2020 equivalent to a total capacity payment of approximately $500 million [3][1].
When considering the market balancing mechanisms described above, a key difference between market balancing via European markets versus an enforced supply side response is the reward to the capacity holder. US offtakers have effectively found themselves holding extremely expensive call options.
Searching for signs of demand recovery
As there is still incredible uncertainty around the trajectory of future demand, the required scale and duration of these shut-ins is up for debate. What is clear is that without a marked increase in demand from key markets in Asia, decisions not to lift cargos - from US liquefaction capacity and other available mechanisms - will be a mainstay for the LNG industry for the remainder of 2020. There may be some reasons to be optimistic:
Whilst optimistic signs will be appreciated by an industry facing waves of bad news in 2020, progress is ultimately dependent on the future recovery of economies in the post-COVID-19 world.
Managing US capacity in the here and now
Despite some signs of potential demand recovery, cancellations look likely until summer 2021 at a minimum based on spot prices and forward curves at their current levels.
[5]Source: Gas Strategies, Reuters
Of course, prices may rebound with seasonal demand over the winter season, but this is still months away. What if we have entered a world where, during sustained periods of oversupply such as we are seeing at present, prices dictate that cargo cancellations from the US become the norm and lifting cargoes the exception? US LNG tollers and buyers may be left holding an extremely expensive de facto market balancing mechanism which was never planned to be the case. This leads to important considerations for LNG market participants:
[1] Assuming average 4TBtu per cargo at a capacity payment of $2.75/MMBtu
For an example of our work in providing commercial due diligence on an operational US LNG project please click here. [6]
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