Japan ruling loosens LNG trade - NGW Magazine

This article is featured in NGW Magazine Volume 2, Issue 14

The Japanese anti-monopoly agency rulings will hasten the arrival of free LNG markets. Its decision allows sellers little flexibility to determine the direction or delay the inevitable.

Last month, the Japanese Free Trade Commission (JFTC) ruled on the anti-competitive nature of standard clauses in long-term LNG contracts: first for prohibiting the buyer from reselling the cargo; and second, for destination clauses, which specify the terminal that cargoes are to be delivered to.

The ruling could push more cargoes into the spot market and create better conditions for a spot price for LNG to emerge, Asian-based partners at law firm King & Spalding told NGW.

But jurisdictional limits allow the sellers some wriggle room. And in an oversupplied market, sellers are already having to adapt their sales on a day to day basis in order to meet buyers’ needs better, and so the lifting of these restrictions from the JFTC will not have as much impact as they would have. One of the difficulties facing sellers is finding buyers that have sufficient credit to launch a project in the first place, they said.

The two types of long-term LNG sales and supply contract – delivery ex ship (DES) and free on board (FOB) – have different statuses, from the point of view of the enforceability of the JFTC decision, the partners said.

On their face, FOB contracts that are intended for delivery into Japan and which contain destination restrictions and diversion constraints are likely to be in breach of Japan’s Antimonopoly Law by JFTC’s definition. And US FOB LNG contracts typically have a clause limiting onward sale to US sanctioned countries – and to non-Free Trade Agreement countries if the exporter does not have approval to sell LNG to non-Free Trade Agreement countries – so these too risk contravening the JFTC survey.

However, an FOB contract that is not governed by Japanese law which is entered into with a non-Japanese producer who does not conduct business in Japan, may be beyond the jurisdiction of Japan and might not be legally bound by the JFTC decisions.

DES contracts have more bite. As the cargoes are delivered into Japan, the law does apply to these contracts. The seller can resist diversions for operational reasons if the port is not compatible with the tanker or if the new buyer is too far away for the tanker to make it back for reloading in time – but not for commercial reasons; nor can the seller restrict who the buyer sells the cargo to, such as one of the other customers of the seller’s LNG from that or some other plant.

Splitting the extra profit from selling a diverted cargo disproportionately in favour of the seller could be anti-competitive, as it would not then be worth the buyer’s time to arrange the diversion; and so the extra profit sharing ratio could be anti-competitive; but this is also open for debate. For example, one of the sellers will have to take the risk of the ultimate buyer’s non-payment or force majeure, as well as other practical considerations such as different port costs, they said.

And should the intermediary buyer share with the original seller commercial information about the ultimate buyer, in order to establish the size of the profit? All these could work either way. If a Japanese buyer wanted to use the JFTC as a defence against a claim outside Japan, it is not clear to what extent an arbitration tribunal would need to take into account the JFTC view on the Antimonoply Law or how much scope there would be for a Japanese court to refuse to enforce an arbitration decision if the seller sought to enforce the decision in Japan.

But the wording of the JFTC report is pragmatic as the seller’s consent for a diversion must be subject to conditions relating to “reasonableness or operational necessity.” There is uncertainty over at what point the seller can say the buyer is asking too much: a seller can always say that it thinks the buyer is being unreasonable.

Second, they say LNG business is evolving but traditionally it has largely operated under a relationship model, where the counterparties have resolved their differences in the past by talking first rather than taking legal action.

In relation to existing contracts, as opposed to new contracts, King & Spalding said the JFTC indicated only that the LNG sellers at least should “review” competition restraining practices rather than expressly require a change to those contracts, which gives some flexibility in handling these contracts.

New price systems

The start-up of US LNG exports is chipping away too at another standard element of long-term contracts, independent of the JFTC. Priced off Henry Hub, they compete for market share with other surplus cargoes, typically priced against crude oil, using formulae spelt out in the term sheet. The JFTC had nothing to say about the negative impact of oil indexation, unlike the European Commission’s competition directorate which sees those clauses as anti-competitive – at least in contracts where Gazprom is the seller.

As time progresses, oil indexation will become diluted, the partners said. “Japan, Singapore and Shanghai are trying to break Asian LNG’s traditional oil linkage and develop a viable LNG spot price. By removing the anti-competitive clauses the JFTC is seeking to push more volume into the spot market, helping the formation of an Asian LNG spot price as well as relieving buyers of the potential oversupply in Japan.”

Japanese firms are also taking positions in regasification terminals outside Japan, to develop markets for their cargoes: such as Indonesia, Pakistan and Sri Lanka, with some of these projects being instigated at a government-to-government level, helping them to ease their over-supply.

The partners said buyers want to have a range of pricing options, so some oil indexation is likely to stay. In an ideal world they would be able to nominate for increased volumes of LNG from whichever of their contracts was cheapest at any moment and correspondingly down-nominate on their expensive contracts, thereby keeping their weighted average cost of gas down without take or pay payments.

For a Japanese LNG buyer, keeping a competitive LNG price will be essential in the growing competitive environment in Japan where the old monopolies downstream are falling away. Japanese electricity companies could become marketers of LNG, and potentially upstream LNG sellers could enter into the downstream Japanese gas market creating significant competition for the existing Japanese LNG players, they said.

Despite the low prices, they said they were continuing to work on projects and had not seen a freeze in final investment decisions; rather, different players are signing up to buy LNG. However, small projects are better positioned than major projects to secure FID owing to the reduced marketing challenges of small projects.

These new patterns have an impact on the negotiation of traditional major projects, which often have a five to seven year lead time. To support the project financing and hence the FID, most require that the bulk of the LNG from a project be sold in principle before FID. Typically, this requires the seller to secure multiple long term LNG contracts with strong credit rated buyers, which, given the oversupply of LNG to Japan and Korea are fewer than in the past.

“The LNG market is not yet like oil where the developer of a project, and its bank, know that there will always be a buyer and so nothing needs to be sold until the first production comes. In other words, the sale of the oil is arranged post-FID and financing. But we are approaching that point,” they said.

One interim solution is to sell to an LNG portfolio player, taking the approach used in Coral LNG’s sale to BP Trading. BP Trading is buying up the entire output from Coral LNG, giving the seller and its lenders a creditworthy buyer and the buyer manages all the off-taker risk, trading from its portfolio of supplies and off its own balance sheet. However, in the current market it may be tough for one LNG portfolio player to buy up all the output from a large LNG development.

This is not the case everywhere: in China, while it appears that competition in the downstream market is being encouraged, upstream LNG sellers may face hurdles competing with Chinese state owned companies. However, India, welcomes investors and recently Shell has said it is targeting industrial users for conversion to gas, and is actively working to generate demand for gas (from LNG) in India.

Shrinking arbitrage

For Asian buyers, the arbitrage offered by Cheniere when it started marketing was big: its LNG was cheap, when oil was trading at $110/barrel (equivalent of about $14.00/mn Btu DES Asia LNG) versus $2.00/mn Btu Henry Hub before liquefaction at $2-3/mn Btu, shipping and regasification are added on.

But five or six years on, oil is down at $45/barrel and US LNG delivered to Asia is around price parity with traditional oil linked prices in Asia. The key question of concern is, which way will it go in the future? If oil prices rise significantly relative to Henry Hub, then US LNG will have a greater advantage.

As they lawyers say, buyers do not know these answers so they will want to have bets both ways, and the flexibility to take advantage of contracted purchases as the price of either contract moves. “In theory, as they do so the market will become more efficient and there will be less difference between the two prices,” they say. To compound the buyers’ price basis dilemma further, there is a third option, which has not yet proved successful, such as Tellurian’s fixed-price offer.

However it seems at the moment, over-supply gives the power to the buyers. As the Koreans and the Japanese work to remove destination and diversion restrictions, seller are likely to be left taking what they can. A gas version of Opec has been proposed in the past, to shift more of the risk on to the buyer, but there is an increasingly diverse number of significant LNG suppliers including the two major OECD countries US and Australia. Even Opec finds it difficult to co-ordinate production and enforce quota discipline. And even if it were legally possible to withhold output to keep prices higher, most of the sellers’ long term LNG contracts oblige nearly all a plant’s output to be pre-sold, as plant financing at the moment depends on firm buyers.

The biggest changes in contracting that King & Spalding have seen in recent years have been on volume and diversion flexibility. Traditionally sellers wanted 100% take or pay with restrictions on destination and diversion; but increasingly new and existing buyers are demanding much greater flexibility on quantities (both up and down) and on destinations and diversions to manage their LNG supply to meet their market demand needs.

Many of the new Asian buyers are familiar with the greater flexibility offered by pipeline gas: for example, there could be 80% take or pay with symmetrical upwards flexibility to 120% of the normal annual volumes. Many new LNG buyers though cannot afford onerous take or pay commitments and inflexible contracts as they need their supply to match their particular market demand and they are looking for some of the demand flexibility that is normally offered by pipeline contracts.

For example, if the LNG buyer is an FSRU-backed power plant that is dispatched mid-range or as a peaking-plant, then that buyer will need considerable flexibility in annual quantities and also the ability to call for volumes at relatively short notice.

Given the current strong buyer’s market many sellers are competing hard to find new contract solutions to meet these new buyers’ needs.

William Powell

This article is featured in NGW Magazine Volume 2, Issue 14