A robust suite of LNG forward curves is a key prerequisite for the proper valuation and risk measurement of LNG portfolios. Tamir Druz of Capra Energy and Carlos Blanco of Black Swan Risk Advisors provide an overview of effective methods for constructing long-term LNG forward price curves, along with in-depth guidance and illustrative results for a proxy-based approach.
Limited Transparency in LNG Forward Markets
Figure 1 – LNG Forward Price Sources and Methods as Function of Tenor
Constructing Proxy-Based Curves: An Overview
Fortunately, both long and short-term LNG prices are strongly tied to more liquid and transparent commodity markets. We can leverage these relationships to construct forward curves that extend beyond the observable horizon (see Fig. 1). One such relationship is the traditional linkage of LNG supply and purchase agreement (SPA) prices to crude oil benchmarks. This practice is especially widespread in East Asian markets such as Japan, South Korea and Taiwan, which collectively represent about two-thirds of global LNG demand, and whose SPA pricing is commonly indexed to Japan Customs-Cleared Crude (JCC, or the “Japanese Crude Cocktail”) or North Sea Brent.
These SPA’s typically specify LNG pricing as a linear function of the crude oil index proxy selected.
If we plot monthly average prices for LNG imports into Japan, the world’s biggest LNG consumer, against Brent crude oil, we find that Japanese LNG prices follow those of Brent crude, with a discernible lag.
Figure 2 – Japan LNG Import Prices vs. Brent Crude Prices(Jan 2000 – May 2014)
Using linear regression analysis, we can estimate the optimal slope and lag. The strongest correlation between Japanese LNG and Brent crude prices occurs for a 4-month lag, for which we observed a correlation of 98.4% (see Table 1).
Table 1 -Japan LNG Import Prices vs. JCC and Brent Crude Prices (Jan 2000 – May 2014)
The 0.143 slope corresponding to this time lag falls within the range that is typically observed for Asian SPA’s. This is joined by a relatively modest premium of $0.24/mmbtu. By applying these parameters, properly lagged, to Brent futures prices, we can construct a forward price curve for the delivered East Asian LNG market (see Figure 2).
Figure 3 – Brent Crude and Estimated East Asian LNG Forward Price Curves (05/30/2014)
It is important to note that while these results are statistically significant, they represent an historical relationship which may not accurately reflect the long-term contract price levels in existence on the valuation date needed. Therefore, to the extent that an LNG business has access to prevailing bids,
offers and transacted levels for SPA price slopes and premiums, these ‘market-observed’ parameters will yield more reliable estimates of long-term pricing at any point in time.
Also, it is useful to track these analytically derived slopes over time (see Figure 4), since this may also provide an indication of changes in long-term pricing. This analysis of historical regression-based parameters can reveal the presence of strong trends, as well as detect abrupt changes in the relationships. The resulting insights can help inform our decisions as to which methods and curves best reflect prevailing prices
Figure 4 – Japan LNG vs. 4-Month-Lagged Brent Crude Oil Slope (Jan 2000 – May 2014)
Beyond Petroleum: Selecting Proxies That Better Reflect Emerging Market Dynamics
In addition, there are growing indications that shorter term prices for East Asia, as well as other key markets, are more closely linked with major natural gas hubs, like UK NBP and US Henry Hub, than they are with crude oil markets. For example, the lagged daily correlation between prompt NBP and spot month Asian LNG prices (see Figure 5) has exceeded 94% over the past year.
Figure 5 – Prompt NBP vs. Spot East Asian LNG (June 2013 – June 2014)
This decoupling of shorter term LNG prices from the oil market is driven by multiple factors. For example, Asian customers are showing a strong interest in diversifying their price risk away from oil and toward the Atlantic natural gas markets. Suppliers have responded with new pricing structures incorporating gas hub indexation for shorter-term deals and, increasingly, even longer-term SPA’s. Also, an increasingly efficient spot arbitrage market via reloads and re-exports from Europe to Asia when locational spreads exceed freight and other costs is constraining inter-market pricing to netback levels.
Recent correlations between delivered LNG prices to Europe and Atlantic natural gas hubs are even stronger. At present, these market dynamics have led to a bifurcated East Asian forward market, with longer-term pricing still heavily influenced by crude oil benchmarks, and shorter-term pricing becoming increasingly linked to natural gas hubs. A critical component of the forward curve building process is the selection of appropriate proxies by time period, as well as by market.
As an illustration, Figure 6 presents short-term forward curves for East Asian LNG constructed using two different proxies: Brent crude oil (blue curve) and UK NBP natural gas (black curve). These are plotted against market-observed quotes (red curve). It is clear that the use of the NBP proxy yields forward pricing that conforms to the LNG market’s seasonality, whereas the Brent-based curve, as expected, follows the contours of the oil market. A further shortcoming of the Brent-based curve is its substantially larger absolute error of 7.5%. This compared to an error of just 3.0%, or less than $0.50/mmbtu, for the NBP-based curve.
Figure 6 – East Asian LNG Forward Prices Based on Brent Proxy, NBP Proxy and Market Quotes (05/30/2014)
The parameter estimation techniques and considerations we have discussed should be applied in combination with market-observed data, to the extent available, and the use of netbacks, as appropriate. And while the dynamics that we have discussed do introduce complexity into the forward curve building process, they also enable the development of curves that properly reflect the shape, seasonality and granular pricing in the forward markets.
As the LNG market continues to evolve, forward price, volatility and correlation curves possessing these features will provide the basis for reliable pricing, structuring, valuation, hedging and risk management of increasingly complex LNG portfolios.