The typical LNG marketing and trading portfolio will contain some of the simplest and some of the most complex derivative structures encountered in energy finance. Some of the more commonly found structures are physical forwards, basis spread options and best-of spread options, but longer-term transactions like SPAs will often contain an even wider array of embedded exotic features. In this post, we provide an example of one of the simpler derivative structures, and demonstrate how it is valued.

The purchase or sale of an LNG cargo for delivery at a future date, whether it be on an ex-ship (DES) or free on board (FOB) basis, is best modeled as a

*. As such, valuation and risk measurement is based on the difference between the contracted price for the cargo, and the forward price for the market where it is to be delivered, for the future delivery period specified in the transaction agreement. More specifically, the value,***physical forward contract****of a long forward position in an LNG cargo to be delivered in forward month***V***is calculated as follows (on a per unit basis):***T*Where

One complication is that deals beyond the spot horizon, which is normally just a few months, are usually done at prices that are indexed to agreed upon market proxies, such as the Japan Customs-Cleared Crude (JCC) price, the UK National Balancing Point (NBP) natural gas price, or the Henry Hub gas price. In such cases (i.e., where there is a floating contract price), the forward contract's value is a function of the prevailing price levels for the underlying proxies, in addition to the variables specified above.

As an example, let us assume that we have purchased an LNG cargo (DES) to be delivered at the UK's Isle of Grain terminal in January of 2016, at a price equal to the average of the last three NBP natural gas futures price settlements for the preceding delivery month (i.e., October 2015, November 2015 and December 2015), plus $2.00/mmtbu. To value this position as of yesterday's close, we would proceed as follows:

*is the forward price for the relevant LNG market***F****mkt,T****,****, for forward month***mkt**,***T****is the contracted price for the cargo, and***C***is the discount rate. The last multiplier within the equation (i.e.,***r**exp(-rT)*), is commonly referred to as the discount factor,**.***DF*One complication is that deals beyond the spot horizon, which is normally just a few months, are usually done at prices that are indexed to agreed upon market proxies, such as the Japan Customs-Cleared Crude (JCC) price, the UK National Balancing Point (NBP) natural gas price, or the Henry Hub gas price. In such cases (i.e., where there is a floating contract price), the forward contract's value is a function of the prevailing price levels for the underlying proxies, in addition to the variables specified above.

As an example, let us assume that we have purchased an LNG cargo (DES) to be delivered at the UK's Isle of Grain terminal in January of 2016, at a price equal to the average of the last three NBP natural gas futures price settlements for the preceding delivery month (i.e., October 2015, November 2015 and December 2015), plus $2.00/mmtbu. To value this position as of yesterday's close, we would proceed as follows:

**Step 1**- We compute the contract floating price,

*C*, as the average of the three relevant NBP futures contracts' prices (see table), and we add the specified contract premium of $2.00/mmbtu:

*= Average($8.596, $9.264, $9.492) + $2.00 =*

**C****$11.117/mmbtu**

**Step 2**- Based on Capra Energy's daily LNG Forward Market Wire, yesterday's January 2016 European market forward price was

**$12.076/mmbtu**.

**Step 3**

*-*

*is calculated as the number of years from the valuation date until the forward month. Assuming delivery in the middle of January 2016, we compute a*

**T***of 1.156 years. We also assume an applicable discount rate of 1.00%, allowing us to calculate a discount factor as follows:*

**T***= exp(-0.01 x 1.156) =*

**DF****0.9885**

**Step 4**

*-*We can now compute the forward contract's value on a per mmbtu basis as:

*= ($12.076/mmbtu - $11.117/mmtbu) x 0.9885 =*

**V****$0.948/mmtbu**