In addition to their basic terms (price formula, quantity, etc.), LNG sale and purchase agreements (SPAs) normally include other provisions that significantly affect such contracts’ value and risk. Price reviews (i.e., “reopeners”), when present, are typically among the most important of these. The main objective of price reviews is to protect the parties to an LNG SPA from the risk that the pricing agreed upon at signing will not reflect future LNG market conditions.
In other words, price reviews are an attempt to prevent the value of either party’s LNG SPA position from going too negative during the contract’s life. The buyer is afforded protection against the scenario of contract prices significantly exceeding market levels, while the seller is hedged against contract pricing that has failed to keep up with the LNG market.
There is a wide array of approaches for structuring price reviews, and proper financial modeling will depend on the specifics of each case. But in many instances, a very helpful derivative structure for capturing the payoff consequences of price reviews is the “knock-in” barrier option. These are options that are activated only if the underlying market price breaches a preset ‘barrier’ over the course of a predefined time period.
When applied to price reviews, these ‘barriers’ represent the LNG forward price levels which would need to be breached in order to allow a reset of the LNG contract price to market levels. In other words, these levels activate the LNG buyer’s or seller’s right to a price review that will succeed in zeroing out the mark-to-market (MTM) value of the remaining SPA position. From the SPA buyer’s perspective, this can be thought of as owning a put option that allows him to recoup the negative MTM value of the position from the seller, but only if the LNG market has moved sufficiently below the contract price.
The buyer has a second barrier option position as well, which is a short knock-in call. This option is activated if the LNG market moves sufficiently above the contract price, and its exercise offsets the accrued MTM value of the position. Figure 1 illustrates the effect of these two knock-in options on the MTM value of the SPA at different LNG market prices.
Figure 1. LNG SPA MTM Value Impact of Price Review
Assuming that the contract was initially priced at a level Pc such that the SPA would have zero MTM value, the price review brings the MTM value back down to zero if the LNG market moves to a discount of d or more below Pc, or a premium of p or greater above Pc. Now we should note here that the LNG market price referenced in a price review clause is actually more of a forward price curve. And the forward periods we have seen referenced have ranged anywhere from 12 months to 10 years to even unspecified ‘long-term’ horizons.
It is also important to properly account for the triggers and other material features specific to a given price review. For example, to the extent that a price review can only be requested according to a specified schedule, the structures we have discussed are best modeled as European knock-in options. These only provide option exercise rights if a barrier has been breached as of a scheduled price review date, which is typically every three to five years of the contract’s life.
In summary, the pricing and structuring of LNG SPA price review clauses can be facilitated by modeling them as embedded knock-in barrier options. The application of this framework does require, however, that your barrier option model be properly configured and parameterized to reflect the unique details of the specific price review provision under consideration.
We would like to thank Ruchdi Maalouf for his valuable contribution to this piece.