A general rule in energy risk management is that there exists an inverse relationship between contractual and operational flexibility, on the one hand, and financial modeling complexity, on the other. An LNG cargo position with different degrees of reload flexibility provides a good illustration of this principle.

**Case 1 – No Destination Flexibility**

Let’s first take the case where a buyer has purchased an LNG cargo, and there is no flexibility with regard to its final delivery destination. To simplify matters, let us also assume that this buyer can readily secure a time or trip charter at the prevailing rate from the destination market , and has access to reload capacity at that terminal.

Regardless of whether the purchase is on an FOB or DES basis, the position can be modeled quite straightforwardly as a long physical forward contract, and is valued against the destination market price. If this position is held through delivery and monetized on a spot basis, its payoff function is as follows:

where ** P1 **is the realized profit or loss (in $),

**is the DES spot price for LNG cargoes at the designated destination market (in $/mmbtu),**

*Smkt1***is the contracted price for the cargo (in $/mmbtu delivered), and**

*C***is the total delivered cargo quantity (in mmbtu). This formula applies for cargos delivered on a DES basis; if the purchase is on an FOB basis, however, then the freight cost needs to be deducted in calculating the profit.**

*Q1***Case 2 – Reload & Re-Export Possible to Single Third Market**

But now let’s suppose that the cargo can be diverted, but only after it has been delivered to the designated market. Furthermore, operational, market or other constraints are such that only a single other market is available as the re-export destination. This degree of flexibility is sufficient to introduce optionality into the position, with the associated incremental value and risk implications. So now, instead of a simple forward position, the cargo buyer is long both a ** physical forward contract** and a

**. The following is the incremental payoff function for the call spread option:**

*call spread option*where ** P2 **is the realized profit or loss,

**is the DES spot price for the re-export market,**

*Smkt2***is the total delivered quantity for the re-exported cargo and**

*Q2***is the total freight cost between the two markets, including reload fees. This payoff function has the form of a call spread option, where the buyer will only exercise the right to re-export the cargo to the second market if the spread exceeds the freight cost incurred in doing so.**

*FCmkt1->mkt2***Case 3 – Multiple Alternative Re-Export Destinations Available**

Finally, let’s take the case where there are two, three or more markets to which the cargo can be redirected following a reload, which best represents reality in most instances. If a cargo can be re-exported to any one of a number of final destination markets, the buyer will choose the location providing the best incremental profit. The most appropriate derivative structure for representing this degree of flexibility is a ** best-of call spread option**, and its payoff is expressed as follows:

where ** P3 **is the realized profit or loss,

**is the DES spot price for a second possible re-export market,**

*Smkt3***is the total delivered quantity if the cargo is re-exported to that market and**

*Q3***is the associated total freight cost. This payoff function as written is for a**

*FCmkt1->mkt3***call spread option, but it can easily be extended to as many markets as needed.**

*best-of-2***Summary of Payoffs and Appropriate Derivative Structures for Varying Levels of Flexibility**

In summary, the three levels of flexibility discussed translate into increasing levels of exotic optionality within the position. From a financial modeling standpoint, this introduces increased complexity into the derivative structures and payoff functions used for valuation and risk analysis:

**Table 1: Payoff & Modeling Approach as Function of Position Flexibility**