14th July 2015
With the focus on greenfield LNG, the oil price collapse, and the imminent arrival of US imports, it’s easy to think that all the action in Asia Pacific LNG is on the supply side. However, global gas markets these days are all about the value chain where developments at the burner tip are just as important as those at the wellhead.
This was the theme of a high profile event hosted by Gaffney, Cline & Associates on 2nd July in the sumptuous surroundings of the British Ambassador’s Residence in Tokyo, where the changes occurring in the Japanese Gas and Power markets, as a result of Prime Minister Abe’s restructuring initiatives, were discussed and debated. The seminar, co-hosted by elite global law firm Allen & Overy, focused on how customer anxiety in the face of high electricity prices, government concerns over global competitiveness and a major shift in LNG supply/demand balance was creating the same “Trinity for Change” that characterised periods of major transformation in the UK in the 1990s and in the US and Canada in the decade before that.
While Japan is one of a number of LNG buyers in Asia Pacific, it continues to account for nearly 40% of LNG imports in the region during the first two months of 2015, and so we should expect any changes to the Japanese market to impact the region more generally, changing the supply/demand dynamic in a number of ways that are yet to be fully understood (Figure 1).
The Roadmap for Gas and Power Market Reform
Reinforced by a Japanese Cabinet ruling just a few days ago, on 30th June 2015, there is a firm timetable for market restructuring in Japan, which will see a gradual liberalisation of markets between now and 2022, by which time a complete separation will exist between the generation, transmission, and retail elements of the power sector and major elements of the gas supply chain.
Japan is one of the last industrialised economies to adopt a more competitive model for its power and gas supply chain, with the UK, the US and Canada having adopted similar policies several decades ago. Although the UK experience is a very close analogy, US and Canadian federal reform has focused on wholesale market liberalisation, especially relating to gas, while power markets still remain significantly influenced by State or Provincial energy policies. Figure 2 shows how the timetable in Japan compares to some of the other markets in which GCA has experience.
Impact on Gas Procurement
As the proposed changes come into force, power and gas retailers in Japan will have to re-evaluate their gas procurement strategies. What has so far been broadly a cost pass-through model will become more competitive in nature, and a different set of risks will start to emerge.
The previous approach to gas procurement, where buyers were able to offer both price and volume certainty, could gradually become a thing of the past as we have seen in North America, the UK, and for the most part, Continental Europe.
Already, the pricing dynamic in Japan is becoming a mix. The traditional oil-indexed long term contracts which characterised the market for so long, have recently been joined by Henry Hub based tolling contracts originating in the US, now amounting to some 10 million tonnes of contracted supply to Japanese buyers. While these US supplies have yet to commence, we are already seeing the influence of regional hub-based indexation mechanisms creeping into Asian gas contracts originating from other parts of the world.
For long-term gas, therefore, the picture is already changing. If we add to this the influence of shorter term or “spot” supplies, the dynamic becomes even more interesting. As we can see in Figure 3, we now have two pricing mechanisms for longer term supplies, as well as a third mechanism for short term gas, driven by true global gas on gas competition where the clearing price for Japan represents a level which can compete with buyers for that same gas in Europe, Latin America, or other parts of Asia.
One of the interesting features of these pricing trends is the gradual shift away from fixed destination contracts towards LNG which is much more globally mobile. Control of destination has now become a key feature of the market as it represents a major value driver, with some kind of value sharing mechanism sometimes present, or, in the case of LNG aggregators, becoming a fundamental driver of the developing “portfolio” business model based on multiple supply points and multiple delivery points.
Pricing Review Mechanisms
The recent seminar in Tokyo presented a case study of gas price evolution in Europe, highlighting some of the major pricing implications of market change. Examples were provided of gas buyers encountering major take-or-pay or mark-to-market liabilities associated with legacy gas contracts, including perhaps the most widely quoted example of recent times, that of British Gas plc. Furthermore, a number of major gas sellers to Europe, either through negotiation or arbitration have agreed major price changes (downward revisions) or other amendments. As the impact of liberalisation begins to take hold, similar pricing trends may be seen in Japan.
Allen & Overy were able to continue this theme with a summary of price review mechanisms under English law LNG SPAs (the majority of SPAs being governed by English law), which have seemingly led to a proliferation of price review processes in the Asia Pacific gas sector, mirroring the proliferation of price review processes that occurred in Europe around the time of liberalisation. Although traditionally English law contracts did not typically include a Price Review clause, this has now become a much more common feature of the SPA and is now always hotly negotiated at the time of entering into the SPA. In effect, this acts as a hedge against future material adverse market changes for the buyer, either by addressing specific triggers, or in some cases a more general set of circumstances which would trigger a discussion, and potentially arbitration. The price review clause can be drafted to operate in favour of the buyer only, the seller only, or for the mutual benefit of the seller and buyer. Traditionally, Japanese buyers would have been reluctant to entertain price review arbitrations, but in many cases we are now seeing such a wide gap between sellers’ and buyers’ positions that arbitration is being viewed as one possible means of breaking the stalemate and forcing a solution.
With the complex pricing and supply mechanisms now impacting on Asia Pacific, coupled with the imminent changes in the downstream marketplace, it would seem that both buyers and sellers need to review their risk assessment processes and forward strategy very carefully.
New Market Entrants
The GCA seminar was attended by a number of companies planning to enter the electricity supply, which has attracted several hundred registered entities, of which perhaps a dozen or so will become significant players over the coming months and years.
The discussion included a brief summary of some of the longer term gas procurement choices that will face these newcomers to the market, including the major impact on electricity and gas selling price competitiveness driven by LNG sourcing choices.
These choices include:
A strategy based on short term supply, which could be exposed to a tightening in the market;
One based on US or Canadian imports, exposed to changes in North American hub pricing; or
A longer term view underpinned by new supplies from greenfield projects but may require a higher level of price support.
Most companies will adopt a portfolio approach, but the blend of risk inherent in these choices will be an important differentiator between success and failure in a competitive retail market.
However, one aspect that came up in the discussion following the event was the current uncertainty around third party access to the many LNG regasification terminals in Japan, many of which serve a particular service territory. Currently, arrangements which would facilitate third party importation of LNG are ill defined, and operationally complex, so this would appear to be a critical factor in the future market development.
The environment in Asia Pacific today seems to be a clear example of how buyers and sellers need to re-connect in new, creative ways that address some of the complex outcomes that will undoubtedly result from market liberalisation.
Our clients on both sides of the sale and purchase equation are addressing an ever more intricate range of risks, which is driving a number of emerging strategies including:
Buyer investment up the value chain to mitigate pricing risk and exposure;
Innovative pricing arrangements for LNG sellers to drive economic viability and financeability but which accept a higher degree of downstream market risk;
Greater reliance on price review mechanisms to avoid an uneven risk distribution between buyer and seller, especially during the transition; and
Emerging regional hub mechanisms to establish a gas-on-gas competitive pricing basis that both buyers and sellers, and finance providers can gradually accept as a suitable price basis.
The seminar in Tokyo was both a timely and thought provoking event that led to a lively and engaging dialogue between both presenters and participants, but the underlying conclusion was clear: energy market reform has definitively arrived in Japan.
How the next few years unfold in Japan is likely to influence regional gas markets in many ways we cannot easily predict today, but based on global experience elsewhere, we can say that change is likely to happen more quickly, and more radically than many may have planned for.
The liberalisation train has arrived, and it’s a case of “All Change!”
GCA is pleased to announce the completion of its "Practical Options for Natural Gas Monetisation" study, within which LNG monetisation is just one of the options considered and modelled. For more info click here.
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