Complexities and challenges of LNG trading

The Russian invasion of Ukraine and the subsequent decrease in Russian gas pipeline exports to Europe has focused attention on Liquefied Natural Gas as a supply source that can cover the shortfall. However, LNG markets operate within complex supply and demand dynamics, strongly dependent on long-term commitments and are greatly exposed to global geopolitics. The conflict has accelerated the evolution of these markets.

Alongside the reduction in Russian gas exports, the drive to decarbonise has also led to a decrease in gas demand; a development that is only expected to continue. As a result, partly due to the long development cycle of LNG assets, many analysts are now expecting an LNG oversupply throughout the second part of this decade and onwards. This predicted oversupply is an indication of the extent to which LNG markets are constantly being reshaped by geopolitics, and the complexity of managing the resulting market risks.

In order to capitalise on the opportunities presented by the LNG industry, it’s essential to explore the inherent risks unique to this industry and propose strategies to effectively mitigate them. In identifying and managing these risks, the LNG sector can play a pivotal role in the success of the energy transition, as a vital source of cleaner energy for the future.

We have highlighted some key challenges related to complexity of LNG trading which Risk Managers of trading organisations must deal with.

Long-term exposure and unique characteristics of sale and purchase agreements (LT SPAs)

Designed to provide stability and security to both parties, LT SPAs are commonly used in LNG contracts and continue to be prevalent given current geopolitical and market conditions. For LNG producers, these enable capital intensive projects that require long-term commitments from buyers to ensure their economic viability. For buyers, they can obtain assurance that the contracted volumes will be received for the agreed-upon duration, allowing them to meet their energy demands without disruptions. SPAs in the LNG market can have a duration of up to 25 years, which creates long-term exposure and requires careful management and hedging.

Off-takes play a crucial role in mitigating the risks associated with this long-term exposure. They act as a natural hedge by aligning buyers and sellers with the terms of the agreement. Off-takes provide an effective tool to manage uncertainties like price fluctuations, delivery location risks, and market volatility. Diversifying off-takes and strategically aligning them with LT SPAs enables market participants to optimise trading books, protect profit margins, and enhance liquidity planning. Ultimately, off-takes serve as a risk mitigation tool, offering flexibility and resilience in the face of market challenges and ensuring profitability in the LNG market.

Counterparty credit risk is another critical element which becomes more difficult to manage with long-term nature of the contracts - buyers' and sellers' creditworthiness can change over time, affecting the contract's financial viability.

Complexity in accounting for volume optionality

Volume optionality built into LNG contracts allows buyers and sellers the flexibility to adjust contracted volumes to optimise supply and cater for market demands. An example that can be executed would be the ability to increase volume when capacity is available at Liquefaction terminals. The growth of the spot market and the increasing number of LNG facilities worldwide have elevated the use of optionality around physical delivery, driving basis risk.

Modelling and managing risk associated with volume optionality in an LNG trading portfolio presents significant challenges. This optionality is hard to value due to varying volume nomination clauses and the absence of a single strike price. The complex nature of physical supply deals further complicates the valuation and deconstruction of flexibility within LNG contracts.

The challenges extend beyond mere volume flexibility and encompass a spectrum of other critical factors. These include pricing flexibility, such as the choice of price indexation; location flexibility, involving the selection of delivery locations; timing flexibility, which entails shifting volume across different periods; and portfolio/logistics flexibility, aimed at optimising cargo logistics, among others. These multifaceted elements collectively contribute to the complexity of assessing and effectively managing the risks associated with volume optionality in LNG trading portfolios.

Complex pricing mechanisms

The LNG market presents complex challenges in terms of pricing and settlement mechanisms. LNG contracts often involve intricate pricing formulas that incorporate multiple units of measure, necessitating the use of conversion factors and introducing an additional layer of complexity. For instance, a cargo priced using the Japan Korea Market (JKM) is quoted in US Dollars per million British thermal units (USD/MMBTU), but settlement can be based on Japanese yen per metric ton (JPY/MT). This requires the application of conversion factors from energy units to volumetric units. While this may not appear overly complex initially, each LNG cargo has a different energy value which prevents the standardisation of conversion factors. As a result, rounding errors can accumulate, leading to pricing discrepancies and potential disputes. Changes in foreign exchange (FX) and interest rates can also significantly impact profit and loss (P&L) and erode profitability.

LNG contracts often involve pricing methods such as S-curve pricing, tier pricing and volume-weighted average pricing, which require frequent hedge adjustments. This challenge is exacerbated when there is a limited availability of liquid pricing instruments. When the hedge portfolio’s longer dated exposure extends beyond the liquid forward curve horizon, this causes the hedging strategy to be ever more complicated.

The LNG market is heavily linked to several key oil benchmark indices such as Brent or JCC as well as gas benchmarks like TTF, NBP, and Henry Hub. However, many LNG portfolios hold significant illiquid exposures that require price curves for specific destinations such as Delivery Ex-ship (DES) Northwest Europe, and West India Market (WIM). The reliance on these illiquid points may amplify the price volatility risk as it may be challenging to accurately assess and hedge against the impact of price fluctuations in specific destinations with limited liquidity.

Complex operational landscape

Depending on the commercial agreement, the operational landscape in LNG is far from simple, requiring multiple parties to collaborate effectively. Joint ventures and Liquefaction Tolling Agreements (LTAs) increase the need for operational coordination.

Various operational aspects such as acquiring gas and handling shipments, meeting quality standards, and overseeing power operations pose operational challenges and potential asymmetric Force Majeure to the parties involved. The LNG market presents a unique range of logistical and operational challenges. It is crucial for stakeholders in the LNG market to navigate these complex logistics and operational challenges effectively by implementing robust operational risk management strategies, ensuring safety, optimising efficiency, and maintaining the reliability of LNG operations.

Risks associated with different parts of LNG supply chain include:

Compliance with regulations and specifications due to environmental impact of gas exploration and extraction,
Availability of capacity at liquefaction and storage facilities,
Unpredictable weather patterns impacting LNG facilities (e.g. The Gulf Coast of the US),
Illiquid freight market making difficult to chart vessels on a spot basis,
Cargo losses / Boil of Gas (BOG) as well as risks related to complex operations of LNG vessels (temperature control, managing the heel, planning for cool-down process, etc.),
Availability of regasification slots at LNG import terminals and other infrastructure constrains.

Challenges in risk mitigation

One of the challenges in hedging LNG is the limited availability of liquid and standardised financial instruments for hedging purposes. Unlike more established commodities such as oil or natural gas, the LNG market lacks deep and liquid derivatives markets. This limits the range of hedging tools available to market participants and makes it more challenging to execute hedging strategies effectively. As a result, market participants often rely on over-the-counter (OTC) derivatives or customised hedging arrangements, which can be more complex and less transparent.

Another consideration in LNG hedging is the cash flow constraints associated with margin requirements. Hedging positions in the LNG market often require participants to commit initial margin (IM), variation margin (VM), or profits as collateral. The longer-dated exposures associated with LNG contracts may require substantial margin commitments, which can strain participants' available liquidity. Managing these cash flow constraints while effectively hedging against price risks is a delicate balance that market participants must navigate.

To address these challenges, market participants in the LNG sector need to develop precise margin estimation techniques and enhance transparency in risk modelling. Accurate margin estimation helps manage the financial implications of hedging positions, enabling participants to optimise their risk exposure while maintaining sufficient liquidity. Moreover, improved risk modelling capabilities can facilitate better understanding and evaluation of different hedging strategies, allowing market participants to make informed decisions and preserve profit margins.

How Baringa can help you create effective strategies for mitigating LNG risks while ensuring profitability and sustainability

Successfully navigating the intricate landscape of LNG risk requires a thoughtful and strategic approach. Businesses can position themselves for long-term success in the LNG market by addressing geopolitical complexities, mitigating and managing credit and liquidity risks, optimising volume optionality, streamlining operations, understanding complex pricing mechanisms, and staying abreast of evolving environmental policies.

We work together with Chief Risk Officers (CROs) of energy trading companies, carving out tailored solutions to strengthen risk frameworks, optimise operations, and reduce risks. We can work to empower your organisation to effectively manage risks related to LNG trading, resulting in greater profitability and sustainability.