Gaspirations: In pursuit of an LNG freight derivatives market

The commoditization of the global LNG market has had implications across several associated industries, ranging from the gas-fired power sector to seaborne gas transportation.

Hence, it came as no surprise that the venerable Baltic Exchange, probably the world's oldest source of shipping information, set out to build an LNG freight index in January that could be launched as early as spring 2018.

LNG carriers are after all the pipelines of the sea. The global LNG carrier fleet now numbers nearly 500 vessels, compared with less than 100 ships in 1997. That's a fivefold increase in two decades.

Assuming an average cost of $200 million for one LNG carrier (it has ranged from $180-$220 million) that equates to nearly $100 billion spent on building the existing LNG carrier fleet.

Related blog post: JKM reveals three LNG surprises in three years – tightness, correlations and seasonality

The fleet is still growing and an increasing number of ships are being chartered on the spot market, in line with the fragmentation of long-term 20-year LNG supply contracts.

"As a liquid spot market for LNG ships develops, only now can we start talking about creating an index for LNG rates," Ralph Leszczynski, Singapore-based head of research at Italian brokerage Banchero Costa, said.

SHIPPING VS DERIVATIVES

The Baltic Exchange has brought in four LNG shipbrokers to assess the routes for its index --Affinity, Braemar ACM, Clarksons and SSY.

Once the index is functional, the next logical step would be launching LNG freight derivatives called forward freight agreements or FFAs.

The Baltic Exchange was acquired by Singapore Exchange Ltd, or SGX, in 2016 with the objective of monetizing freight market information through derivatives products.

FFAs are cleared through Nasdaq, SGX, European Energy Exchange, Chicago Mercantile Exchange, and the Intercontinental Exchange, among others.

However, building out a paper market for shipping derivatives is another ball game altogether, as the shipping sector lags other industries like aviation and oil in using derivatives products for hedging purposes.

"When it comes to the index being used for FFA contracts, I'm sure [a paper market] is the long-term objective. However it will take time," Leszczynski said, adding that even the Baltic LPG freight index has existed for many years now, but it is not very well known and there isn't much FFA activity on LPG at the moment.

"To be frank, even in the tanker FFA market (for VLCCS or MRs) there is still little liquidity, except for just some routes, certainly less than for dry bulk FFAs," he added.

The total volume of tanker and dry bulk freight derivatives is roughly a few hundred thousand lots, equating to around 200 to 300 million mt.

By comparison, total shipping volumes reached 10.3 billion mt in 2016, out of which two thirds was petroleum, minerals and grains.

There are several reasons why shipping has been averse to derivatives.

There's a cultural resistance to risk management through financial markets; the commoditization of freight has been unsuccessful; some shipping corporations suffered huge derivatives losses during the financial crisis; and a prolonged shipping downturn has hurt the industry.

Typically, there are two of participants in the FFA market -- the ship owner who wants to hedge against downside risks in freight revenue and the charterer who wants to hedge against upside risk in freight cost.

However, these parties prefer to use timecharter agreements and contracts of affreightment to manage risk, and fuel oil derivatives to hedge against bunker fuel volatility.

IF YOU BUILD IT, WILL THEY COME?

Still, the importance of an LNG freight index must not be underestimated.

Another shipping index, the Baltic Dry Index, which assesses freight costs for vital commodities like coal and iron ore, is practically a global economic indicator and measure of global economic health.

Shipping data shows that nearly 90 companies own LNG carriers, and traditional owners like national carriers and oil majors have been supplemented with private independent owners who account for nearly one third of the global fleet.

Traders like Trafigura, Glencore and Vitol have joined the fray.

As LNG use spreads to power utilities and new industries like LNG bunkering, more parties would need to hedge their LNG transportation costs in future. Spot LNG freight rates have raced between $30,000/day to $150,000/day.

"Lots of LNG tankers are owned by Greek ship owners and these vessels are charter-free/spot market," Basil Karatzas, shipping consultant at Karatzas Marine Advisors & Co, said.

He said there's a clear sign that these participants want to exploit spot market freight rates for LNG, beyond the risk-free yield that oil majors and energy companies allowed in the past. This necessitates a need for risk management products.

"Probably we are a long way from a fully functioning market or index and/or FFA hedging -- but you have to start somewhere and sometime," Karatzas said. "Maybe it's a case of 'build it and they will come'."