Global LNG term contracting sees structural changes, greater adoption of market-based pricing

In 2022, the LNG market saw a great deal of term contracting activity – a total of 52 LNG sales and purchase agreements signed with tenures of 10 years or longer, reaching more than 65 million mt, up from 41.3 million mt in 2021, according to S&P Global Commodity Insights data.

The momentum of term contracting is expected to continue into 2023 as appetite for term supply remain strong with several regasification terminals in Europe coming online in the next couple of years and multiple existing term contracts of up to 23 million mt slated to expire this year.

Extreme market volatility in 2022 due to the outbreak of the Russia-Ukraine war meant that LNG prices on the forward curve have also fluctuated significantly throughout the year.

This volatility has made it increasingly difficult for market participants to determine a crude oil slope to price their term contracts, which is commonly seen in LNG term contracts. The relationship between LNG prices and crude oil slopes has become a moving target, according to a range of market participants.

Buyers and sellers struggle to agree on crude oil slopes that would be fair to both parties. On one hand, agreeing to contracts now that could leave buyers at historically high slope levels with a risk of downward LNG price movement. On the other hand, sellers also do not want to leave value on the table given the potential to sell LNG in the next few years at considerably higher prices – based on current forward curve values – than historical Brent slope levels would imply.

In fact, contracts for LNG cargoes supplied any time between 2023 and 2026 have been heard to be priced against Platts JKM as sellers attempt to capture higher prices in mid-term horizon.

The complication above could have also contributed to the drop in crude oil-linked term contracts signed in 2022 compared to 2021. According to IHS Connect's LNG contract database, 5.9 million mt of purely Brent-linked SPAs were signed in 2022, or approximately 8.7% of total SPAs signed, compared to 18.3 million mt in 2021, or about 38% of total SPAs signed.

Another factor that would further complicate the determination of the equivalent slopes against LNG prices is the fluctuations of crude oil prices on the forward curve.

Based on S&P Global data, the correlation between Dated Brent and Platts JKM has decreased from 62% in 2021 to 3% in 2022. This highlights a growing disconnect between oil prices and LNG prices, which is inevitable considering the fundamental differences between these two commodities.

In addition, the period at which term deliveries begin and the tenure of the term contracts also affect term contract prices as LNG prices are expected to remain elevated in the short-term prior to 2026, after which many new production facilities, mainly from North America, are expected to commission, easing the supply-demand dynamics.

For instance, the 0.8 million mt/year SPA signed between Oman LNG and JERA was reportedly concluded at a mid-13% Brent slope on an FOB basis for a contract tenure of 10 years, starting in 2025.

Meanwhile, Sinopec and QatarEnergy signed a 27-year contract for 4 million mt/year, deliveries starting 2026 at high-12% Brent slope, although one caveat is that the SPA is understood to be linked to the Chinese firm's equity investment in QatarEnergy's North Field East expansion.

With a new wave of liquefaction capacity expected to come online in the second half of this decade, such non-LNG-based pricing carries risks of contracts not being priced against prevailing demand and supply fundamentals.

The lack of efficient price signals could lead to similar market gluts and shortages seen over previous commodity cycles, most notably observed in the record price lows of 2020 and peaks in 2022.

The LNG market has started leaning toward innovative solutions to mitigate these difficulties. Some of them include price reviews taking place at greater cadence than before, with contracts recently being negotiated to conduct price reviews as frequent as once a year, from the usual once every three to five years. This allows more room for counterparties to reflect changes in market fundamentals to the contractual price on a more timely basis. Price reviews often involve external consultants, lawyers, time commitment and potential commercial friction between counterparties.

Companies are also incorporating LNG-based pricing, such as Platts JKM, for the first few years of delivery especially for term contracts that have deliveries beginning before 2026. This is to accommodate the difficulties mentioned above as companies on both sides of the transaction seek a compromise. This compromise is necessary as the 25%¹ crude oil slopes that would likely be unacceptable to buyers and sellers seek to win long-term business, but are unwilling to sacrifice their medium-term advantaged position. Market-based LNG pricing is seen as the compromise as a transparent forward curve has taken shape for the next several years on LNG derivatives contracts such as Platts JKM.

In addition, more companies are seen implementing an LNG price cap and/or collar on top of the crude oil slope, creating a hybrid pricing formula where term contract prices would be following market-based pricing if the crude oil-linked prices are to move above the LNG price cap or below the collar.

Moving forward, more of such structural changes could potentially be seen built into term contracts as buyers and sellers attempt to reach a middle ground.

¹ With LNG prices averaging $15-20/MMBtu from 2023-2026 and crude oil prices averaging $70-80/b in the same period as of January 19, 2023; source: S&P Global Commodity Insights.