LAUNCESTON, Australia (Reuters) - Asian buyers of liquefied natural gas may come to view the plunge in oil prices as a case of be careful what you wish for, as you may get it.
For several years Asian LNG consumers have been keen to see an end to the long-standing practice of linking the price of the super-chilled fuel to crude oil, most often with a sliding scale referred to as a slope.
The buyers have argued that this exposes them to rising crude oil prices that have little bearing on the price of extracting and chilling the gas. In other words, LNG producers have been gaining at the expense of consumers.
This has been the case in recent years, given the steady rise in oil prices, with only a brief reversal in the wake of the 2008 global financial crises.
But with Brent crude down some 60 percent since the middle of 2014, and the prospect of weak prices for many years to come, oil-linked LNG isn’t looking as bad an option as it was.
Certainly, the weaker oil prices will already be reducing the price paid for LNG, but the real issue for LNG consumers is whether they believe the current situation is a structural change, or merely another temporary reversal.
If low crude prices do persist for several years, then sticking with longer-term oil-linked contracts could be the best way to ensure reliable supplies at a relatively low cost.
However, if oil prices do recover strongly, then the push to short-term contracts linked to other global gas benchmarks such as the UK’s National Balancing Point or the U.S. Henry Hub will make more sense.
It’s virtually impossible to accurately predict where oil prices will go. All that an analyst can reasonably do is assess current trends and make forecasts based on these trends continuing.
Currently this means that oil prices will likely remain below $100 a barrel for an extended period, especially if major swing producer Saudi Arabia continues its policy of not surrendering market share in order to boost prices for the benefit of rival producers.
Even if U.S. shale oil and other higher-cost crude such as Canadian tar sands and deep offshore wells are forced from the market, they will come back as soon as prices recover.
Given the uncertainty of where oil prices will go in the next few years, the temptation for LNG buyers will be to stick to their current campaign of trying to end, or reduce, oil-linked prices.
They will also be seeking to use more short-term contracts, end restrictions such as destination clauses and encourage price flexibility.
SHORT-TERM GAIN, LONGER-TERM PAIN?
This is all good when the market is in surplus, which is now the case given the increasing LNG supply as projects in Australia and elsewhere start to come online.
Demand growth in Asia has also been lower than expected, especially in China, which bought 17.8 million tonnes in the first 11 months of last year.
While this is 14.5 percent higher than the same period in 2013, LNG producers have been banking on substantially higher growth rates for Chinese demand in order to soak up the output of Australia’s seven new projects, as well as those under construction in the United States.
While buyers now enjoy the upper hand, they should be wary of shifting the market to more of a spot and short-term contract model.
This will only work if your expectation is that LNG will remain in surplus in perpetuity, and this is almost certainly not the case.
It’s yet to become a flood, but already new projects are being put on ice.
If I was a betting man, I would say that no new projects will take a final investment decision in 2015, and maybe none will be approved until the oil price recovers.
This means the next wave of proposed LNG plants in both the United States and western Canada has little chance of going ahead.
This raises the possibility that the LNG market will return to deficit early in the next decade, thus handing the whip hand back to producers.
If producers are forced by current weak energy prices to shift away from long-term, oil-linked prices, it would be a fair bet that when the market returns to deficit they will be ruthless in applying their pricing power.
If the market is then based on short-term contracts, buyers could be in for a hard time.
It may be a bit of a reverse example, but LNG buyers may want to look at the experience of BHP Billiton and iron ore.
The world’s biggest miner led the charge to move the iron ore market away from annual contacts to virtually spot pricing.
This worked very well for the producer during the recent years of market deficit, but is probably no longer working for it as well given the current supply surplus.
However, unlike the iron ore market, which is likely to be in sustained surplus for many years, LNG’s oversupply is likely to be a more temporary state.
Editing by Richard Pullin