LNG Spot Prices - The Billion-Dollar Question
In our previous LNG Blog, we argued that most LNG demand discussions are rather pointless, as demand will (almost) always match supply. But with spot prices balancing the market, how should participants manage uncertainties? As spot trades gain market share, and more gas producers enter into spot netback deals, this is literally a billion-dollar question. Here is our take.
[This article is not financial or investment advice, but provided for general information purposes only. All information is subject to change and should not be relied upon for any decision making. See Webpage Terms of Use.]
The Argument
In our previous blog, we already talked about why sunk cost economics are key to understanding LNG demand dynamics, and why they “normally” lead to demand matching supply. When it comes to spot prices, sunk cost economics are again key. In a nutshell, here is how we recommend thinking about LNG spot prices to our clients:
Develop Scenarios, not Forecasts
Understand sunk cost economics
Focus on the downside scenarios and incentives
And most importantly, rigor in thinking through consequences is often more important than getting a scenario exactly right.
Develop Scenarios, not Forecasts
Forecasts can be valuable for consultants, as they seem to indicate some special market insights if they play out - and there is always an excuse if they don’t (Covid / Ukraine / Fukushima / Tariffs / …). But for market participants, single point forecasts are all but useless. Scenarios on the other hand allow for effective planning and risk management. This may sound obvious, but remarkably often, it is not implemented.
Frequently, we see base case or budgetary estimates combined with sensitivities. That’s a good starting point, but it does not answer the most important question: what are the impacts of the credible worst case (and best case) scenarios?
For example, if the base case is JKM at USD 10.5/MMBtu, what would be the implications of e.g. USD 6/MMBtu for 6 consecutive quarters? How about USD 25/MMBtu for 6 consecutive quarters? How would cash flows and credit metrics be impacted and managed? “Head in the oven, feet in the freezer, and on average you’re comfortably warm”?
Working through scenarios beyond just calculating sensitivities is crucial.
Understand Sunk Cost Economics and Incentives
Understanding sunk cost economics is key to understanding market dynamics in capital-intensive industries like LNG. The question we have been asked most often lately is where we see the LNG spot market heading between now and 2030 as a wall of supply is entering the market. As outlined above, we don’t provide forecasts, but help develop scenarios worth preparing for.
And in a way, scenarios are easier than forecasts. Projects may be delayed, there could be geopolitical or Natural Catastrophe induced disruptions, or a recession - but when focusing on scenarios rather than forecasts, this doesn’t impact the way to look at the market. There is a material chance that the market will see a significant amount of oversupply, and spot prices will need to drop far enough to lead to supply shut-ins. And shut-ins will only materialize once spot prices drop below the marginal cost of supply, excluding any sunk costs. Keep in mind though that even some of the spot-indexed deals come with long-term supply obligations, leaving limited room for suppliers to cut unprofitable cargoes.
Focus on downside scenarios and incentives
Downside scenarios tend to have a disproportionately large impact on a company’s viability, thus they deserve focus. And keep in mind that especially in complex value chains, what looks like an upside scenario may quickly turn into a downside, e.g. by incentivizing one of the value chain counterparts to look for contractual loopholes to capture more of the upside for themselves. What if another value chain element does not have corresponding back-to-back provisions, leaving an entity exposed in the middle?
If you understand and cater for the downside, every other scenario becomes an opportunity.
Want to explore this, or other topics, further?
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