More on the gas market “swaps” mess

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From the AIG:

The shortage in the domestic market could be between 10 PJ and 54 PJ per year if AEMO is right, or somewhat higher if other observers are correct. But the export channel is expected to send 1300-1400 PJ overseas each year. A modest contraction in this volume could easily cover domestic shortfalls for the several years required for other supply- and demand-side options to deliver.

Meanwhile, there are large volumes of gas available on international spot LNG markets. In 2015 nearly 4,000 PJ of gas was traded as LNG outside of long term contracts, and supply has increased since. Spot prices for LNG landed in Japan have been well below historic levels recently. With oil prices rising from recent lows, spot LNG has recovered from below AUD$6/GJ in May 2016 to around AUD$12/GJ in February. Those remain well below the prices originally anticipated for gas landed in Japan under long term contract. Some of the spot gas actually comes from Australia, particularly from WA projects.

With spot LNG plentiful and relatively affordable, it should be possible to put together a ‘swap’ arrangement in which some of the commitments made by Australian exporters to overseas customers are instead met with gas from outside Eastern Australia, freeing up local gas to be sold into the domestic market. This could involve:

a) Australian LNG producers with wider international portfolios making internal arrangements to deliver gas from their assets outside Eastern Australia;

b) Australian LNG producers arranging to purchase LNG from third parties to deliver to their customers;

c) Overseas customers making arrangements with Australian LNG producers to either forego delivery of a portion of their entitlement, or on-sell some of their entitlement within Australia without requiring physical delivery;

Domestic customers could be involved as contracting parties to provide certainty of demand for any volumes released.

Since prices appear to be modest in spot markets and high within Australia, it should be possible for this arrangement to leave nobody worse off and the domestic market considerably better off than the status quo. While the details of the LNG export contracts are confidential and Ai Group is not experienced in international gas trading, the following illustrative example may be worth considering:

  • 10 PJ of gas is contracted for delivery in Japan, landed at $14/GJ, while domestic Australian retail customers are facing contract offers of $12-$22-GJ.
  • 10 PJ of gas is purchased on the spot market to fulfil the contract, at a cost to the exporter of $12/GJ and to the importer at the contracted price of $14/GJ (or perhaps $13/GJ if the customer’s consent to a change of contractual clauses is required to facilitate the arrangement)
  • 10 PJ of gas is sold by the exporter into the domestic market at an oil-linked export parity price (we believe this is about $9.50/GJ at current oil prices)

If these assumptions are close to correct the arrangement would be positive sum and all parties could benefit, though different distributions of benefit are possible and would be a matter for negotiation.

Possible hurdles

It may be asked why, if a swap makes so much sense, it is not already happening. We are told that two of the LNG consortia are already net contributors to the domestic market, and have made some significant swaps. We also understand that international gas traders are taking an increasing interest in the situation. However there are several possible barriers which may explain why the problem is not already solved.

  1. Less favourable economicsIt may be that the real relative costs of a sufficiently large swap are less favourable than we suppose. Moderately unfavourable costs could potentially be bridged by private parties accepting a loss, or the public sector providing a subsidy, if they judged avoiding a domestic supply crisis to be in their larger interest. If costs were very unfavourable it is unlikely anyone would pursue a swap.

    Better information about relative costs is required.

    1. Contractual barriersWhile the LNG export contracts are confidential, it is widely supposed that they contain terms that may need to be changed, waived or worked around for a swap to proceed. In particular, at least some of the contracts are said to contain location clauses that either oblige the seller to provide supply from a particular source, or forbid buyers from on-selling the gas, or both. If this is correct, resolving this would be possible but sensitive. APPEA have suggested to us that their overseas customers would need to initiate any swap, though it is not obvious why overseas customers would be sufficiently motivated to solve Australian supply problems.

      Better information about relevant contractual terms and possible workarounds is required.

      1. Sensitivity to contractual changesThe biggest barrier is likely to be that the existing LNG export contracts are central to the value of these projects, and in the case of Santos to the financial stability of the companies concerned. The contracts were settled at a very different time when conditions were more favourable to sellers and oil and gas prices, and gas demand, were expected to be higher. Sellers may be extremely worried that any variation in their contracts may give buyers an out, or lead to wider renegotiation. The potential for benefit through redirecting small volumes of gas at the margins would be outweighed (for the exporter) by the risk of lower returns on the large volumes committed for export.

        Better information about the positions and preferences of exporters and their overseas customers is required.

        1. Unintended consequencesIf a swap were executed by one or more exporters and freed more gas in the Australian market, it is possible that another exporter might simply acquire some or all of that gas to meet its own export commitments or spot opportunities, leaving the local market still short. The apparent travails of Santos and its GLNG partners in meeting even their base level of commitment mean this is a real threat. Indeed, we are told by producers that some gas has already been sold to help the domestic market, then onsold to GLNG.

          This risk might be reduced either by involving domestic customers directly in arrangements, or by commitments by all exporters not to snap up freed gas – potentially enforced by the national interest test described further below.

          1. Australian on-costsIf a swap were executed it is possible that additional on-shore costs in Australia (particularly for transport through pipelines) could substantially increase the cost to domestic customers of any gas freed. Any contractable gas, even at a high price, would be helpful at this point.

            However, transport costs could be reduced through a second level of purely domestic gas swaps. Large national entities, such as the major energy retailers, may be well placed to swap between Queensland CSG, Cooper conventional and Victorian offshore supplies to minimise transportation costs.

            1. Lack of information and transparencyIt is clear that the most immediate barrier to a swap is the lack of readily available information. Government may be able to play a critical role as a neutral and trusted player able to acquire and collate the necessary information, much of which is highly commercially sensitive.

            I got a few aspects of this plan wrong earlier today but it’s clear now and is still a really bad idea. Local manufacturers will be exposed to the oil price as a benchmark and thus forex risk, eliminating any advantage they have when the dollar falls. As well, it implicitly prevents local prices from falling to export net back by embedding the costs of liquefaction and shipping even though they will not be necessary.

            The AIG and Labor has rocks in its head. This is not a solution it’s desperate gambit to pull prices down to ridiculous versus today’s ludicrous:

            This is a failed market and the preference has to be for a structural fix with some big and dumb new rules to fix it. There has to be a loser and it is either GLNG or it is everyone else, as Credit Suisse argues:

            ■ Our preferred option is to reclaim the third-party gas currently being exported: Aside from the Horizon contract between GLNG and Santos, there was no evidence in the EIS or FID presentations that more non-indigenous gas was required. As such, one could argue reclaiming what has only been signed due to a scope failure, is equitable. Including the Horizon contract GLNG will be exporting >160PJa of third-party gas in the later part of this decade. Whilst we get less disclosure these days, BG previously said that after an initial 10–20% in the early days (now gone) QCLNG would use ~5%

            ■ Our preferred option is to reclaim the third-party gas currently being exported: Aside from the Horizon contract between GLNG and Santos, there was no evidence in the EIS or FID presentations that more non-indigenous gas was required. As such, one could argue reclaiming what has only been signed due to a scope failure, is equitable. Including the Horizon contract GLNG will be exporting >160PJa of third-party gas in the later part of this decade. Whilst we get less disclosure these days, BG previously said that after an initial 10–20% in the early days (now gone) QCLNG would use ~5% thirdparty gas – 20–25PJa. APLNG is self-sufficient, but as can be seen the other thirdparty gas would get extremely close to balancing the market. Clearly these things are far better done by mutual agreement from all parties, rather than a political mandate.

            ■ GLNG loses but can all be compensated? We estimate that, at a US$65/bbl oil price, GLNG as an entity would lose US$447m p.a. of FCF if they could no longer toll thirdparty volumes. Interestingly, if Kogas and Petronas could recontract their offtake on a slope of 12x (doable in the current LNG market) then their losses as an equity partner are all offset (not equally between the two albeit). Santos would see ~50% of its US$134mn net GLNG loss offset if the Horizon contract could move up to a slope of 8x from 6x. The clear loser would be Total. We wonder whether cheap government debt, a la NAIF, could be provided at the (new, lower volume) project level or even to take/fund an equity stake in it? In reality all parties (domestic buyers included) have some culpability in the situation, so a sharing of pain does not seem unreasonable 02 March 2017 Australia and NZ Market daily 31.

            Ban third party exports plus install “use it or lose it laws” and domestic reservation.

About the author
David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geo-politics and economics portal. He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.