Negotiation Standards for LNG Contracts
Our LNG trading desk deals mostly with three major pricing systems in LNG contracts:
- Oil indexed contract (or crude basket) used primarily in Japan, Korea, Taiwan and China;
- Crude, oil products and other energy carriers indexed used in Continental Europe; and
- contracts indexed to Henry Hub (HH) for US and National Balancing Point (NBP) for UK gas.
The formula for an indexed price is as follows: CP = BP + β X (BP: constant part or base price; β: gradient; X: indexation). The formula has been widely used in Asian LNG SPAs, where base price refers to a term that represents various non-oil factors, but usually a constant determined by negotiation at a level which can prevent LNG prices from falling below a certain level. It thus varies regardless of oil price fluctuation. Oil parity is the LNG price that would be equal to that of crude oil on a barrel of oil equivalent basis. If the LNG price exceeds the price of crude oil in BOE terms, then the situation is called broken oil parity. A coefficient of 0.1724 results in full oil parity. In most cases the price of LNG is less the price of crude oil in BOE terms. In 2009, in several spot cargo deals especially in East Asia, oil parity approached the full oil parity or even exceeds oil parity.
Sellers have become more sophisticated the last years and are now proposing sharing of arbitrage opportunities and moving away from so called S-curve pricing. There has been much discussion regarding the creation of an OGEC, the OPEC equivalent of natural gas. Russia, Iran and Qatar, countries with the largest and the third largest natural gas reserves in the world, have finally supported such move.
S-Curve: many formula include an S-curve, where the price formula is different above and below a certain oil price, to dampen the impact of high oil prices on the buyer, and low oil prices on the seller. JCC and ICP: in most of the East Asian LNG contracts, price formula is indexed to a basket of crude imported to Japan called the Japan Crude Cocktail (JCC). In Indonesian LNG contracts, price formula is linked to Indonesian Crude Price (ICP).
Brent and other energy carriers: in the continental Europe, the price formula indexation does not follow the same format, and it varies from contract to contract. Brent crude price (B), heavy fuel oil price (HFO), light fuel oil price (LFO), gas oil price (GO), coal price, electricity price and in some cases, consumer and producer price indexes are the indexation elements of price formulas.
Price review: usually there exists a clause allowing parties to trigger the price revision or price reopening in LNGSPAs. In some contracts there are two options for triggering a price revision. regular and special. Regular ones are the dates that will be agreed and defined in the LNGSPAs for the purpose of price review.
Cargo diversion: based on the LNGSPAs, LNG is destined for pre-agreed destinations, and diversion of that LNG is not allowed. However if Seller and Buyer make a mutual agreement, then diversion of the cargoes is possible but subject to sharing the profits coming from such diversion. In some jurisdictions such as the European Union it is not allowed to apply the profit-sharing clause in the LNGSPAs for any diverted cargoes inside the EU territories.
Quality regulations: LNG quality is one of the most important issues regarding the legal contracting. Any gas which does not conform to the agreed specifications in the sale and purchase agreement is regarded as “off-specification” (off-spec) or “off-quality” gas or LNG. Total Quality Management serves three purpose: (1) to ensure that the gas distributed is non-corrosive and non-toxic, below the upper limits for H2S, total sulphur, CO2 and Hg content; (2) to guard against the formation of liquids or hydrates in the networks, through maximum water and hydrocarbon dewpoints; (3) to allow interchangeability of the gases distributed, via limits on the variation range for parameters affecting combustion such as e.g.: content of inert gases, calorific value, Wobbe Index, Soot Index, Incomplete Combustion Factor, Yellow Tip Index. In the case of off-spec gas or LNG the buyer can refuse to accept the gas or LNG and the seller has to pay liquidated damages for the respective off-spec gas volumes. The quality of gas or LNG is measured at delivery point by using an instrument such as a gas chromatograph.