IEEJ: March 2003

LNG: Falling Price and Increasing Flexibility of Supply– Risk Redistribution Creates Contract Diversity –Koji Morita
General Manager, First Research Department
The Institute of Energy Economics, Japan<Research Objective>
In the past few years, a growing number of electric and gas utilities in Japan haveargued that their LNG sales contracts, which are comparatively costly and lacking in
flexibility, should be reviewed, stating that otherwise, Japan’s LNG demand is unlikely toincrease. Under these circumstances, the media reported that cheap-priced LNG would
be supplied to China. Meanwhile, the Japanese LNG importers for their part, taking
every opportunity and particularly through contract renewal talks, have won concessions
from the suppliers for price cuts and greater flexibility of contract volume as a result of
repeated negotiations. This research analyzes the changing environment surrounding
LNG and the key factors behind the changes, and then provides an estimate of theprobable LNG price levels and pricing formulas in the days ahead.
<Major Conclusions>
1. Although Japan-bound LNG has been long characterized by higher prices than
US/EU-bound consignments and more rigid supply terms, falling prices andimproving rigidity are likely from now on thanks to such factors as a loose
supply-demand balance and sharply trimmed supply costs, particularly ofliquefaction and hauling costs.
2. LNG prices are expected to converge into the contract price offered to China ’s
Guangdong project, to which LNG supplies will start around 2005. When correctedby distance, the Guangdong price is equivalent to a little over $3/MMBTU (whencrude oil price is $20/bbl) in terms of the LNG price in Japan. From now on, thestrong likelihood is that the Japanese importers will demand that their prices must be
lowered to the Guangdong price level during price negotiations and contract renewal
talks.
3. LNG projects have been affected by risk sharing between the supply side andimporters on the demand side. The importers, howeve r, are now seriously seeking
risk redistribution. This is because they are being squeezed by intensifying
deregulatory moves, etc. and can no longer afford all risks, regardless of price orvolume. Indeed, when renewing their contracts with Malaysia I, Tokyo ElectricPower and Tokyo Gas won a price cut and effectively relieved take-or-pay (TOP), asa result of which they decided to assume part of hauling services by themselves.
TEPCO and Tokyo Gas also plan participation in the whole of the LNG chain,including upstream, of the Darwin Project, Australia, which will start supplies in

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IEEJ: March 2003

2006. These developments demonstrate the emerging strategy of the Japanese
importers in which, rather than just reducing conventional risks, they are now
increasingly aggressive—that is, they are oriented toward optimization of LNG
procurement even by assuming additional risks.
4. Risk redistribution under way creates diversity of LNG sales contracts, with a plural
number of pricing formulas paired with different trading terms (e.g. long-, mediumand short-term options, varying TOP coverage, non-uniform deliveries). Already
Korea Gas Corporation has given its consent to the North West Shelf project (NWS),
Australia, for the signing of a medium- term (7-year) agreement, which endorsed ahighly flexible supply (e.g. priority deliveries in winter seasons).
These developments enable electric utilities to realize the best power mix more easily
than ever and help electricity and city gas alike to increase price competitiveness, allof which contribute to promoting natural gas use.
It will be essential for the Japanese importers to try to construct an optimal portfolioof LNG sales contracts by using the diverse options in the best combinations formeeting their demand patterns and customers’ needs.
1. What is at stake? – LNG projects cannot be affected without risk taking on thepart of buyers –To start up an LNG project involves huge capital outlays. (For example, North West
Shelf project, which shipped the first cargoes in 1989, reportedly required an investment
equivalent to about one trillion yen.) To finance the staggering investment, not only theseller but also Japanese users, or the buyers, were required to bear the risks incurred in the
project. In specific terms, the Japanese buyers were urged to take the risks in such forms
as a sizeable contract volume, a contract term of as long as 20-25 years, the take-or-pay(TOP) clause (quantitative risk), and higher prices than those payable by their Westerncounterparts (price risk).
(1) Higher prices than in the US/EU
The price of LNG supplied in Japan has stayed much higher than in the United Statesand Europe. In 2000, for example, the CIF price of LNG averaged $3.10/MMBTU in the
EU and $3.43/MMBTU in the U.S. compared with $4.73/MMBTU in Japan, which
represented a higher price level of 53% and 40%, respectively. In 2001, the tripartite
differentials narrowed a little in reflection of natural gas price spikes in the U.S., which
sent the LNG price rising to $4.22 in the U.S., while the price in Japan stayed at $4.64(IEA Energy Prices & Taxes).
The differentials are still too big to be explained by differences among the consuming
regions in their actual conditions, such as the availability of natural gas and alternative
energy resources, hauling distance from sources and the presence of rivaling pipelinedgas.
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IEEJ: March 2003

Fig. 1 LNG Prices (Comparisons among Japan, the U.S. and the EU)
5.00$/MMBTIU

4.50

Japan

4.00

EU
USA

3.50
3.00
2.50
2.00
1.50
1.00
0.50

01

00

20

99

20

98

19

97

19

96

19

95

19

94

19

93

19

92

19

91

19

90

19

89

19

19

19

88

0.00

year

(Souece) IEA "Energy Prices & Taxes"(2) Long-term and rigid trading conditions
Owing to the character of LNG projects, sizeable contract volume, long contract term
and take-or-pay (TOP) have been seen as crucial to LNG. Also, LNG has beencharacterized by bilateral contracts between specified sellers and buyers anduniform/fixed-rate deliveries, among others. All of these characteristics guarantee
stability of supply but, concurrently, represent rigidity.
During the initial period following introduction of LNG, LNG accounted for only afraction of the supply mix for both electric and gas utilities alike, which meant that they
had little difficulty in consuming all of the LNG they received constantly either as fuel orfeedstock.
However, as a result of the increasing proportion occupied by LNG, TOP has becomea heavy burden. By 1990, fuel switching to LNG in the electricity sector had advanced somuch as to make LNG account for 28% of generated output by the nine electric utilities.
Moreover, in the process of changing the roles of LNG from a base load source to a
middle load and further to middle & peak loads, mounting constraints have hampered theelastic operation not only of LNG but also of other power sources by electric utilities.

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IEEJ: March 2003

Fig. 2 Power Source Mix (Nine Utilities)
100%
90%

7.8

Oil

32.7

LNG

25.9

80%

49.4

70%

43.1

60%

28.9

50%

20.7

40%

25.4

30%

Coal

5.9

3.1
28.8

17.6

20%

12.3

38.7

Nuclear

10%

Hydeo

0%
1970

1980

1990

2000

(Source)EDMC "Hanbook of Energy & Economic Statistics in Japan"

In the city gas sector, the share of LNG/natural gas in the feedstock mix had jumped
from 51% in 1980 to 76% by 1990. As of the start of the 1990s, Tokyo Gas, Osaka Gas
and Toho Gas had all completed switching to natural gas. By 2000 LNG share reached ahigh 87% nationwide.
Thus, both electric and gas utilities had their LNG shares saturated. In other words,“they reached their limits in taking the quantitative risk.”

300,000

City gas sales volumes

250,000

LNG/Natural gas

200,000

Share of LNG

150,000
100,000
50,000
0

100.0
90.0
80.0
70.0
60.0
50.0
40.0
30.0
20.0
10.0
0.0

1965 1970 1975 1980 1985 1990 1995 2000 2001
(Source)EDMC "Handbook of Energy & Economic Statistics in Japan"
4%10^10kcal

Fig. 3 City Gas and LNG

IEEJ: March 2003

This is the reason why a growing number of electric and gas utilities have become
outspoken about TOP. They contend that the TOP coverage should be limited to, say,
70-80% of the contract volume, instead of the conventional 100%, although they still
acknowledge the significance of the take-or-pay clause as an element of vital importancein effecting LNG projects.
2. What things are changing? – New times and trends affecting conventional
structure of risk distribution –(1) Waves of liberalization flowing over LNG importers
The Electric Utility Industry Law and the Gas Utility Industry Law as amended andre-amended in 1995 and 1999 freed about 30% of both electricity and city gas sales.
Moreover, during the current session, the Diet is expected to amend the two industry laws
again, thus further expand ing the scope of liberalization.
Naturally, neither the electric nor the gas utilities have much choice but to seek LNG at
the lowest possible price. In addition, they are finding it increasingly difficult to set
fuel/feedstock procurement targets due to growing uncertainties that make electricity/city
gas demand more volatile than ever. Furthermore, finding customers on the freed markets
requires not only good economics but, more importantly, flexible supplies that can best
match customers’ demand patterns. Thus, the electric and gas utilities are being forced todiversify their fuel/feedstock procurement.
One solid fact unchanged since the early period of LNG introduction is that theJapanese importers have materialized the necessary investments for effecting LNG
projects by taking “price risks” and “quantitative risks.” In fact, the Japanese LNG
importers have been able to pass on the greater part of the risks to final consumers, sincethese have been authorized monopolistic electricity/city gas services. This approach,however, is rapidly being eroded by the widening scope of liberalization.
In the midst of the changing environment, the concept of LNG procurement isapparently varying on the demand side. In other words, shifts are being made fromconventional principles—i.e., preferring long-term contracts for supply security reasonsto economics and flexibility of supply (by accepting TOP and higher prices than in the
US/Europe).
(2) Jostling new projects on supply side and drastic cost cuts
At the start of the 1990s, large numbers of new construction/capacity expansion
projects were anno unced one after another.
These include the start- up of Malaysia II and a plan of the third project (TIGA)

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IEEJ: March 2003

announced by Malaysia, capacity expansion of the fourth train (liquefaction unit) plannedby a North West Shelf project, Australia, and additional trains planned and installed by
the Bongtang terminal, Indonesia. Among others, new LNG projects were announced,
including Tangguh (Indonesia) and Sakhalin I & II.
In the Middle East, ADGAS of Abu Dhabi introduced an additional train, which
increased the company’s export capacity to 4.30 million tons from 1994 onward. In 1997,
Qatar managed to initiate supplies to a Japanese-buyer consortium led by Chubu ElectricPower. Later, the second project (Ras Rafan) of Qatar started supplies almost
simultaneously with an Omani project. Among others, Yemen and Iran announced theircandidacies as LNG suppliers.
As a result, with the projects still at the F/S stage included, LNG supply capacities
available for Asia have increased remarkably during the 1990s.
Simultaneously supply cost was reduced to a considerable extent.
Fig. 4 Image of Falling Costs at Liquefaction Plants
100

%
%

0
Brunei
Designed
1969
inMalaysia I

Australia/
NSW

Malaysia II

Nigeria

Oman

Malaysia III

1978

1985

1990

1993

1995

1999

(Source)Royal Dutch Shell Homepage

The primary contributors are technological innovations, introduction of large plants(typically liquefaction units) and very large tankers, and price competition triggered bymultiplying entrants.
The per-ton construction cost of LNG liquefaction plants continued to fall steadily
from the 1970s through the 1990s. For instance, an Omani project on stream in 2000
announced that its per-ton construction cost was 50% of a Brunei plant having started
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IEEJ: March 2003

supply in 1972.
Meanwhile, t he cost of transporting LNG is much higher than that of moving crude oiland LPG because of a characteristic of LNG—that is, its ultra-low temperature (-162o C).
Particularly during the early 1990s, the cost of building the-then standard LNG tanker of
130,000 m3 skyrocketed to more than $250 million.
Later, however, the construction cost took a downward turn and briefly plunged toaround $150 million, largely due to an orders-receiving race triggered by the plural
number of Korean shipyards launching into LNG tanker construction. In addition, theintroduction of very large tankers contributed greatly to slashing the unit construction
cost.
The realities of the falling costs of liquefaction plants and LNG tankers are beneficial
in two ways: making start-ups of new projects easier, and enabling such start-ups without
100%-assured outlets. In other words, conspicuously excessive capacities larger thancontracted volumes are beginning to emerge in the Asia/Pacific region.
(3) Asia-bound LNG priced cheaper
In August 2002, an Australian LNG consortium (North West Shelf) finally succeededin getting a supply agreement signed with China for it s first LNG receiving terminal
situated in Guangdong. The contract term is reported to be 25 years from 2005-2006, andthe contract volume 3.30 million tons imported yearly.
In the following September, Indonesia ’s Tangguh project won a supply contract toanother LNG terminal to be built in Fujian. Under the contract, 2.60 million tons a year
will be exported over 25 years. With its construction commencing in 2004, the receiving
terminal is scheduled to start operation in 2007.
The cheapness of LNG is very surprising. The LNG price in Guangdong is reported
to be around $3/MMBTU, while crude oil is priced at the level of $20/bbl. Correcting the
Guangdong price by distance puts the LNG price in Japan at a little above $3. Incomparison, the ex-ship price of LNG imported from NSW to Japan stays within thelatter half of the $3/MMBTU mark when linked to $20/bbl of crude oil (estimated from
customs clearance statistics and others). Hence, if the reported Guangdong price iscorrect, the resultant differentials amount to as much as 20%.
Also, in August 2002, India’s Petronet project reached an agreement with RasGas of
Qatar on the price offered to the Daheji LNG terminal. This project will receive LNG in
the amount of 5.00 million tons a year. The LNG price, basically linked to JCC, isdesigned to limit its volatility to within the range from $2.03 ($16/bbl of crude oil) to$3.04 ($24/bbl) by virtue of pre-set ceiling and floor prices (“Arab Oil & Gas” dated

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IEEJ: March 2003

September 9). The contract price appears to be very cheap even when account is taken of
the short hauling distance between Qatar and the West Coast of India.
3. Risk redistribution on the rise – falling price and increasing flexibility of supply–(1) “New risk distribution model” with lower price and flexibility incorporated
In March 2002, the Malaysia I project had its 20- year contract term matured. Since
1983, this project has supplied to TEPCO and Tokyo Gas the entirety of their contract
volumes – 4.80 million tons and 2.60 million tons a year, respectively – under ex-shiparrangement (under which the seller is obliged to deliver goods to a port named by thebuyer). The renewal talks yielded a two-tiered contract term, with some of the contract
volume (TEPCO 700,000 tons, Tokyo Gas 500,000 tons) included in a short-termfour-year contract. The portion of the long-term contract was shortened to 15 years as
well. The newly incorporated short-term contract, combined with greater flexibility
embedded in the conventional long-term contract portion, is expected to increase theflexibility of contract volumes by around 20%. This means effective easing of TOP.
At the same time, TEPCO and Tokyo Gas each put 1.20 million tons and 600,000 tons
under an FOB (free-on-board) contract (under which goods are delivered at a port situatedin the producer’s area), which would be hauled by themselves using their captive LNG
tankers.
Some press news articles also reported that an agreement was reached on a price cut ofaround 5%. Thus, both price and quantitative risks were redistributed.
From the importers’ perspectives, however, the latest contract renewal was moresignificant than a simple reduction of the risks they have borne. It enabled them to seek
returns for a new risk which they dare to assume by launching into the hauling services
hitherto offered by suppliers. In other words, the significance of the “new risk
distribution model” as redistribution of profits must not be overlooked.
TEPCO and Tokyo Gas also announced and outlined their participation in the Darwin
project, Australia, to be commissioned in 2006. TEPCO and Tokyo Gas will receive 2.00
million tons and 1.00 million tons a year, respectively, for 17 years under a n FOB contract,with the entirety of contract volumes to be hauled by LNG tankers chartered by theutilities. Of particular interest is the fact that the both companies invested in Darwin LNG,
the supplier. This means that TEPCO and Tokyo Gas are the sellers, transporters andbuyers. A plausible interpretation is that, in return for taking new risks by participating in
the entire LNG chain, they obtain a new opportunity of profit sharing and head for
optimization of LNG procurement. This move can be highly evaluated as the evolution

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IEEJ: March 2003

of a “new risk distribution model.”(2) Expanding spot trading contributes to increasing flexibility of supply
Spot trading of LNG, which is a yardstick of flexibility, is increasing at a rapid rate.
Transactions under short-term contracts (less than a year and inclusive of spot trading) in2001 recorded a tenfold increase over 1992 levels and reached a hefty 8% of total trade(IEA, “Flexibility in Natural Gas Supply and Demand”). Above all, conspicuous rises
were noted in spot-traded LNG destined for the US.
In order to expand their LNG sales, the oil majors, among others, are no longer
remaining idle in the position of investors, interest holders and/or suppliers of LNG in the
upstream sector. They are adopting the strategy of becoming LNG buyers themselves andare collecting the surplus capacities of many projects, while tapping new demand. The
colossal U.S. market (consuming ten times more natural gas than Japan) can easily digest
such moves. This is why the US-bound LNG spot trading is ballooning so rapidly.
This concept is becoming real in the Atlantic market, as demonstrated by expanding
spot transactions. In the Asia/Pacific market too, introduction of a similar strategy isunder consideration. LNG terminal construction projects and commercialization of
on-board gasification technology on the U.S. West Coast, among others, all point to thisconcept.
Expanding spot trading is beneficial to both suppliers and consumers, since it enables
the former to put their surplus capacities fully in operation and the latter to gain more
flexibility in LNG procurement.
(3) Price options ready, contract renewal talks imminent
In 2003, several projects are going to enter an official round of price negotiations.
Looking further to 2010, the plural number of projects will have their contract terms
matured and involve negotiations if their renewal is being considered.
After the renewal talks, the LNG price is likely to go down and the so far rigid contract
terms will probably improve, as in the cases of Malaysia I and Australia’s Darwin project,in such forms as a shortened contract term and increased flexibility of supply.
The above guesses are grounded on the suppositions that:
1. The supply-demand balance will remain loose in the medium term.
2. The costs of construction of liquefaction plants and LNG tankers have dropped.
3. The investment recovery of most of the existing projects is complete.
4. Expanding spot trading leads to greater influence of the US price.
5. Cheapness of the LNG price payable by the Guangdong project is well known among
the LNG importers in Japan and the rest of Asia.

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IEEJ: March 2003

To what level can the price be expected to drop?
The strong likelihood is that importers will demand a price cut to the same level as theprice offered to the Guangdong project in China, the differentials of which are poorly
grounded (partly due to the fact that little information is available), that is, to $3-plus/MMBTU in Japan. As a result, it appears reasonable to expect that the LNG price inJapan will converge into the Guangdong level.
Many observers expect drastic price cuts to result from the price negotiations
scheduled this year. However, the process of winning a drastic price cut to the
Guangdong level can be very time-consuming. Perhaps it will not be achieved before
2005, when China actually receives LNG from the North West Shelf and Tangguh
projects, or around 2008, when renewal talks start on agreements of the NSW and theIndonesian first projects.
Negotiations will not be easy, and the above-mentioned grounds can easily becontended.
Firstly, the looseness of the supply-demand balance can be undermined by rapid
expansion of the Atlantic market. Exports to the US/Europe have doubled in the latter
half of 1990’s. The loose supply-demand balance on the Asia/Pacific market will not besustainable in the event of massive LNG inflows from the more or less capacity-glutted
Pacific into the LNG-thirsty Atlantic.
Second ly, despite the solid facts that plant/tanker costs fell sharply and investment
recovery of many projects was completed, LNG price negotiations naturally consider not
merely “cost-based” aspects but also on-going market conditions. It remains uncertain towhat extent the importers can utilize the fact of shrinking cost on the supply side as ajustification for a price cut.
The market-based price in the U.S. is highly volatile. So far the price has rarely
surpassed $3/MMBTU, but since 1999, in reflection of crude oil price spikes and others
factors, the LNG price has stayed high, and is not always so low in the U.S. either.
(4) Consideration of pricing -formula options
Options of future “pricing formula” are summarized below.
l Fixed pricing (stated by a PETRONAS vice president for gas at SPEC 2002; oriented
toward a crude oil price- free mechanism)l Quasi- fixed pricing by setting a small figure for “a” in the formula, P = aX + b(adopted by China/India; oriented toward lower price and stability)
l Raising the ratio of fixed elements while lowering the ratio of the crude oil- linked
portio n (proposed by a Japanese importer at the World Gas Congress 2000; oriented
toward lower price and stability)
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IEEJ: March 2003

l The retail price of coal/coal- heavy fuel oil-crude oil/electricity, etc. taken as priceindicators (prevailing on the European Continent; to help LNG-fired power
retain/stabilize its competitiveness against rival power sources)l Petroleum products such as heavy fuel oil and kerosene taken as price indicators(prevailing on the European Continent; to help LNG-derived city gas retain/stabilize
its competitiveness against rival fuels)l LNG pricing linked to NYMEX/IPE futures (in order to reflect on- going market
conditions)l Making the contract two-tiered, with a flexible delivery portion (to better meetseasonal demand) and a fixed delivery portion (separation of price and flexibility)
Many options of pricing formula will be available in the future. It is also possible toarrange a wide variety of LNG contracts by pairing different pricing formulas withvarious trading patterns, each having flexibility of its own (e.g. long, medium and shortcontract terms, varying TOP coverage, non-uniform deliveries).
The Japanese importers are most likely to favor LNG procurement based on as many
LNG contracts as necessary for meeting their demand patterns and customers’ needs. In
fact, Korea Gas Corporation, when signing a new contract with NSW, reached an accordthat ensured a medium-term (seven-year) highly flexible supply (widely variable
deliveries, mostly concentrating on winter seasons).
Naturally, there will be less need for all importers to organize a consortium and buy
LNG priced according to a uniform formula. In other words, there will be an increasing
number of LNG procurements, each made by a single importer or a group consisting of a
few buyers.
Conclusion – Risk redistribution creates contract diversity –Carefully watching the two Chinese projects as well as India ’s Petronet, the Japanese
LNG consumers are waiting for the start of second- and third-round negotiations to pus hforward little by little the “new risk distribution model,” first proposed during the
Malaysia I contract renewal talks. Further evolution of the “new risk distribution model”
is very likely.
The evolution of the “new risk distribution model” means that the importers not only
demand that the suppliers bear some of the risks they have taken, but also that they havestarted aggressively seeking new profits in return for the additional risks they assume bylaunching into an entire LNG chain.
The evolution of a “new risk distribution model” is expected to spur the rise of diverse
LNG contracts, with pricing terms (e.g. price level, variable range) combined withvarious trading terms. This allows the electric utilities to lower generating costs and11

IEEJ: March 2003

realize the best power mix more easily than ever, which will ultimately lead to expansionof electricity demand. Likewise, the gas utilities can improve the competitiveness of city
gas against rival fuels. In addition, there will be great hopes for the promotion of natural
gas use and expansion of LNG demand in Japan.
It is a matter of vital importance for the Japanese importers to endeavor to create an
optimal portfolio of LNG contracts by pairing different pricing formulas with different
trading terms so that they can best match their demand patterns and customers’ needs.
Contact: ieej- info@tky.ieej.or.jp

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