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Vivien Yang -- Long-term LNG contracts good for Asia

Long-term contracts have formed the foundation for the growth of the liquefied natural gas market in Asia. These agreements have helped support investments in projects because LNG resource developers are financially assured that they can sell a certain quantity annually under the contract terms. For better or worse, producers and buyers are in this together and will need to engage with each other to meet market challenges over the duration of the contracts.

Asia represents more than 70% of global LNG demand, with north Asian LNG importers in Japan, South Korea and China accounting for most of the global market growth in the past decade. But these long-term contracts have been criticized, for several reasons.

Asian LNG buyers pay a so-called "Asian premium" since the traditional pricing mechanism link to Japan customs cleared crude (JCC) caused prices charged to them under fixed-term contracts to be higher than those paid by buyers in North America and Europe, where prices are largely set by trading hub prices for oil, oil products or natural gas that reflect supply and demand conditions.

In addition, Asian customers are subject to rigid requirements on supply quantities, and restrictions on where LNG can be delivered. Buyers who cannot take stipulated LNG quantities are required to make payments to suppliers as if the stipulated quantities have been taken -- known as "take or pay" obligations.

New LNG export projects coming on stream in the next few years in Australia, North America, Russia, and East Africa were originally developed in the belief that Asian demand would continue to grow and that the existing contract structure would largely stay in place.

However, challenges have arisen recently in Asia's LNG market due to the sluggish global economy, including China's economic slowdown; the availability of cheaper fuels as a result of low oil prices; and excessive LNG volumes in the market. Japan, South Korea and China reduced LNG imports last year and several Asian LNG buyers have sought to renegotiate long-term LNG contracts to cope with slowing gas demand while seeking to make LNG supplies more price competitive against other fuels.

LNG producers are engaging with customers to seek solutions for the current market challenges, without resorting to dispute resolution processes to enforce existing contractual obligations. For example, India's Petronet successfully renegotiated an existing 25-year contract with Qatar's RasGas to have a take or pay payment waived for supply amounts that Petronet failed to purchase in 2015.

The settlement reduced the contract price by nearly half, with a take or pay commitment to accept delivery of the rest of the 2015 contracted supply over the remaining term of the 25-year contract. Petronet has also moved to renegotiate the contract price with ExxonMobil for LNG supplies from the Gorgon gas project in Western Australia. China's Sinopec is reported to be renegotiating its contract with Australia Pacific LNG.

Low price environment

The low oil price environment over the last two years has been both a blessing and a curse for Asian LNG players. On one hand, LNG demand has been undermined by the weak global economy, while low oil prices make oil an attractive alternative for many LNG downstream customers. On the other hand, the fact that long-term LNG contracts are indexed to regional oil prices is resulting in lower LNG prices. More importantly, lower LNG prices are increasing interest in long-term LNG contracts as buyers seek to take advantage of the currently favorable level of prices.

Increased potential demand is emerging in Asia. South Asian countries, including India, Pakistan and Bangladesh are building new regasification terminals and contracting new LNG supplies. India's oil ministry announced in June that India will more than double the capacity of its LNG import terminals to 47.5 million tons per annum by 2022.

Pakistan has contracted with Nigeria and Qatar to buy long-term LNG supplies, and it is currently developing a second regasification terminal of around 3 million tons per annum capacity. Bangladesh will increase its LNG consumption to up to 19 million tons per annum by 2022 to fuel its growing economy.

Southeast Asian countries will also drive increased LNG demand. According to the International Energy Agency, their growing economies will result in the region becoming a net gas importer by 2040, with around 10 billion cubic meters of gas.

In addition, Taiwan is said to be planning a third regasification terminal in Guantang, starting from 2022. It also seems inevitable that Taiwan will need to increase more LNG supplies as it phases out nuclear power. Hong Kong also has revived plans to build an LNG terminal and to use LNG for the region's gas-fired power plants.

In China, the relaxation of import restrictions and investments in oil and gas and China's plan to reduce coal-fired power plants are increasing LNG demand. Most of these potential buyers are power plants, industrial users, and city gas companies, which are already consumers of LNG or regasified LNG. They represent creditworthy customers for LNG producers. China will see an increasingly diverse pool of LNG buyers as trading markets are created to provide supplies to smaller players, including medium-scale power plants and LNG refill stations.

For all these reasons Asian demand for LNG is likely to remain strong in the future. Players are likely to continue to enter into long-term contracts to support future demand and hedge against price risks.

Contracting trends

There are also potential changes in long-term contract provisions that date back to the 1960s, including oil-linked pricing, strict take or pay and scheduling obligations, and destination restrictions. LNG customers view the current market as a buyers' market, and are seeking to take advantage of their market power to challenge the existing long-term contract structure.

Take the pricing mechanism as an example. The recent drop in oil prices has weakened the argument that oil-price indexing is disadvantageous for customers. But Asian buyers may be reluctant to go back to JCC-only price indexation even with strong price review provisions in future contracts.

The emergence of Asian LNG trading hubs will create open spot markets with prices determined by supply and demand, similar to the oil trade. Once Asian LNG hubs are established, they will provide more options for index pricing, including hybrid indexation. It is very likely that the market for long-term LNG contracts will shift toward prices based on LNG/natural gas prices in one or more of the Asian LNG hubs.

Asian buyers will continue to seek more flexibility in destination and resale conditions in response to reduced demand, emergency situations, weather conditions or simply profit opportunities. Japan's Fair Trade Commission is investigating destination restrictions and its findings could be announced by early 2017.

If the commission finds these restrictions violate Japan's fair trade laws, that would lead to the renegotiation or ending of these restrictions in long-term contracts governing Japanese LNG imports. Other Asian LNG countries could follow suit, which could promote the development of Asian LNG hubs.

In addition, easing annual contracted supply requirements for short periods during the life of a long-term contract or within each contract year could be allowed in order to achieve greater flexibility in rescheduling to meet downstream and seasonal market requirements. Tighter security terms will also likely be introduced to address potential credit issues concerning smaller LNG buyers and sellers.

Despite the current slowdown of Asian LNG demand, Asia is likely to continue to drive the development of the global LNG market. Asian buyers will continue entering into long-term contracts to diversify and mitigate risks that cannot be addressed in spot trades, which include risks arising from natural disasters, political instability, and potentially tighter supplies due to a lack of investment resulting from low oil prices.

Vivien Yang is a partner with law firm Simmons & Simmons in Hong Kong.

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