Industry ignoring potential of bidirectional LNG flows

Jan. 28, 2008
With record levels of LNG traveling in opposite directions through the Suez Canal, the economic rationale for swapping cargoes is growing stronger.

With record levels of LNG traveling in opposite directions through the Suez Canal, the economic rationale for swapping cargoes is growing stronger. The concept is simple: Instead of two ships embarking from different sides of the world and passing each other to supply remote markets, the parties involved agree to supply the markets closest to them, saving time, fuel, and money.

Paradoxically, however, we are seeing robust growth in bidirectional trade between the Atlantic and Pacific basins. Swappable volumes increased to 3.4 million tonnes/year (tpy) in 2006 from 0.3 million tpy in 2005 and will exceed 6.0 million tpy in 2007. Growth is being driven by Asia’s thirst to soak up volumes to support buoyant gas demand and make up for shortfalls in supply from Indonesia and delays to new projects such as Sakhalin 2.

Business is booming but the new dynamic is exposing a major inefficiency in the LNG market—a reluctance to swap cargoes. What’s the commercial incentive for doing so? The answer is an average saving of up to $4 million/swap ($2 million/cargo); the equivalent of $240 million in 2006 and potentially more than $400 million in 2007 based upon Wood Mackenzie estimates.

Numerous factors are currently inhibiting the free trade of LNG cargoes and limiting the amount of swap deals taking place. But what stands out most notably is a lack of cooperation across the industry. Suppliers recognize that they could enhance their returns by taking advantage of high prices and cost savings through swaps, but contractual constraints, issues around execution, and a lack of transparency across the industry currently limits their ability to do so.

As the market evolves and moves towards an increased level of short-term and spot activity, the opportunity to find swap counterparties will increase. Strategic partnerships between key players will help to facilitate swap deals but formation of a forum, or an “LNG Swap Club” involving suppliers and buyers within each basin, would expedite the process and offer wider benefits to the industry. Over time this could potentially evolve into an independent exchange to enable buyers and sellers to submit bids and offer cargoes.

Development of an LNG Swap Club would improve the operational efficiency of the industry and offer mutual benefits to suppliers and buyers. Whether the concept takes off will depend on how the cooperative is set up and the appetite of the various players to be involved. Either way, the pressing question being asked by many is not if swaps will happen, but when?

Flows between basins

LNG flows have moved through the Suez Canal for more than a decade, but until 2005 they were primarily in one direction—westwards from the Middle East and Pacific supply projects to meet demand in the Atlantic Basin. With large growth in Middle Eastern supply and greater dependency on LNG across Europe and North America, the level of traffic heading west should increase greatly.

Recent years, however, have seen a rapid rise in LNG flowing in the opposite direction. The occasional trickle of spot cargoes heading east has been replaced by a steady stream of deliveries into the Pacific Basin because of strong demand and higher prices in the Asian market (Fig. 1).

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Growth in trade from the Atlantic to the Pacific has been staggering. Volumes increased to 3.4 million tpy in 2006 and are forecast to rise by 100% to reach 6.8 million tpy in 2007. As well as growing in size, the number of countries participating in the trade is also increasing. Egypt and Equatorial Guinea have joined Algeria, Nigeria, and Trinidad as key Atlantic basin suppliers. And China and India have joined Korea, Japan, and Taiwan as key buyers in the Pacific basin.

Swap potential

The increase in flows from the Atlantic to the Pacific set against the larger tide of flows in the opposite direction highlights one of the LNG market’s anomalies.

To the observer the emergence of bidirectional flows through the Suez is confusing and counterintuitive. Why are ships not being redirected to supply the markets in their own respective basins? Or put simply, why are ships going a “long way for a short-cut” when they could be going a ‘short way’ for a “large cut”? Surely it would be more prudent to share the savings from the reduced transport costs and thereby improve the profitability of each respective trade.

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To look at the transbasin trade dynamics in more detail we have used 2006 as a case study (accompanying table). The flows on Fig. 2 clearly illustrate how swaps drastically reduce transit distances. While most of the eastbound cargoes transit the Suez Canal, some go via the Cape of Good Hope (46 and 14 assumed, respectively, in 2006). With the average toll for a return journey through the Suez amounting to $0.5 million, savings through swaps in canal fees alone would exceed $50 million.

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As well as these cost savings, avoidance of the Suez Canal would reduce journey times, fuel consumption, and the risk of disruption by technical, operational, and geopolitical factors. The shortening of the supply chain would also improve the productivity of LNG assets and enable suppliers to respond more quickly and profitably to market opportunities. A more timely delivery cycle also reduces working capital and insurance expenses.

Based upon our analysis the savings are considerable. To put this into context, around 120 cargoes could have been swapped in 2006. Doing so would have saved more than 700,000 nautical miles, 1,900 days or 5 years’ sailing time, 260,000 tonnes of fuel-oil equivalent, and around $240 million in costs (about $4 million/swap, $2 million/cargo).

Environmental considerations provide a further impetus to swap. The reduced fuel oil and boiloff consumption would have reduced the industry’s carbon footprint by 900,000 tonnes. Shipping is not currently subject to any international carbon regulations, but an equivalent reduction in the industrial sector in Europe would have generated carbon-cost savings of around $22 million, assuming a European Union emission trading scheme price of €20/tonne.

Potential savings for 2007 would be even greater. Using 2006 as a basis and applying growth in trade on a pro-rata basis would generate savings of more than $400 million for 2007. While the savings from canal fees, reduced fuel consumption, and other operating costs are valid, however, it is questionable whether the capital element of the savings would be redeployable. This will depend on the flexibility and schedule constraints of the shipowner or charterer.

Excluding the capital element of the shipping costs would reduce the potential savings during 2006 by about a third. Care should also be taken in considering the timeframe for the swaps. We have used 2006 as a single annual increment to assess the swap potential. In reality, closer scrutiny would be required of the figures on a monthly or weekly basis. (For more detail, see the discussion of shipping assumptions above.)

The transbasin trade dynamic highlights a wider issue across the global gas industry: a reluctance to swap cargoes. Consider the potential savings from transatlantic swaps and a scenario in which global LNG flows are optimized by geographical proximity and the savings would amount to billions. Factor in LNG for piped gas swaps potential and the figure would be even greater.

Regional gas markets, once virtually separate from each other, are now becoming increasingly interconnected, and with that trend a new global dynamic is evolving. This subject warrants a thesis in itself and can be explored in more detail with Wood Mackenzie’s Global Gas Model.

Why not more common?

If the concept of swapping is simple and the returns attractive, why are cargoes rarely being swapped? Numerous factors are currently inhibiting the free trade of LNG cargoes and limiting the amount of swap deals taking place, including:

LNG specification. Several sources—Libya, Nigeria, and Oman, for examples—currently produce LNG with a heat content too rich to be accepted by certain markets. Some import terminals can accept rich LNG because the downstream market can accommodate gas with a high calorific value or because those terminals have blending to reduce the calorific value of the gas.

Ship, port compatibility. Incompatibility at the ship-shore interface has traditionally been an impediment to the redirection of cargoes. Most fleets were designed for specific terminals. An increasing number of ships, however, are being built or modified for flexible trading.

Technological innovation in cargo-handling equipment and jetty infrastructure is also leading to new and upgraded terminal facilities being more adaptable to ships of various sizes and designs. Storage capacity would be the main limiting factor for ships larger than 200,000 cu m participating in swaps, although terminal owners are beginning to realize advantages of being able to accommodate this size.

Ships older than 20 years may also constitute an impediment to swapping of cargoes. Provided the ships have gained sufficient Condition Assessment Programme (CAP) and Class Survey approvals, however, and absent of any technical incompatibility, operators and terminals are unlikely to reject a ship for spot-cargo movements.

Security of supply. Traditionally a large proportion of LNG supply has been traded under inflexible long-term contracts to underwrite the significant capital investment along the LNG value chain and assure buyers that they can meet the demands of their own customer bases. Many of the established buyers have been reluctant to participate in swaps due to the perceived risk and threat to security of supply.

Contractual constraints. Destination flexibility is becoming more common, particularly for volumes in the Atlantic Basin, but the structure of the more traditional contracts currently impedes the redirection of LNG to other markets. Many include clauses that prohibit the purchaser from redirecting or reselling LNG cargoes into alternative markets or restrict the use of facilities (e.g., project-dedicated ships) for alternative purposes. While some purchasers have successfully redirected cargoes, the clauses have undoubtedly curtailed some redirections.

The lack of a standardized contract for swap transactions also acts as a hindrance. Efforts by the Association of International Petroleum Negotiators (AIPN) to develop a standardized LNG sales and purchase agreement (SPA) for spot transactions have met mixed responses. The style and liabilities are in keeping with a traditional SPA, but the agreement is very different from what traders would use for buying and selling spot cargoes.

Profit split, shipping savings split. Determining how profits will be split is often a thorny issue. Everybody involved will naturally seek a share of profits and other benefits. Profit splits are used to describe the difference between the price and the cost to get it to market, divided by the number of parties involved.

The benefits associated with swapping cargos, however, are due to shipping-cost savings. Therefore, a more appropriate term to use would be shipping savings split (SSS). Swapping out two cargoes across the Suez might generate savings of $4 million.

The windfall looks attractive, but trying to get consensus on how it should be distributed is where the transaction becomes difficult. Who gets what will depend on several factors, including the number of parties involved and their respective roles and influence as a buyer or seller; contract terms (e.g., FOB/DES delivery point); and whether the swap is for a spot cargo or long-term contracted volume.

Timeliness issues. The short-term nature of swap deals, as opposed to long-term contracts, naturally places a premium upon an expeditious negotiating process. The logistics involved, however, tend to be complex.

Swaps tend to involve several parties located in different parts of the world, creating communication obstacles. While the logistics of rescheduling and provisioning ships and ensuring terminal accessibility frequently complicate matters.

Quantifying and agreeing upon the allocation of costs and rewards of the swap deals are usually time-consuming and often difficult. Formulation of a series of standardized pro-forma agreements covering various scenarios and benchmark measures would go some way towards helping to address this issue.

Operational control, risk. The long-term contractual nature of the LNG industry has nurtured a risk-averse culture and a desire for operational control. It has also given incumbents a strategic advantage and made it difficult for new players to enter the industry, although this in itself should not impede swaps.

Some suppliers have been reluctant to swap cargoes because they consider the operational risk too great and do not want to jeopardize their reputations as reliable exporters. If a cargo were swapped for another and something untoward happened, for instance, who would be liable for the ship, its contents, and any potential damage to the port facilities? Would relationships be undermined and what would be the impact on future delivery schedules?

Swapping cargoes also raises a dilemma for longer-term shipping capacity planning. Should companies contract shipping for their base commitments or for assumed swaps? Some players could find themselves in a position with insufficient capacity to deliver cargoes to their original counterparties if swap opportunities fail to materialize, a situation potentially remedied by procuring short-term capacity.

Desire for opacity. While producers may be able to achieve cost reductions by using swaps, these savings may be outweighed by the additional revenues that they can realize through continued opacity around the commercial arrangements for LNG supply. Pricing arrangements for LNG trades, particularly spot cargoes, tend to be quite opaque and producers may worry that by engaging in swaps, they will have to reveal the terms of their arrangements to counter parties who might then arbitrage away some of their profits or somehow release this information into the market.

These constraints represent significant barriers in the short to medium term, but their significance is likely to diminish as the market evolves. Closer inspection of the bidirectional flows through the Suez suggests that some factors are more prevalent than others.

Most of the 5.3 million tpy flowing westwards through the Suez during 2006 was delivered into Spain under long-term agreements from Qatar and Oman. Consequently it is improbable that technical issues associated with LNG specification and ship-port compatibility hindered trade as the Pacific buyers already import significant volumes from the Middle East, and Spain has received regular deliveries from Atlantic suppliers in the past.

Other factors have played a part, but contractual constraints and operational control and risk factors appear to be the main barriers inhibiting potential swap trades. The contracted position (3 million tpy) of Spain’s Gas Natural with Qatar illustrates this point.

Given its track record of diverting Trinidadian volumes between Europe and the US, the Spanish utility is not averse to trading out volumes to take advantage of arbitrage opportunities, but few of the Qatari cargoes are being switched for volumes in the Pacific. This may be due to strict destination clauses imposed by the Qataris or to commercial terms associated with the financing of the supply project that prohibit swaps from taking place.

As the primary source of the trans-Suez trade, Qatar stands to gain the most value by swapping volumes between the two basins. It is not doing so at present likely because of difficulties in negotiating swaps with equivalent counter parties in the Atlantic basin and some of the issues mentioned previously.

Arranging SSSs with Gas Natural may not be as lucrative as it could be in projects in which Qatar Petroleum has an integrated position along the value chain, for example, in Qatargas 2 where fewer parties would be involved in any SSS in the event of a swap. QP may in fact be biding its time and waiting until Qatargas 2 starts up before it takes advantage of the arbitrage opportunities between the two basins.

Competition, cooperation?

While it makes logistical sense to swap out volumes across the Suez, the major factor inhibiting it is the clash of two opposing forces—competition and cooperation.

Suppliers are competing with each other to get the highest price and best value for their cargoes. Similarly buyers are competing with one another to attract cargoes to their respective markets. Currently the margins generated from higher prices in Asia are far greater than the cost reductions from swaps. Hence, the reason for bidirectional flows between the two basins. But ultimately the most prudent strategy would be to take advantage of high prices and cost reductions via potential swaps.

How could this additional value be realized? In essence by removing the difficulties associated with executing swap deals and by improving cooperation across the industry. This could be initiated by a roundtable forum involving suppliers and buyers within each basin to discuss the issues in a more open format.

LNG Swap Club

The forum could be used to facilitate trade and create an LNG Swap Club. Over time the forum could become more sophisticated and potentially evolve into an independent exchange to enable buyers and sellers to submit bids and offer available cargoes. As well as facilitating swaps, the forum could be used to share information on ships’ delivery schedules, identify obvious commercial opportunities, and improve the overall efficiency of the industry.

Setting up an exchange, however, is likely to be easier said than done. While openness would be appreciated by many, the lack of transparency in the current market benefits others. Suppliers may be reluctant to reveal the terms of their arrangements and share information with counter parties due to commercially sensitive contractual obligations and concerns.

Although these have traditionally been barriers, there are signs that things are starting to change. For example, there has already been a noticeable improvement in the amount of information more openly available over recent years and with new technologies evolving it is becoming easier to track cargo movements across the industry.

The author

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John Meagher (john.meagher has worked for Wood Mackenzie for more than 7 years and is an experienced member of the energy research team. He has primarily focused on LNG and currently manages Wood Mackenzie’s Global LNG services. Before working on LNG, John was involved in analyzing energy markets across Europe, Latin America, and North America. Before joining Wood Mackenzie, John worked as a process engineer with Kvaerner on various international infrastructure projects in both a technical and commercial capacity. He holds a BEng (honors) in chemical engineering from the University of Edinburgh.

Shipping assumptions

In reality, several to additional factors would need to be considered accurately to assess the opportunity value in swapping out cargoes between the Atlantic and Pacific basins. For the purposes of this analysis, we have made a number of simplifying assumptions to show a general directional trend and an estimate of the potential benefit in swapping out cargoes.

These include:

  • Shipping journeys for each cargo are based on return journeys from and to the supply project.
  • Trade benefits based on a simple annual calculation. Different figures would be generated for swaps on a monthly resolution.
  • The maximum swappable volume is based on the lower of the two flows between the two basins. The trade from the Atlantic to the Pacific is the smaller of the two. This figure amounted to 3.4 million tpy (7. 8 million cu m) LNG in 2006.
  • An equivalent number of journeys is undertaken, i.e., the estimated 60 Atlantic to Pacific basin shipments during 2006 are swapped for 60 Atlantic to Atlantic journeys. Similarly an equivalent of 60 Pacific to Atlantic journeys are swapped out for 60 Pacific to Pacific Basin journeys.
  • Shipping costs are based on a 145,000-cu m vessel size.

Although swaps can generate substantial savings in transport costs, a full appreciation of the extent of benefits would require consideration of what value the freed-up shipping capacity constitutes.

Today’s LNG shipping market is characterized by surplus capacity, and therefore the improved productivity of ships as a result of swap activity is unlikely to result in significant opportunity value. Indeed, capacity idleness may increase; in that case the associated costs incurred by the ship operators should be offset somewhat against the value derived from the swaps.

On the other hand, the surplus of shipping capacity has undoubtedly been a key factor in generating increased trade and long-haul movement of spot cargoes. If and when this spare capacity dissipates, the increased efficiencies of swaps should become even more pertinent.