China's big appetite for liquified natural gas is a game-changer

China's big appetite for liquified natural gas is a game-changer
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China’s growing uncontracted liquefied natural gas (LNG) demand is set to transform the industry over the next few years, impacting global fundamentals and prices, China’s domestic gas sector and international LNG supply agreements.

In 2017, China became the largest contributor to global LNG consumption growth, surpassing South Korea as the world’s second-biggest LNG importer.

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The country’s LNG demand is expected to nearly double to 68 million metric tons per year (mt/year) by 2023 and to exceed that of Japan, the world’s biggest consumer, before 2030, according to S&P Global Platts Analytics.

 

China’s power sector coal-to-gas conversion policies, GDP expansion and industrial recovery are driving the country’s gas consumption to record highs. 

With domestic output and pipeline imports unable to keep up, LNG will be increasingly needed to bridge this gap, especially in the highly populated coastal regions, which are more distant from gas fields and import pipelines.

As China’s LNG contracted volumes grow at a slower pace than its demand projections over the next five years, with more than a quarter of its estimated 2023 demand still uncontracted, spot requirements will likely increase. 

Growing exposure to LNG spot markets

On the international stage, China’s growing reliance on spot purchases will give it an increasingly significant role in driving global LNG fundamentals and prices.

This means China’s ability to address its LNG capacity bottlenecks and logistical constraints at its northern winter peak demand centers will likely determine future seasonal volatility in global LNG prices.

Domestically, higher uncontracted imports mean greater influence for spot prices versus term contracts, and a more competitive downstream sector, as demand and the number of active spot market participants continue to grow.

More and more Chinese companies are entering the LNG market, drawn by growing domestic consumption and the opportunity to trade the arbitrage between spot LNG prices and regulated gas hub prices or oil-linked LNG contracts.

They include gas distribution companies and city gas companies such as ENN, Guanghui, Jovo and Beijing Gas Group, as well as power utilities like Huadian, Huaneng and Guangdong Development.

A slew of term contracts have also been signed by these independent players. In 2017, long-term contracts by non state-owned companies accounted for 0.5 million metric tons (mt), or 1.3 percent of contracted volumes into China. This will rise to 4.42 million mt, close to 10 percent of contracted LNG, in 2020.

Given state incumbents’ resistance to granting third-party access to existing terminals, some independent buyers are also building their own LNG import facilities, despite being hampered by high taxes and an onerous approval process.

As internal competition rises, pressure to turn domestic gas sector liberalization guidelines into policy and push for greater flexibility in international supply agreements will follow, with challenges and opportunities for all LNG stakeholders

Domestic policies and rigid LNG contracts under pressure

China’s growing gas demand will put state-owned companies under mounting pressure to free up terminal and pipeline infrastructure to more end-users as the government seeks to improve end-user cost efficiency and enhance supply security. China’s LNG terminal capacity utilization stood at 65 percent in 2017.

As the share of LNG in total Chinese gas supply increases, there will also be a political imperative to inject domestic pricing formulas that more closely reflect LNG market fundamentals.

This will inevitably impact the traditional supply model, based on long-term, take-or-pay contracts. There is an inherent risk in pricing long-term LNG against a different commodity, as it creates a disparity between expected delivered prices when the contracts are signed and market prices when deliveries begin.

The risk increases when the contracted LNG is delivered not into regulated monopolies, but increasingly competitive downstream markets with growing exposure to international spot fundamentals and prices.

This is accelerating the erosion of the traditional LNG supply model globally, in favor of deals that are shorter, smaller and more flexible, and priced not against an associated commodity but LNG itself.

Managing risk re-allocation

This transformation increasingly shifts the focus of risk from buyers to sellers. The question then becomes how to mitigate this new risk, and the answer lies, as in other commodities, in the development of greater transparency and a more robust financial architecture.

That is one that more closely reflects the increasingly pivotal role of spot markets, with robust pricing benchmarks strengthening the market’s hedging capabilities.

The LNG derivatives markets are experiencing exponential growth, driven by two key factors: demand for risk management solutions as the transition from the inflexible supply agreements of the past into a more versatile industry gathers pace, and support for the only liquid LNG financial instrument, the JKM Swap.

Exchanges cleared a record-high volume of 9,523 lots of the Platts JKM Swap contract in January, the equivalent of 1.83 million mt of LNG, smashing the previous record high of 6,720 lots in August 2017, according to exchange and broker data.

Abache Abreu is a senior editor for LNG News and Analysis for the Asia-Pacific and Middle East regions at S&P Global Platts.