Future is for LNG as derivatives trading takes off
Bloomberg/Singapore
With natural gas demand growing faster than for any other fossil fuel, LNG futures may be finally taking off.
Derivatives represented about 2% of global LNG production at the beginning of 2017 as an array of contracts around the world struggled to gain traction. But by the end of last year, volumes had grown to almost 23%, led by a burgeoning Intercontinental Exchange Inc contract based on S&P Global Platts’ Japan-Korea Marker spot price assessments.
While volumes are a long way off established global energy benchmarks such as Brent crude – where trade dwarfs worldwide oil production many times over – the accelerating growth in LNG derivatives illustrates how the market is maturing. An explosion in supply, from the US to Australia, is bringing more market participants and a shift away from traditional pricing.
“There’s more short-term physical trading indexed to JKM and new counterparties active in the market,” said Tobias Davis, head of LNG–Asia at brokerage Tullett Prebon. “This creates more liquidity and in turn, builds more confidence in trading the swap and using it as a viable hedging tool.”
There are now at least six derivative contracts for LNG, ranging from US Gulf Coast futures on ICE to Kuwait-India on Singapore Exchange Ltd. The most established by far is ICE’s Japan-Korea Marker, launched in 2012. More than 17,000 contracts traded in December, a 10-fold increase from January 2017. The next most active is CME Group Inc’s futures contract, also based on S&P Global Platts’ JKM assessment. Its monthly volume peaked in November last year at 3,335 contracts.
The need for a liquid LNG benchmark has been the subject of much debate. Traditionally, when oil was used more commonly in power generation and production, it was almost exclusively valued relative to crude oil and brought and sold under long- term contracts. One advantage of that system is that oil has a liquid and established futures market that gives market participants visibility and the confidence to hedge.
But oil and gas don’t move in lockstep and buyers have become increasingly reluctant to be tied to crude markets. The expansion in global supply, most notably with the development of shale reserves that transformed the US into a major natural gas exporter, has opened up other options and stimulated a shift to more spot trading.
About 27% of LNG was sold under spot-or short-term deals in 2017, up from 12% in 2003, according to the International Group of LNG Importers.
That just increased the need for a reliable price benchmark and liquid futures market for hedging. Regional gas benchmarks such as Louisiana’s Henry Hub, the UK’s National Balancing Point or Dutch Title Transfer Facility reflect local fundamentals and therefore may not be ideal proxies for the global LNG trade, where the vast majority of sales are in Asia. So that’s where LNG futures come in.
JKM “is much more trusted, much more accurate, and the paper market is helping make it be more responsive to price movements,” Gordon D Waters, the global head of LNG at ENGIE, said by phone on Friday. JKM contracts could reach the level of NBP or TTF “most likely within the next 5 years.” NBP and TTF volumes both averaged about 37,000 contracts a day in 2018.
There’s still a long way to go. ICE JKM is still much smaller than other global oil and gas benchmarks. Exchange open interest, or the amount of outstanding bets at the end of every day, accounted for about $2bn at the end of 2018, compared with $36bn for US natural gas and more than $100bn for Brent oil, according to Bloomberg estimates.
For a futures market to be considered truly liquid, volumes should be about 10 times the size of the actual physical trade, according to Total SA, one of the world’s biggest producers and a major participant in the JKM market. With volumes multiplying by about three times a year, JKM should reach that level in about five years, Philip Olivier, Total’s general manager of global LNG, said in October.
Brent and US gas traders also have much more flexibility, as they’re able to buy and sell futures by the second, with prices updating to reflect the fast-moving market. Most JKM LNG trades are still brokered offline and then cleared by exchanges. Contract values are based on a monthly average of Platts assessments, so the price updates once a day when the new assessment is added.
Still, LNG has already surpassed one energy derivative. ICE’s JKM contract now has more value in open interest than the exchange’s Newcastle coal contract. The two fuels, of course, also vie in the real world for space in power plants in some regions.
“If you have a look at how the coal market developed in the mid-2000s, it took over a decade to transition to a liquid exchange order book,” said Gordon Bennett, managing director for utility markets at ICE. “It definitely feels like JKM is evolving quicker.”
MILAN – About a decade ago, the Commission on Growth and Development (which I chaired) published a report that attempted to distill 20 years of research and experience in a wide range of countries into lessons for developing economies. Perhaps the most important lesson was that growth patterns that lack inclusiveness and fuel inequality generally fail.
The reason for this failure is not strictly economic. Those who are adversely affected by the means of development, together with those who lack sufficient opportunities to reap its benefits, become increasingly frustrated. This fuels social polarization, which can lead to political instability, gridlock, or short-sighted decision-making, with serious long-term consequences for economic performance.
There is no reason to believe that inclusiveness affects the sustainability of growth patterns only in developing countries, though the specific dynamics depend on a number of factors. For example, rising inequality is less likely to be politically and socially disruptive in a high-growth environment (think a 5-7% annual rate) than in a low- or no-growth environment, where the incomes and opportunities of a subset of the population are either stagnant or declining.
The latter dynamic is now playing out in France, with the “Yellow Vest” protests of the last month. The immediate cause of the protests was a new fuel tax. The added cost was not all that large (about $0.30 per gallon), but fuel prices in France were already among the highest in Europe (roughly $7 per gallon, including existing taxes).
Although such a tax might advance environmental objectives by bringing about a reduction in emissions, it raises international competitiveness issues. Moreover, as proposed, the tax (which has now been rescinded) was neither revenue-neutral nor intended to fund expenditures aimed at helping France’s struggling households, especially in rural areas and smaller cities.
In reality, the eruption of the Yellow Vest protests was less about the fuel tax than what its introduction represented: the government’s indifference to the plight of the middle class outside France’s largest urban centers. With job and income polarization having increased across all developed economies in recent decades, the unrest in France should serve as a wake-up call to others.
y most accounts, the adverse distributional features of growth patterns in developed economies began about 40 years ago, when labor’s share of national income began to decline. Later, developed economies’ labor-intensive manufacturing sectors began to face increased pressure from an increasingly competitive China and, more recently, automation.
For a time, growth and employment held up, obscuring the underlying job and income polarization. But when the 2008 global financial crisis erupted, growth collapsed, unemployment spiked, and banks that had been allowed to become too large to fail had to be bailed out to prevent a broader economic meltdown. This exposed far-reaching economic insecurity, while undermining trust and confidence in establishment leaders and institutions.
To be sure, France, like a number of other European countries, has its share of impediments to growth and employment, such as those rooted in the structure and regulation of labor markets. But any effort to address these issues must be coupled with measures that mitigate and eventually reverse the job and income polarization that has been fueling popular discontent and political instability.
So far, however, Europe has failed abysmally on this front – and paid a high price. In many countries, nationalist and anti-establishment political forces have gained ground. In the United Kingdom, widespread frustration with the status quo fueled the vote in 2016 to leave the EU, and similar sentiment is now undermining the French and German governments. In Italy, it contributed to the victory of a populist coalition government. At this point, it is difficult to discern viable solutions for deepening European integration, let alone the political leadership needed to implement them.
The situation is not much better in the United States. As in Europe, the gap between those in the middle and at the top of the income and wealth distribution – and between those in major cities and the rest – is growing rapidly. This contributed to voters’ rejection of establishment politicians, enabling the victory in 2016 of US President Donald Trump, who has since placed voter frustration in the service of enacting policies that may only exacerbate inequality.
In the longer term, persistent non-inclusive growth patterns can produce policy paralysis or swings from one relatively extreme policy agenda to another. Latin America, for example, has considerable experience with populist governments that pursue fiscally unsustainable agendas that favor distributional components over growth-enhancing investments. It also has considerable experience with subsequent abrupt shifts to extreme market-driven models that ignore the complementary roles that government and the private sector must play to sustain strong growth.
Greater political polarization has also resulted in an increasingly confrontational approach in international relations. This will hurt global growth by undermining the world’s ability to modify the rules governing trade, investment, and the movement of people and information. It will also hamper the world’s ability to address longer-term challenges like climate change and labor-market reform.
But to go back to the beginning, the main lessons from experience in developing and now developed economies are that sustainability in the broad sense and inclusiveness are inextricably linked. Moreover, large-scale failures of inclusion derail reforms and investments that sustain longer-term growth. And economic and social progress should be pursued effectively – not with a simple list of policies and reforms, but with a strategy and an agenda that involves careful sequencing and pacing of reforms and devotes more than passing attention to the distributional consequences.
The hard part of constructing inclusive growth strategies is not knowing where you want to end up so much as figuring out how to get there. And it ishard, which is why leadership and policymaking skill play a crucial role.