The conditions necessary for the emergence of an LNG price hub in Russia

Shprygov Yurii 199034, Russia, Leningradskaya oblast', g. Saint Petersburg, nab. Universitetskaya, 7/9 yury.shprygov@gmail.com

The conditions necessary for the emergence of an LNG price hub in Russia

This article discusses the challenges and prospects regarding the creation of a price hub in Russia for the sale of liquefied natural gas (hereinafter – LNG). The first part of the work is devoted to assessing the role of hubs in the global gas market. For this purpose, the current pricing, the practice of pricing contracts for the sale of LNG, including the use of price quotations of the corresponding gas hubs in formula pricing, is presented. The experience of creating price gas hubs in Europe and the USA, their formation and current position in the global gas market are also considered. In the final part of the article, an analysis of possible challenges in the framework of the creation of an LNG price hub in Russia is carried out, and an initiative is proposed to create an independent electronic auction platform or use the current resources of the St. Petersburg International Commodity Exchange for LNG trading.

Current trends in LNG pricing, classification and types of hubs

The international LNG market continues to be one of the most rapidly developing segments of the natural gas trade. According to the BP(British Petroleum) statistical bulletin, global LNG exports in 2016 amounted to 356.7 billion cubic meters. However, in 2017, this figure increased to 393.4 billion cubic meters^[1]. The positive dynamics (about 12%) was primarily due to increased demand in the Asian market, as well as the commissioning of new facilities in the USA and Australia^[2].

Taking into account the current trend towards the consumption of environmentally friendly fuels, buyers demonstrate a high demand for natural gas, which stimulates the development of the global LNG market. In 2017, LNG imports in the regional context had the following structure: Asia – 283.5 billion cubic meters, Europe – 65.7 billion cubic meters, South and Central America – 13.8 billion cubic meters, the Middle East – 13 billion cubic meters, North America – 9.2 billion cubic meters, Africa – 8.2 billion cubic meters^[3]. In turn, the main consumers of the Asian market were: Japan – 113.9 billion cubic meters, China – 52.6 billion cubic meters, South Korea – 51.3 billion cubic meters^[4].

Within the framework of existing LNG trading practices, the interaction of counterparties takes place on an over-the-counter and exchange basis. The over–the-counter basis means the conclusion of a direct contract between a supplier and a consumer, while the exchange basis means auction trading within the gas hub.

On the one hand, when concluding contracts for the supply of LNG outside of auctions, the parties conduct negotiations in which mutually acceptable conditions such as price, period and volume of supply are reached. On the other hand, auction trading within the gas hub is based on unified purchase and sale contracts - futures, the pricing of which depends on supply and demand at a particular hub.

Turning to the issues of modern pricing of LNG supply contracts and the identification of the role of price hubs in the world, we turn to the work of A.A. Konoplyanik and J. A song that offers the following vision:

Fig. 1. A.A. Konoplyanik, J. Sun, Is there a chance for American LNG?//Russian oil. 2016. No.5-6. pp. 11-19.

From this table, we can see that the pricing of the European and Asian (APR – Asia-Pacific region) markets differs by the basis of the defining hub. However, price formation in both variants is hybrid – it combines linking to petroleum products and price indices at gas hubs.

However, there is an opinion that the formation of price quotations at the hub is not self-sufficient, since it depends on the prices of long-term contracts linked to the prices of petroleum products. When comparing the trend line of Brent or BAFA oil with the quotes of the most liquid TTF and NBP hubs, we observe a corresponding correlation: when oil prices rise, spot LNG prices rise, when they fall, they decrease^{[5] [6]}. Thus, it can be concluded that the volatility of spot prices at gas hubs has a direct correlation with oil prices^[7].

One of the reasons for this phenomenon is the fact that oil and gas are considered substitutes. The formula pricing of contracts in this approach implies the alternative use of natural gas instead of petroleum products. However, in 2009, when the price per barrel of oil reached $ 100, there was a sharp transition to price formation linked to the indices of gas hubs. The price level of gas purchased under long-term contracts has become uncompetitive in relation to the price indices of gas hubs. In addition, one of the reasons was the increase in the volume of LNG supplies from the United States, the pricing of which is tied to the North American Henry Hub. As a result, European gas suppliers (Gasterra and Statoil) agreed to change the formula pricing in accordance with the price quotes at gas hubs^[8].

Leading information and analytical agencies offer their indexes, based mostly on the price of hubs - Platts JKM^[9], Argus ANEA^[10], SGX LNG Index Group^[11] and JCC^[12].

In our opinion, a gas hub is a virtual or physical trading platform where ownership of natural gas is transferred between interested parties. In one of his works, P. Heather points out that most European hubs, except for the most developed ones (TTF and NBP), are balancing^{[13] [14]}. This implies an electronic trading platform where market participants (suppliers, gas transmission operators) have the opportunity to purchase or sell gas in order to balance the volumes of distributed gas and fulfill contractual obligations^[15].

At the same time, the International Energy Agency (IEA) labels all European hubs as trading or trading hubs, regardless of their liquidity and market maturity^[16]. The European Federation of Energy Traders adheres to a similar classification^[17]. A trading hub should be understood as a platform where it is possible to conclude futures contracts for the supply of natural gas in order to optimize the contract portfolio and hedge the risks of price volatility. In fact, only hubs with a high level of liquidity can be called trading hubs^[18].

TTF, NBP and Henry Hub hubs have turned from trading platforms into benchmark hubs, whose price quotes are currently used in formula pricing on other platforms. These hubs are the most liquid and transparent, as well as accessible to a wide range of participants.

Having considered the various types of hubs, let's take a closer look at the price-forming hubs of Europe (TTF, NBP) and the USA (Henry Hub). These hubs are considered to be key due to the largest number of concluded LNG supply deals.

Table 1. Trading volumes at NBP and TTF hubs in 2018.

The exact trading volumes on Henry Hub in 2018 are unknown, but on November 13, 2018, about 1.2 million futures contracts were concluded (the average volume of supply under a futures contract is about 260 thousand cubic meters^[21]). Thus, on this day, the trading volume amounted to 320 billion cubic meters or 231 million tons of LNG.

When determining the liquidity level of the hub, it is worth referring to the churn ratio indicator. Doctor of Economics, Professor A.A. Konoplyanik describes it as follows: "... it is characteristic of stock trading and reflects the ratio between the volume of contracts concluded (open positions) and the cost of physical volumes of goods delivered on them from this trading platform. Therefore, its "point" values can fluctuate in a very significant range. It is generally accepted that liquid markets start with a weighted average churn ratio of 15 and above"^[22]. At the same time, there is another definition of this indicator. For example, a senior researcher at the Oxford Institute for Energy Research (OIES), P. Heather, interprets it as the number of trade transactions before the physical supply of gas to the buyer^[23]. For example, in accordance with the requirements of Gazprom PJSC, the liquidity level of the hub at the churn ratio level should be at least 15^[24].

The NBP and TTF gas hubs under consideration have a churn ratio of over 20, Henry Hub – 400^[25].

To understand the conditions of the emergence and formation of these gas hubs, it is necessary to elaborate on each of them in more detail.

TTF (Title Transfer Facility) is a virtual gas hub in the Netherlands, operated by gas transportation operator Gasunie Transport Services^[26]. The auction is organized by the exchange and clearing company Intercontinental Exchange and takes place on its electronic platform^[27]. This hub was founded in 2003. According to researcher and Professor K. Shi, the TTF gas hub is the only benchmark in continental Europe, whereas the formation of quotations at other hubs is actually based on the spread from TTF^[28]. Until 2009, TTF had a slow pace of development and establishment in the gas market. However, in 2009, the gas transportation operator standardized the trade in natural gas, unifying such a qualitative indicator of gas as caloric content. Then Gasunie Transport Services carried out the process of balancing gas transmission networks^[29]. In addition, natural gas suppliers, including GasTerra, Shell and Exxon, have become participants in TTF trading. The regulator controlling the activities of the trading hub is ACM^[30].

The liberalization of the British gas market in 1996 led to the creation of the National Balancing Point (NBP) trading hub. NBP is a virtual trading platform operated by the National Grid energy company. Auction trading is organized on the electronic platform of the exchange and clearing company Intercontinental Exchange^[31]. Prices at the NBP trading hub were regulated solely by supply and demand. However, with the commissioning of the Interconnector (IUK) gas pipeline in 1998, which connected the UK and European gas transmission networks, European gas contracts with a price link to oil began to influence pricing in the UK^[32]. The regulator controlling the activities of the trading hub is GEMA^[33].

One of the main conditions for the development of these gas hubs was the expanded process of liberalizing the gas market. Such initiatives primarily contribute to the creation of a competitive environment, in the absence of which significant barriers to the development of the gas industry arise. Thus, according to K. Shi, gas hubs in Italy and France have not been adequately developed due to the lack of an appropriate level of liberalization of national markets^[34].

The process of liberalizing the gas industry is multifaceted and is aimed at providing conditions for access to infrastructure through the creation of a market for gas transportation capacities, the separation of vertically integrated companies in relation to the transportation and trade of commercial gas, the expansion and unification of gas transportation networks of European countries, the creation of independent national regulators and the implementation of relevant legislation that forms the norms and rules of the gas market^[35].

Henry Hub is a North American gas hub located in Louisiana. The owner of this hub is the gas transportation operator SABINE PIPE LINE LLC. Henry Hub-linked natural gas futures are traded on the New York Mercantile Exchange, as well as on the European ICE Exchange (Intercontinental Exchange). The hub was founded in the 50s of the twentieth century. P. Heather describes Henry Hub as follows: "In general, the American gas market has a rather complex structure: there are a total of 33 hubs, and traders have to "move" gas between hubs, sometimes through 5 or 6 or 8 hubs to deliver gas from the point of delivery to the end user"^[36]. In addition, P. Heather points out the following facts about the formation and structure of the hub: "... in 1978, there was a weakening of strict price control, in 1985 — the abandonment of the system of price regulation at the wellhead and pricing at an intermediate stage; in addition, all suppliers were provided with third–party access conditions (TPA - Third Party Access)"^[37]. Big changes occurred in 1990 with the advent of gas futures contracts on the NYMEX platform, using Henry Hub quotes as a marker for price formation." The regulator controlling trading activities is FERC^[38]

In addition, it is worth noting the work of researchers K.Miriello and M. Polo, which considers the following way of becoming a gas hub: the development of trade to balance the contract portfolio, the use of a gas hub as an alternative supply channel in comparison with long-term contracts, the creation of financial trading instruments to hedge risks^[39]. In addition, in their opinion, the key determinants of the successful development of the gas market are: liberalized wholesale trade, separation of vertically integrated companies, open and transparent access of third parties to gas transmission networks, implementation of network codes aimed at the development of competition and the policy of state non-interference.

Thus, the formation of a price hub for natural gas can be achieved under the following conditions:

Table No.2. Conditions for the formation of a price gas hub based on the experience of European and North American hubs.

Creation of a gas hub in Russia: challenges and prospects

Currently, there are several LNG projects in Russia: Yamal LNG, Cryogaz-Vysotsk and Sakhalin-2. The total production capacity is estimated at 27.6 million tons of LNG per year^{[40] [41] [42]}.

These production facilities allow Russia to become one of the world's leading LNG exporters. Given this fact, it seems advisable to consider the possibility of creating an LNG price hub in Russia, which allows gas companies to expect an increase in the marginality of LNG sales on a spot basis.

More than half of the global LNG volume is sold in the premium Asian market. Below is information regarding the cost of gas on world markets in 2017.

Figure 1. Statistical review of world energy. https://www.bp.com/content/dam/bp/business-sites/en/global/corporate/pdfs/energy-economics/statistical-review/bp-stats-review-2018-full-report.pdf

Taking into account the presented data, as well as taking into account the favorable geographical location of Russia, which allows optimizing supply logistics, it becomes obvious that the Asian region can become a new market for the sale of Russian LNG. So, below is a table indicating the average cost of a vessel's freight for LNG transportation in the amount of 180 thousand cubic meters. m with delivery to Asian ports (South Korea/China)^[43]:

Table 3. Cost of sea transportation to South Korean markets/China.

The presented table allows us to assess the advantage of logistics in the supply of Russian LNG from the Far Eastern region to the Asian market.

Thus, in order to use a short logistical leverage and, accordingly, optimize transport costs, it is necessary to create an appropriate infrastructure in the Far East, which should also include transshipment terminals and LNG storage tanks. In addition, this project will require the creation of an electronic platform for organizing auctions.

Nevertheless, when creating a physical and price hub in the Far East, it will be necessary to overcome possible challenges:

Table 4. Challenges in the implementation of a gas hub in the Far East.

In order to ensure the operation of the gas hub at a preliminary stage, it seems necessary to create an electronic platform with open access by third parties in relation to the LNG auction trade. The implementation of such an initiative can be carried out in accordance with the following action plan:

Table 5. Implementation of an electronic trading platform as part of the creation of a physical hub in the Far East.

None of the existing electronic trading platforms in Russia – SPbMTSB and ETP Gazprom Export LLC - takes into account the specifics of maritime logistics. In this regard, it is important to develop an electronic platform taking into account various supply bases, as well as to involve international information and analytical agencies to popularize it.

In conclusion, we will consider a possible pricing model for the sale of LNG on a spot basis.

According to C.Steuer, the cost of LNG production in Russian projects is as follows:

Table 6. Cost of LNG production in Russian projects, EUROMATCH

We use the Henry Hub Month Ahead gas futures (May 2019) for modeling and assume that the price level of suppliers corresponds to the level of the hub quotes without taking into account the premium. The price of the Henry Hub May 2019 futures is about 8 Euros/MWh ($2.65 per million BTE). The costs of liquefaction and logistics account for an additional 15%^[49].

Table 7. Cost of delivery from Henry Hub to South Korean markets/China, Euro/MWh

The estimated cost of supplying Russian LNG (Arctic projects), taking into account logistical costs, including transshipment at the Far East terminal:

Table 8. Cost of delivery from Arctic LNG projects from Russia through the Far East to South Korean markets/China, incl. cost of production and logistics, Euro/MWh

Thus, in May 2019, the price difference for North American and Russian LNG could be about 1.45 Euros/MWh. However, taking into account the short logistical leverage for LNG supplies from Russia, a premium to Henry Hub is acceptable, its determination is possible through auctions.

Conclusions

NBP, TTF and Henry Hub hubs have firmly established their position in relation to formula pricing under LNG supply contracts. The following factors influenced the emergence and development of gas hubs: liberalization of the gas industry, favorable geographical location, developed gas transportation infrastructure, open auction trade, involvement of information and analytical agencies, trust of bidders.

In Russia, the creation of a physical LNG hub, combined with a virtual auction platform, will expand export channels for the sale of Russian LNG. However, in order to implement such a project, it is necessary to overcome possible challenges: insufficient resource of illegally contracted LNG for sale on a spot basis, the absence of a wide range of bidders, the monopoly position of Gazprom PJSC, the lack of state regulation in the field of LNG trade, the risks of fines in case of violation of delivery conditions. Separately, it is worth noting the possibility of changing the institutional environment in Russia.

The primary stage in the development of the hub will be the establishment of an electronic trading platform as a project of national interest within the framework of the development of Russian LNG export channels and the integration of new Russian players into the global gas industry.

^[1]Statistical review of world energy. https://www.bp.com/content/dam/bp/business-sites/en/global/corporate/pdfs/energy-economics/statistical-review/bp-stats-review-2018-full-report.pdf

^[2]2018 World LNG Report. 27th World Gas Conference Edition. https://www.igu.org/sites/default/files/node-document-field_file/IGU_LNG_2018_0.pdf

^[3] Statistical review of world energy. https://www.bp.com/content/dam/bp/business-sites/en/global/corporate/pdfs/energy-economics/statistical-review/bp-stats-review-2018-full-report.pdf

^[4] In the same place

^[5] Buyers are unable and sellers are unwilling. http://www.gazprom.com/press/news/reports/2014/european-market-at-a-crossroads/

^[6] In the same place

^[7] In the same place

^[8]Stern, J. and Rogers, H. (2011), The Transition to Hub-Based Gas Pricing in Continental Europe’,

NG49, OIES, http://www.oxfordenergy.org/wpcms/wp-content/uploads/2011/03/NG49.pdf

^[9]This is the benchmark index score for spot LNG supplies. Reflects the cost of spot shipments based on DES for Japan, South Korea, China and Taiwan. https://www.spglobal.com/platts/en/our-methodology/price-assessments/natural-gas/jkmt-japan-korea-marker-gas-price-assessments

^[10] The ANEA index is used as a benchmark in the global liquefied natural gas spot market and reflects trading activity in regional markets. ANEA is a series of forward swap quotes in Northeast Asia published in Argus LNG Daily. ANEA's spot quotations of physical volumes reflect the cost of LNG shipments delivered on a free-on-board (DES) basis to ports in Japan, South Korea and Taiwan with a delivery period of 6-12 weeks. https://www.argusmedia.com/ru/methodology/key-prices/anea-lng

^[11]An index developed jointly with the Singapore Stock Exchange and the Energy Market Company. There are separate indexes Singapore Sling, North Asia Sling, DKI Sling. https://www.emcsg.com/sling

^[12] JCC (Japan Crude Cocktail) is the arithmetic mean of all imports of crude oil to Japan cleared of customs duties. It is widely used in pricing for LNG supplies to Japan, Korea and Taiwan. Information on the value is published monthly by the Japanese Government.

^[13]P. Heather. The evolution of European traded gas hubs. OIES, Oxford (2015)

^[14]p. Heather. The development of gas hubs and their role in the formation of benchmarks for physical contracts for the supply of natural gas. Skolkovo. July 2017

^[15]Xunpeng Shi, Hari M.P. Variam. Key elements for functioning gas hubs: A case study of East Asia. Natural gas industry B. Volume 5, Issue 2, March 2018, Pages 167-176

^[16]IEA.Developing a natural gas trading hub in Asia: obstacles and opportunities. International Energy Agency, Paris. 2013

^[17] Gas hub scorecard 2018 update. https://efet.org/Files/Documents/EFET_GasHubs2018_EAGC.pdf

^[18] Gas hub scorecard 2018 update. https://efet.org/Files/Documents/EFET_GasHubs2018_EAGC.pdf

^[19]https://www.icis.com/explore/resources/news/2019/01/02/10301180/european-brokered-gas-trade-jumps-by-more-than-25-in-2018/

^[20]In the same place

^[21] CME Group Announces Henry Hub Natural Gas Futures All-Time Daily Volume Record, Surpassing 1.2 Million Contracts. https://www.prnewswire.com/news-releases/cme-group-announces-henry-hub-natural-gas-futures-all-time-daily-volume-record-surpassing-1-2-million-contracts-300750523.html.

^[22]The evolution of the pricing system in the global energy market: economic consequences for Russia / edited by O.I. Malikova, E.S. Orlova. - M:Faculty of Economics, Lomonosov Moscow State University, 2017. - 432 p.

^[23]P. Heather. The evolution and functioning of the traded gas market in Britain. OIES working paper NG 44, OIES< August 2010.

^[24]The evolution of European traded gas hubs. https://ora.ox.ac.uk/objects/uuid:3f7dfc77-85d0-400b-8d66-60c67ac39af3

^[25]Evolving Natural Gas Paradigms – Risks and Opportunities for Industry Participants. http://gaffney-cline-focus.com/evolving-natural-gas-paradigms-risks-and-opportunities-for-industry-partici

^[26]https://www.gasunietransportservices.nl/en/about-gts/publications

^[27]https://www.theice.com/products/27996665/Dutch-TTF-Gas-Futures

^[28]Xunpeng Shi. Development of Europe's gas hubs^ Implications for East Asia . Natural Gas Industry B. https://proxy.library.spbu.ru:2068/science/article/pii/S2352854016300766

^[29]L. Dickx, C. Miriello, M. Polo Balancing systems and flexibility tools In European gas markets. IEFE Centre for Research on Energy and Environmental Economics and Policy, Bocconi University, Milano(2014)

^[30]Authority for Consumers and Markets. https://www.acm.nl/en

^[31]https://www.theice.com/index

^[32]The dynamics of a liberalized European gas market: Key determinants of hub prices, and roles and risks of major players. https://www.oxfordenergy.org/wpcms/wp-content/uploads/2014/12/NG-94.pdf

^[33] Office of Gas and Electricity Markets. https://www.ofgem.gov.uk/

^[34] A. Neumann, B. Siliverstovs, C. von Hirschhausen Convergence of European spot market prices for natural gas? A real-time analysis of market integration using the Kalman filter Appl Econ Lett, 13 (2006), pp. 727-732

^[35] Melnikova S.I., Geller E.I., Mitrova T.A., Kulagin V.A. / THE EU GAS MARKET: the epoch

reform// INEI RAS-HSE, Moscow, 2016

^[36]p. Heather. The development of gas hubs and their role in the formation of benchmarks for physical contracts for the supply of natural gas. Skolkovo. July 2017

^[37] Ibid.

^[38] Federal Energy Regulatory Commission. https://www.ferc.gov/

^[39]. Dickx, C. Miriello, M. Polo Balancing systems and flexibility tools In European gas markets. IEFE Centre for Research on Energy and Environmental Economics and Policy, Bocconi University, Milano(2014)

^[40] Sakhalin – 2. Gazprom PJSC. http://www.gazprom.ru/projects/sakhalin2/

^[41] Cryogaz-Vysotsk has started serial shipments of LNG. PJSC Novatek. http://www.novatek.ru/ru/press/releases/index.php?id_4=3171

^[42] Yamal LNG is an integrated project for the extraction, liquefaction and sale of gas. http://www.novatek.ru/ru/business/yamal-lng/

^[43]LNG vessel 180 thousand cubic meters, freight 72 thousand dollars per day, speed - 17 knots.

Outlook for competitive LNG supply. March 2019. https://www.oxfordenergy.org/wpcms/wpcontent/uploads/2019/03/Outlook-for-Competitive-LNG-Supply-NG-142.pdf

^[44] Problems and prospects of LNG projects in Russia. https://www.pwc.ru/ru/oil-and-gas/assets/challenges-and-outlook-for-lng-projects-rus.pdf

^[45] Cryogas-Vysotsky will end Lithuanian "Independence" https://1prime.ru/energy/20190425/829929872.html

^[46] http://mondovisione.com/news/trading-volumes-in-2018-pegas-sets-a-record-volume-on-its-spot-segment-in-201/

^[47] St. Petersburg International Commodity Exchange

^[48] Outlook for competitive LNG supply. March 2019. https://www.oxfordenergy.org/wpcms/wpcontent/uploads/2019/03/Outlook-for-Competitive-LNG-Supply-NG-142.pdf

^[49] "An LNG import contract with a price link to the Henry Hub and the competitiveness of two LNG pricing models in the Asia-Pacific region: preliminary research results https://www.imemo.ru/files/File/ru/conf/2015/15062015/15062015_PRZ_JUN.pdf