Driving factors of LNG financial derivatives

Abstract: Natural gas consists of carbon hydrates and is utilized in the residential, commercial industrial and transportation sector and for power generation. Due to the fact that natural gas emits 23 % and 44 % less carbon dioxide than oil and coal respectively when burned, it becomes a more attractive fuel from an environmental perspective. Traditionally, natural gas is transported via pipelines. However, due to the fact that the geographical areas where natural gas is used often are a long distance away from the gas fields where natural gas is extracted, the gas needs to be transported long distances. For this reason, natural gas is cooled to a temperature of -162 °C to become liquid, or liquefied natural gas (LNG) in order to transport the gas in specially designed shipping vessels or trucks. LNG has a volume that is 1/600 of natural gas in gaseous state. For numerous reasons, most LNG is traded on long term contracts and priced on a formula linked to the oil price. One main reason being that infrastructure investments required for delivering and receiving LNG are capital intensive, thus need to acquire financing by securing cash flow through reliable long-term contracts. At the moment, Japan is the largest buyer of LNG in the world and the index for Japan and Korea LNG import prices, more known as the Japan/Korea marker, serves as the most common LNG-based index for spot trade. Financial derivatives are a common instrument in most commodity markets that is utilized for hedging price risks and speculating on price developments for the underlying commodity. Financial derivatives need to be traded on a market with enough trading volume in order to become sufficiently liquid to satisfy the needs of stakeholders trading the derivatives. However, the contracts currently priced on an LNG index only make up a fraction of the global LNG market and therefore the financial derivatives referencing to the price are traded in very small volumes and cannot be considered liquid. This study is conducted in order to look at the development of financial derivatives in the LNG market. The aim of the study is to identify driving factors for the liquidity of LNG financial derivatives. A qualitative approach is used in order to gather data that is used to map the LNG market, its actors and different price mechanisms. An analysis of the data is carried out in order to create new theories about the research question. The results of the study identify ten driving factors that affect the liquidity of LNG financial derivatives: 1. Supply of LNG, 2. Demand of LNG, 3. Leaving oil indexation, 4. Fragmentation among suppliers, 5. Number of players in physical market, 6. LNG index reliability, 7. Willingness to price on LNG index, 8. Players trading financially, 9. Clearing houses, and 10. Contract length. From further analysis, it is concluded that the current immature and illiquid market situation for LNG financial derivatives is mainly derived from reluctance to use LNG indices when pricing physically traded volumes. Factors that drive the future pricing of the contracts are a decrease in length of the physical contracts and fragmentation among suppliers of LNG.