The Hindu : Business : LNG pricing: relevance of crude linkage

Online edition of India's National Newspaper
Monday, Jan 24, 2005

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LNG pricing: relevance of crude linkage

If gas is to play its rightful role as the fuel of the future, all gas importers must come together to address the relevance of gas-oil price linkage urgently, says Sudha Mahalingam

LNG terminal at Dahej. India has just signed a major deal with Iran for supply of LNG which is cheaper than naphtha now used by many power plants.

INDIA HAS just signed its second major LNG (liquefied natural gas) deal. A consortium of Indian oil and gas public sector undertakings has committed to buy 7.5 million tonnes of LNG from Iran for 25 years. The gas is expected to flow from 2009 onwards. The price has a fixed component and a floating component linked to the Brent marker crude.

LNG is one of the most marvellous inventions of our times. Liquefaction was known even in the 19th Century but commercial operation became feasible only in 1912. Natural gas, normally 90 per cent methane, is cooled to minus 256 degrees Farenheit (-160 degrees Celsius) so that it becomes a liquid and shrinks to 1/500th of its gaseous volume. It is shipped in tankers and at the destination reheated to 41 degrees Farenheit (special regassification terminals need to be built for the purpose) to convert it into gas to be sent through pipelines to consumers. As much as 30 per cent of the energy is lost in the reheating process and one must factor this in while working out the economics of LNG.

Despite its fungibility, LNG is not oil. Gas pricing is different from oil pricing. Oil price is determined essentially by the market — the equilibrium level between the forces of demand and supply. The oil market is well evolved, there are hedging options and a producers' cartel in the form of OPEC (Organization of the Petroleum Exporting Countries) periodically fine tunes supply to peg prices at the desired levels. Global oil importers are essentially price takers, price is quoted in crude barrels free on board with each importer paying the extra cost of shipment to its shores.

Transport linked tariff

Gas is a different ball game altogether. It is still deemed a regional resource and it lacks a liquid market despite the advent of LNG on the scene. The delivered price of gas is determined substantially by transportation tariff. Once capital is sunk in drilling for gas, operational cost of extracting gas is minimal, if not virtually zero. Therefore, gas producers are often willing to take what is called `netback pricing,' that is, the seller and the buyer agree to a final delivered price that substantially consists of the transportation tariff with only the residual reaching the producer. Thus the pricing differs from region to region although in the U.S., the Henry Hub has introduced a modicum of price standardisation. In other regions, gas prices reflect the relative bargaining powers of the seller and the buyer, which explains the huge differential in prices across continents.

The crude link

Two energy vulnerable Asian countries, Japan and South Korea, set an unfortunate precedent, agreeing to link the price of gas to oil. Thus, apart from liquefaction, transportation and regassification costs, Japan agreed to a price that was linked to a basket of crude and its derivatives called the Japanese Crude Cocktail (JCC). In other words, LNG price was allowed to float along with a basket of crudes. Thus, whenever crude prices breached the charts, as they did last year, LNG prices would soar with them. Of course, there would be a floor and a ceiling and this is often not fixed for the duration of the contract, but is subject to periodic revision.

India had chosen to follow the Japanese formula — considered the most expensive — in its LNG deal with Qatar's Rasgas signed two years ago. However, as crude prices soared and it became evident that LNG prices would be too steep to be affordable, India managed to renegotiate a reprieve for six years wherein it persuaded Qatar to agree to a price band of $16-24 a barrel of crude. In 2008, this reprieve will end and the price will come up for renegotiation. Going by the northward spiral in crude prices last year, it is inevitable that the price band will be moved to the right sending India's LNG import prices soaring.

Already, regassified LNG costs the consumer more than 2.5 times the price of domestic gas supplied by GAIL India through HBJ (Hazira-Bijapur-Jagdishpur), the country's arterial pipeline network. Power and fertilizers, the two main downstream industries consuming 80 per cent of domestic gas production, have prudently stayed away from high-priced LNG.

Time for rethink

Now the Iran deal is being hailed as a prize catch because the gas is expected to be cheaper than Qatar LNG after the review of the latter's price band in 2008. LNG is in any case cheaper than naphtha which many combined cycle gas turbine (CCGT) power generators now use. (A little over 10 per cent of domestic power generation capacity is based on CCGT technology) With coal prices at just $10 a barrel equivalent, LNG — whether Qatari or Iranian — is way too expensive for power generation.

The Iran deal is perhaps a shade better than the Qatari deal in as much as it has limited the linkage to Brent instead of the expensive JCC and the extent of linkage itself is small. However, it is time India questioned the rationale for linking gas prices to any crude at all. The recent volatility in crude prices and its cascading impact on gas prices has prompted even Claude Mandil, Executive Director of the International Energy Agency, to raise this issue. If gas is to play its rightful role as the fuel of the future, all gas importers must come together to address the relevance of gas-oil price linkage urgently.

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