April 17, 2019 - Japanese utility Tokyo Gas' LNG contract with Royal Dutch Shell, which was partly linked to coal prices, underscored how Asian buyers are pushing hard for price diversification, a factor that will increasingly influence upcoming contract negotiations and renegotiations.

The Tokyo Gas-Shell deal raised eyebrows because of the inclusion of coal-linked pricing for probably the first time in an LNG contract. However, market participants said the bigger overarching issue is of buyers willing to explore alternatives to oil-indexation.

"[T]his is another nail in the coffin of oil indexation," Craig Pirrong, Professor of Finance at the University of Houston, said. "We are in a stage of experimentation with non-oil indexation," he said. Pirrong, who has authored whitepapers for trading houses, once called the practice of oil-indexation a barbarous relic.

Oil indexation is one of three fronts, in LNG contracting, on which Asian LNG buyers have pushed back in recent years -- the other two being destination clauses and contract durations.

Japan's energy ministry advocated for the abolishment of destination clauses for years, and even collaborated with the European Union to promote market flexibility rules. Asian buyers have also gained traction in cutting contract durations with the market structure moving in favor of shorter term contracts, despite a surge in contract durations in 2018.

Oil-indexation, however, has been tougher to dislodge, even with the introduction of Henry Hub-based indexation and hybrid pricing models. The market has sought an Asian gas benchmark more reflective of demand-supply fundamentals.

"It also doesn't make sense for an LNG player to be exposed to a mine or rail disruption whenever a cyclone hits the Hunter Valley," one trader said. Hunter Valley is a coal mining region in Australia.

When asked about the reasoning behind coal-indexation, Tokyo Gas said it aims to diversify LNG procurement, including diversification of suppliers, contract conditions, and LNG networks. It said the Shell contract "contributes to the stabilization of LNG procurement prices, which is one of the contract conditions."

New Ideas in Price Diversification

On April 5, Tokyo Gas signed a 10-year non-binding LNG supply agreement starting from April 2020, with Shell Eastern Trading, for 500,000 mt/year of LNG on average, on a delivered ex-ship, or DES, basis. It was partly based on coal-indexed pricing.

"This is an example of diversification of pricing, in line with Tokyo Gas' previously stated strategy," Hiroshi Hashimoto, senior analyst of gas group, at the Institute of Energy Economics of Japan or IEEJ. "The deal demonstrates the two companies' flexibility and capability that can accommodate new ideas in LNG transactions," he added.

Hashimoto noted that the coal linkage represents only a part of the deal, which, in turn, represents only small portions of Tokyo Gas' and Shell's respective LNG portfolios.

"It also helps with the diversification in price risk for Japanese buyers. It seems like this should be an increasingly important trend moving forward, as diversification in pricing will matter more as the spot market grows," Jeff Moore, manager for Asian LNG Analytics at S&P Global Platts said.

"This is more of a bespoke solution from a major portfolio player, which has the breadth to offer this sort of solution, but is unlikely to be a mainstay trend in the industry," a trader said.

Coal Indexation

Coal and LNG traders in Asia Pacific were skeptical about the wider adoption of coal indices in LNG contracts.

The argument in favor of coal-indexation is that coal has similar end-user demand fundamentals as LNG in power generation, and it may be possible to hedge LNG against coal-fired power derivatives. If coal prices were to drop, LNG would also drop and remain competitive.

A power trader said the relative share of coal and gas in Japan's energy mix should stay the same if their fuel prices move in tandem, as coal-price linkage will function as a sort of stabilizer for LNG demand in the power sector.

Japan has 8.7 GW of new coal plants under construction to replace 8.2 GW of older units being retired over the next five years, according to Global Energy Monitor data. Japan's Environment Ministry said it would no longer sanction new coal-fired power plants or upgrade existing ones.

"Key risk is basis risk. The basic idea is apparently that coal will be at the generation margin, and hence the utility's revenue will vary with the coal price. If that turns out to be incorrect, it would be problematic for the utility," Pirrong said.

He said Shell is basically taking on a long coal/short LNG hedge, so it is exposed to that spread, but that is what traders do.

It's hard to say whether coal indexation will get much traction, especially given the tenuous position of coal as a generating fuel, and with gas driving out coal, gas-on-gas pricing will be more dominant, Pirrong said.

LNG traders said coal-price indexation creates substantial risk management difficulties as coal markets are less developed and transparent than oil or gas. Some coal traders said the coal benchmark is likely to be a high-calorific value Australian grade like the Newcastle 6,000 kcal/kg NAR thermal coal index, but this could not be confirmed.