August 8, 2019

The rise of LNG Derivatives

There have been fundamental changes in the way LNG is traded and priced which have resulted in the emergence of LNG derivatives as a risk management tool. Between 2017 and 2019 the growth of ICE JKM LNG futures contract has been exponential. We explore this development in this Article.

Traditionally, LNG has been traded under long-term contracts under which pricing was almost always linked to the price of crude oil. One advantage of this system was that, since oil has a liquid and established futures market, traders could hedge their positions easily. However, the oil and gas markets have evolved in different ways so that the price of oil and gas no longer correlates. An increase in supply from the US, Australia, Africa and Papua New Guinea has brought more  participants to the LNG market and a shift towards spot-trading. While the LNG market continues to be largely made up of legacy long-term contracts, recent figures have shown that an increasing number of LNG transactions are done on a spot or a shot-term basis. LNG spot transactions, where trades are concluded for delivery in the next 90 days, accounted for around 25% of global trade volumes in 2018, according to the International Group of LNG Importers. This trend required more appropriate pricing of LNG, using LNG-related price data.

Various indexes have emerged over time. However, the Platts JKM™ (Japan Korea Marker) LNG Price Assessment ("JKM") is the one that has gained most traction in the market. S&P Global Platts launched the JKM index in February 2009. It reflects the reality of global LNG demand since a majority of LNG is delivered in Asia, where underdeveloped infrastructure means LNG is a key source of energy. The index has been increasingly used, and not only for spot-trades. For instance, Indonesia is reported to have issued tenders to sell LNG linked to JKM, and Tellurian concluded a 15-year agreement with Vitol for the supply of LNG priced using the JKM index.

The use of a reliable benchmark has been accompanied by a growth in the need for LNG derivatives in order to manage risk and hedge price movements. Unsurprisingly, JKM futures contracts have proved most popular in the market. These futures settle against the JKM and are cleared through ICE and CME Group. JKM options are also available.  The ICE JKM LNG contract hit a record 44,394 lots for futures and options in June and reached a new open interest record of 52,080 lots at the end of June.

However, the LNG futures market remains illiquid when compared to oil futures. A recent study of the Oxford Institute for Energy Studies noted that, by way of comparison, open interest on ICE in April stood at around USD 3 billion for JKM futures, compared to USD 10 billion for natural gas futures delivered at the National Balancing Point and USD 145 billion for Brent oil futures. Nevertheless, the amount of liquidity has been increasing which gives hope that the market will become more liquid.

Traders should remember that LNG derivatives are regulated by MiFID II. The JKM futures contract is subject to MiFID II's regime on commodity derivatives. This establishes a position limit regime for all commodity derivative contracts traded on EU trading venues and an obligation to report them. This regime applies to any person that trades LNG derivatives whether they are regulated or not. However, there is an exception for non-financial entities who trade in commodity derivatives, to hedge risk.

The Financial Conduct Authority is the competent authority to fix the position limits for the ICE JKM LNG (PLATTS) Futures contracts and has fixed the position limit for that contract at 16,550 lots for the spot month and 5,000 lots for other months.

Conclusion

Demand for LNG derivatives should increase with the rise in supply and demand for LNG globally, and the need to mitigate risks on a market which is not yet as stable as that for other commodities.  It is an open question whether the JKM index will remain the price benchmark or challenger indices will develop for the European market.