Say “Sayonara” to Destination Clauses, and “Konnichiwa” to LNG Trading
The LNG market is undergoing a dramatic change: a couple of years ago, I characterized it as “racing to an inflection point.” The gas glut that has resulted from slow demand growth and the activation of major Australian and US production capacity has not just weighed on prices, but has undermined the contractual structures that underpinned the industry from its beginnings in the mid-1960s: oil linked pricing in long term contracts; take-or-pay arrangements; and destination clauses. Oil linkage was akin to the drunk looking for his keys under the lamppost: the light was good there, but in recent years in particular oil and gas prices have become de-linked, meaning that the light shines in the wrong place. Take-or-pay clauses make sense as a way of addressing opportunism problems that arise in the presence of long-lived, specific assets, but the development of a more liquid short-term trading market reduces asset specificity. Destination clauses were a way that sellers with market power could support price discrimination (by preventing low-price buyers from reselling to those willing to pay higher prices), but the proliferation of new sellers has undermined that market power.
Furthermore, the glut of gas has undermined seller market and bargaining power, and buyers are looking to renegotiate deals done when market conditions were different. They are enlisting the help of regulators, and in Japan (the largest LNG purchaser), their call is being answered. Japan’s antitrust authorities are investigating whether the destination clauses violate fair trade laws, and the likely outcome is that these clauses will be retroactively eliminated, or that sellers will “voluntarily” remove them to preempt antitrust action.
It’s not as if the economics of these clauses have changed overnight: it’s that the changes in market fundamentals have also affected the political economy that drives antitrust enforcement. As contract and spot prices have diverged, and as the pattern of gas consumption and production has diverged from what existed at the time the contracts were formed, the deadweight costs of the clauses have increased, and these costs have fallen heavily on buyers. In a classic illustration of Peltzman-Becker-Stigler theories of regulation, regulators are responding to these efficiency and distributive changes by intervening to challenge contracts that they didn’t object to when conditions were different.
This development will accelerate the process that I wrote about in 2014. More cargoes will be looking for new homes, because the original buyers overbought, and this reallocation will spur short-term trading. This exogenous shock to short term trading will increase market liquidity and the reliability of short term/spot prices, which will spur more short term trading and hasten the demise of oil linking. The virtuous liquidity cycle was already underway as a result of the gas glut, and the emergence of the US as a supplier, but the elimination of destination clauses in legacy Japanese contracts will provide a huge boost to this cycle.
The LNG market may never look exactly like the oil market, but it is becoming more similar all the time. The intervention of Japanese regulators to strike down another barbarous relic of an earlier age will only expedite that process, and substantially so.