A 1 mtpa LNG supply contract covers more than $500m a year of annual cargo value. Many supply contracts are multiples of this volume with billions of dollars of annual value at stake.
Price review or re-opener clauses have become more common in LNG contracts over time, particularly in Asia where oil-indexation is more prevalent. These clauses provide a trigger for price negotiation & arbitration.
Price reviews act as contract protection for both counterparties against unreasonable economic impairment e.g. in case of structural deviations between contract & LNG market prices.
Large price swings across the last 5 years in gas & oil markets are resulting in an increasing amount of value at stake under price review clauses. In today’s article we map out price review negotiation strategy, look at key value & risk drivers and illustrate value at stake using an LNG contract case study.
A key principle to establish upfront is that price review processes do not need to start in open warfare. There are potential ‘win-win’ outcomes available from constructive counterparty engagement.
In Diagram 1 we map out the steps through a typical price review negotiation process.
Source: Nick Perry
The key to a constructive outcome is creativity. This facilitates a move away from a ‘win-lose’ outcome. Some examples of creativity include negotiated trade-offs around:
Contract renegotiation should not just be confined to price reviews triggered by contract clauses. The creativity to negotiate ‘win win’ outcomes is just as possible via proactive counterparty engagement, a key skill of a strong origination team.
The simple answer is there have been major shifts in energy market fundamentals. This includes changes in:
Low correlation between LNG market prices & oil indexes has caused significant shifts in value from LNG contracts with ‘oil slope’ price indexation as illustrated in Chart 1. The chart shows the extent of swings in the ratio of the JKM Asian LNG price vs Brent prices (JKM in $/mmbtu divided by Brent in $/bbl).
Source: ICE, Timera
Chart 1 illustrates how swings in oil-indexed contract value have been exacerbated by significant volatility in global LNG markets. JKM vs Brent slopes have swung between a range of 10-75% over the past 3 years, vs typical LT contract pricing terms of 10-15% Brent. This range is even more extreme if we extend back to the Covid related impacts of 2020.
The impact of these large relative swings in gas vs oil price substantially increases the value at stake under price review clauses. To put this in context, a 10c per mmbtu shift in contract price across a 5 year 5mtpa deal impacts value by around $140m.
Changes in the value of contract flexibility terms can also be substantial (especially volume flex, e.g. cargo volume flex or DQT/UQT). These terms can be a key ‘creative’ negotiation lever and source of value upside as part of a renegotiation or price review process.
Robust analysis of LNG contract value underpins any price review or negotiation process. If you can’t accurately quantify value, competitive advantage shifts firmly against you.
Historically LNG contract value analysis focused on reported slopes from recent deals struck in the market. There are several reasons why this approach is inadequate:
These factors have been driving a strong increase in focus across LNG companies on more robust contract valuation analysis, including capturing portfolio interdependency effects. We have seen direct evidence of this from our LNG client base in the form of an increase in LNG contract valuation work to support renegotiations using our LNG Bridge portfolio modelling framework.
There is no better way to understand LNG contract value changes than quantifying them via a practical case study.
In Chart 2 we show the change in value of a 5 year strip of cargoes (for 2025-29 delivery) at two different points in time:
The contract we analyse is a DES NE Asia purchase (sell into JKM spot), with 12% Brent slope, 12 cargoes a year (ACQ) and 3 cargoes per year UQT for the seller (i.e. the seller has the right to take 3 additional cargoes a year).
Source: Timera Energy’s LNG Bridge portfolio valuation model
The left hand panel shows the value of the contract shortly after it was signed in 2020. Value is relatively low given the contract is close to ‘at the money’. It is important to note that most of the contract value is driven by the value of the embedded UQT flexibility term.
The buyer UQT flexibility enables to buyer to nominate 3 additional cargos per year when contract prices are below prevailing spot prices. In 2020 with the contract ‘at the money’, this UQT flex consists mostly of extrinsic value.
Now let’s step forward 4 years in time to see how the contract valuation changes in 2024. LNG market prices (JKM) have risen substantially relative to the oil indexed contract price. This has driven some major shifts in contract value that illustrates the potential motivations (in this case for the seller) to trigger a price review or renegotiation process. A summary of changes:
The case study illustrates the significant value that is often contained in the flexibility terms in LNG contracts and the importance of keeping these within the scope of negotiations. Creativity around use of these flex terms in a negotiation process can be a valuable route to conflict resolution. However competitive advantage here depends on robust quantification of value impacts (from both buyer & seller perspective).
We finish in Table 1 with a summary of ‘lessons learned’ based on our experience supporting clients with LNG contract price reviews & re-negotiations.
| Takeaway | Summary |
| The prize is big | LNG supply contracts are very high value (usually $ billions). This raises the stakes at the negotiation table & the benefits of negotiating a successful outcome.
|
| Preparation & strategy is key | Map out a clear strategy pathway & define key levers that will impact the outcome (e.g. portfolio positions / strategy, market view, value of contract terms, risk appetite).
It is important to be prepared & quantify different options to enable proactive focus on areas of greatest value impact. |
| Robust valuation drives competitive advantage | Simple value analysis based on headline pricing terms erodes competitive advantage.
Robust valuation of embedded flex terms (inc. extrinsic value) can substantially enhance negotiating power. |
| Consider risk too | LNG contract flex terms can also be a key lever to mitigate downside risk. It is important to consider all of the expected value and margin distribution risk impact when assessing changes to contract terms, as well as risk capital impact. |
| Creative negotiation trumps warfare | It is a mistake to think about negotiation processes as solely a transfer of value to the impaired counterparty.
Creative negotiation informed by quantitative analysis can drive many outcomes that benefit both parties (e.g. due to different portfolio positions, market views, risk appetites). |
Source: Timera Energy
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