Anyone who has touched and follows the the current flurry of activity in the Asian LNG marketplace must be startled. The casual LNG observer might have the impression that it’s just some contractual clauses that are at the heart of the problem and that their modification – or even better their removal solves all ills of the world. That’s an almost fraudulent misrepresentation of how things really stand – and those who entertain it either don’t have a clue of the inner workings of LNG and even energy markets, or they are vicious fraudsters.
Let’s pull one thing straight first: Japan currently conducts an investigation into destination clauses. Did anyone expect such an investigation 3 years ago? Certainly not as Japan wanted all LNG they could possibly lay their hands on in their terminals. The world was still in undersupply.
But now we are in oversupply and those destination clauses – that had assured them of their supply when they needed it – suddenly become an economic burden.
Have those Japanese negotiators not known that whatever constitutes a contractual advantage may just as easily turn into a contractual liability? It always only depends on the state of the market. Plenty of LNG and you want to be able to fend some of the contracted LNG off into the wider world. Scarcity of LNG and you want to be sure you can force the supplier to come to your place and not some place that pays better than you are willing to.
This story of looking into Destination Clauses right now smacks a lot of Japan wanting to have its sandwich and eat it at the same time. You might say – fair enough. In the recent past, sellers were outrageous in their behavior and their demands too. Still, that does not make Japan a moral authority in LNG now.
However, their urge to game the market better is at least commercially understandable. Most Japanese buyers had over-contracted on long-term LNG for the years up to 2014 as there was a feeling that there will never be quite enough of the stuff so it’s better to get what you can lay your hands on.
They fixed themselves quite an expensive sandwich in the process. While LNG prices globally were on the extremely high side, this did not matter much. When everyone is in the same boat, one does bite the bullet and eat humble pie. But now that the world is basking in cheaper (not really cheap) energy, those same utilities – that binged on expensive long-term LNG – now get their butts kicked.
And yes, destination clauses have become some sort of an oddity since the EU has eradicated them from contracts bringing LNG (and of course pipeline gas) into the common market. Is the stance of Japan towards Destination Clauses comparable with what the EU did 10 years ago?
In the EU, it was the consequence of the general liberalization of the internal EU gas market which was – at that time – well underway for many years and the removal of Destination Clauses was only one aspect of this general drive. Besides, the world at the time was on the cusp of a seller’s market so it was not market pressure that dictated those moves but rather a general desire to end restrictive practices. They wanted to force the old boys to break up their cozy structures and those old players were not uniformly happy with those liberalizing tendencies at the time.
In Japan, there is no generalized market to speak of and it’s very strange that this investigation happens just at the moment when Japanese utilities are buckling under the weight of the old contracts. And sellers cry foul because they fear for their Project Financing arrangements that have come under assault with lower prices. Pushing this a little further one might be justified in thinking that sellers want to ensure every single drop of LNG contracted to Japan actually goes there so the utilities ease their coal binge a little and hence would not diminish the LNG market in the process.
But I digress.
How could we help hard-pressed Japanese utilities without breaking the bank then? Most term LNG going to Japan is Delivered Ex Ship (DES) which means that the seller controls the transport link and hence passes ownership of the LNG at the flange of the receiving terminal. In such a case, the Destination Clauses don’t matter that much – one must have the contractual right to order the vessel to divert away which is hard if you don’t own vessel or title of the LNG. Strictly speaking, it’s the sellers LNG until terminal flange and Take or Pay (ToP) ensures that you have to take it if he shows up at your terminal at the agreed slot. He must show up and you must take it.
Of course, there is a problem if the buyer cannot take it as tanks are full. He would have to pay for the cargo regardless. The seller is then stuck with a vessel that he cannot unload but which he needs empty for the next cargo. Perfect stalemate then. What the buyer really needs is less or no ToP which the seller can impossibly accept as this breaks his Project Financing – which rests on the assumption that the buyer will always pay the agreed price – completely. Opening this is a can of worms.
What is sorely needed is cooperation between the seller and the buyer. And this is what this drive for the removal of Destination Clauses is really about. Japanese utilities want to be able to force sellers to redirect their vessels to other destinations if the buyer tells them so.
Many of them have established trading divisions in order to sell the excess LNG off into other markets, sometimes as far away as Europe. This activity is in itself a huge drain of resources to them. Right now, diverting cargos away from Japan involves landing them there first, having them unloaded in a Japanese terminal, having them reloaded into a new ship in order to comply with the Destination Clause and then having the new ship go wherever it must go. This is obviously very expensive plus it puts a huge strain in their planning departments as those Japanese terminals are not built for this kind of thing.
Having the (theoretical) possibility to divert the cargo while it’s on the way to Japan or even better, to remarket it before it is even loaded at the producers terminal would make things a terrible lot easier and cheaper. Destination Clauses prevent that and the only effective and safe (for the buyers) way to deal with that is if the Japanese government declares them unlawful. A bit like the EU did many years ago.
The utility buyers cannot break the news on this to their suppliers without problems – they must save face. It’s much easier if they are able to pretend that it’s not them but the public authorities that want this and they are merely complying with what the regulator, government or whatever other authority asks them to. This little stratagem allows the utilities to tell their suppliers that this is some sort of Force Majeure that they must comply with so please let’s take out the Destination Clause. It lets them save face while saving a buck. And it also lets the sellers save face while they wrestle with their lenders.
This is – of course – just a theory of mine as nobody in Japan will ever admit this but it makes a hell of a lot of sense and I would do it would I be in their place.
Besides, to the sellers it should not matter much to take the Destination Clauses out. As long as the buyers are happy to pay the pre-agreed price formula it should not matter to them where the cargo goes. The times when suppliers could manage the world market are over but some suppliers have spot marketing arms that whey fear will be outcompeted by those Japanese utilities. Those utilities are willing to undercut spot prices just in order to get rid of the cargo which is of course toxic to spot sellers anywhere. Besides, Japan is currently rejigging its power production portfolio away from LNG and oil towards more coal which means that LNG use is going down. Breaking the Destination Clause would help them a lot to drive this change.
Suppliers are in oversupply pains anyhow so they fear even more LNG on the world market from a Japan that uses less of it. Japan keeps the pressure on prices intact by their actions which is good for them as a buyer.
Yes, I think that this time it’s serious but I also think that Japan uses this to apply pressure on suppliers not only to break the Destination Clause but also to lower price levels (again, that can never be said in the open by them) and this is much harder to acquiesce to by sellers as it threatens the
fixed on the European sink as it will provide balance to the market.
And considering how jagged the LNG marketplace is going to be for the next decade or so, balance providers will be priceless.
What are we learning from all this? Despite all the banter, efforts, hype and strongarming by other wannabe LNG hubs, it’s not the smart contracts that make a hub but rather the physical ability to swallow LNG and spew it back into the market that really whips the cream. And none of the