AUSTIN, Texas ─ Professor Craig Pirrong of the University of Houston’s Bauer School of Business channeled early 20th century economist John Maynard Keynes when he pronounced the prevalent LNG industry pricing mechanism as a step behind the times. Keynes, writing “A Tract on Monetary Reform” in 1923, proclaimed the gold standard “already a barbarous relic.” He went on to write, “Advocates of the ancient standard do not observe how remote it now is from the spirit and the requirements of the age.”

To Pirrong, and to a growing number in the LNG industry, those words are remarkably prescient.

Craig Pirrong Source: Bauer College of Business, University of Houston

“I think the oil linkage of LNG has similarly become a barbarous relic,” he said at the Thirteenth World LNG Series Americas Summit in front of a packed crowd of about 150. While the rain drizzled away outside, Pirrong expounded on his data to argue that the oil-linked standard for LNG no longer holds any water and that the emergence of North America as a major exporter will help to correct this fact.

Traditionally, the price of LNG, especially when sold to Asian buyers, has been linked to the price of crude, generally at a 14% to 15% slope. When it was first instituted, this made some sense; producers and consumers at the time had no better measure of its value, and theoretically, oil and natural gas could act as substitutes for power generation or heating. However, in today’s evolving, globalizing LNG market, such a connection makes about as much sense as searching for a lost quarter at night under a lamp post, knowing that you lost the coin about two blocks away, à la a Mutt and Jeff cartoon. Just because you can see with the light post, or with oil, doesn’t mean it makes sense to use that guide.

“This is problematic because it results in severe misalignments between contract prices and values, which can lead to disputes between buyers and sellers,” he said. “And they can send incorrect price signals. And when there are incorrect price signals, that can lead to a wasteful misallocation of resources.”

No Goldilocks Moment

As an illustration, Pirrong compared the ratios of the Japan-Korea Marker (JKM), widely regarded as a spot import price for LNG entering Asian markets, to the Brent crude price and to that of gold. What he discovered was that the correlation between JKM and Brent was about 0.05, while the correlation between JKM and gold was -0.03. Those numbers are similarly awful when pricing LNG.

“So the gold standard really wouldn’t be that much worse,” he said.

He did admit there was a co-integration, a sort of long-term correlation, of oil prices and LNG prices, but even with the long-term view there are distortions in the pricing mechanism.

“The excursions away from a sort of long-term mean in the relationship are very long and persistent,” he said.

The difference between the price of oil and LNG tend to equal out when adjusted for scaling, he said, but for very long periods there may be a divergence, which is problematic.

“So the price is almost never just right. There’s no Goldilocks moment.”

The cost of this misalignment will grow with the size of the LNG market.

“As we become bigger, I think it’s incredibly important to get a pricing mechanism that is more reflective of the fundamentals of LNG.”

Where To Next?

Pirrong said that a couple of factors will lead to a tipping point toward a different pricing mechanism. The first is the supplies coming onstream from Australia and the U.S. in the next five years. Combined with a slight abatement in demand growth, the new supply might have some trouble finding a dedicated home, leaving more room for the growth in spot and short-term trades. The second factor is a growing buyer discontent in oil linkage, as he sees it.

“You put those factors together, and that creates the potential for more trading, and when you look and you see this in a variety of different markets, pricing mechanisms tend to be ‘tippy.’ That is, they may jump from one pricing mechanism to another pricing mechanism due to the nature of liquidity. Liquidity attracts liquidity, and using one pricing mechanism leads others to use that same pricing mechanism.” There’s a growing gravitational mass that attracts other market players, he said.

North American supply, he commented, looked to be a likely source for the marginal ton for major consuming regions, especially Asia, meaning that it would have a role in expediting the tipping of the pricing mechanism from the old to the new.

“Values are determined at the margin. This means that North American prices are likely to be the major component of the value in major consumption regions.”

Add that marginal determination to the fact that the U.S. already has a liquid and transparent physical market, a vibrant and relatively long-dated paper market that facilitates buyer hedging, and a diverse selection of buyers and sellers and resultant flow of transactions, and North American pricing looks attractive.

“So this is a market with some desirable characteristics and pricing mechanisms.”

Pirrong ended his presentation by forecasting that the entrance of U.S. LNG to the world market would facilitate a tipping of a large fraction of the market to a North American pricing benchmark and that global basis markets will develop around a pricing hub. Hedging interests will become more balanced.

And that barbarous relic of oil linkage?

“Consigned to the ash heap of history.”