Geopolitics in a Liberalizing LNG Market: A Primer

This is a guest post by Brian Myers, a graduate student at the Center for Global Affairs at New York University.

While the U.S.-China trade war has cast a pall over the previous rosy outlook for global liquefied natural gas (LNG) markets, the signing of new financing deals for U.S. LNG exports has brought room for renewed optimism that rising U.S. natural gas production can find a home abroad. The trend, if sustained, could alter the geopolitics of gas and help U.S. developers even in the face of declining interest from China. LNG now comprises 60 percent of China’s natural gas imports and the country is seeking a more diversified slate of imports. The U.S. delivered 2.9 billion cubic meters per annum (bcma) of LNG to China in 2017, roughly 15 percent of all U.S. LNG exports. Shipments began robustly in 2018 but then trickled to a stop in the latter part of the year. Only 0.3 bcma of imported U.S. LNG reached China in the first half of 2019. While it seemed that trade disputes could slow U.S. LNG development, recent financing deals show that growing liquidity in LNG markets are in the U.S. favor as the global natural gas market shifts to a more commoditized paradigm.

U.S. LNG developer Tellurian and French supermajor Total SA reached an agreement in July of 2019 that quietly added some momentum to a growing commoditization reshaping liquefied natural gas (LNG) finance, with potential geopolitical consequences. Total agreed to take an equity stake in Tellurian’s Driftwood liquefaction project for $500 million, in exchange for offtake from the project’s LNG shipments and purchase of $200 million in Tellurian shares. Tellurian will finance much of the project with commercial debt from Driftwood Holdings LLC. The “equity/cost model” being used for Driftwood and other similar projects reflects a progression towards a more liberalized LNG market away from rigid, government to government sponsored financial arrangements of the past such as trade credits or long term government-backed loans combined with equity stakes. Tellurian must now finalize the remaining details for the $28 billion Driftwood project, which has a tentative purchase agreement from India’s Petronet and a deal with trader Vitol to invest and purchase natural gas. The Driftwood LNG terminal near Lake Charles Louisiana would be the largest privately-funded infrastructure project in the United States.

Industry officials believe that the Total-Tellurian deal signals an emerging LNG market structure featuring abundant supply sources that will allow for destination flexibility, shorter-term contracts, larger volumes of spot transactions, and critically, a diminution of government involvement. Commercialization of the LNG industry away from state financial sponsorship has been driven by global competition in the private sector to meet potential global demand growth of 40-65 million tons per annum (MMtpa). As demand for LNG rises, the second wave of U.S. projects currently in development is expected to benefit. However, market liberalization faces resistance from powerful energy market players: Saudi Arabia, Russia, and China. All three countries look poised to use their geopolitical positions to influence outcomes in the LNG space.

LNG is natural gas that has been cooled and liquefied, which concentrates its volume so that it can be economically transported on tankers and shipped around the world. Natural gas is also exported by pipeline, but this transport mode typically limits cross border sales to regional trade, given the expense to building long-distance pipelines. In contrast to regional pipeline networks, LNG is a globally traded commodity.

The LNG industry began as a way for natural gas that would otherwise have been stranded by limited regional pipeline capacity to reach international markets. Algeria became the world’s first LNG exporting country in the 1960’s and since then, Qatar, Australia, and Russia have become the largest LNG exporters. In nascent years, LNG sellers indexed their prices to regional baskets of crude oil in contracts that often stretched out twenty years or longer. Purchase agreements were highly influenced by the role of governments, since reliability was a major concern and development of liquefaction (export) and regasification (import) terminals was extremely capital intensive, sometimes reaching $20 billion or more and requiring years before they can load or receive a cargo. This reality gave LNG a geopolitical tinge that remains to this day.

Now, the U.S. shale revolution is rapidly altering the geopolitics of natural gas. By combining horizontal drilling and hydraulic fracturing, the United States suddenly became home to some of the most prolific natural gas producing basins in the world. As the U.S. shale phenomenon has grown, so has U.S. associated gas production from tight crude oil wells in the giant Permian Basin, among other locations. The United States also has cheap, prolific dry gas fields in the Haynesville and Marcellus shale plays. All this has contributed to an abundance of U.S. domestic natural gas supplies, creating impetus to find export markets.

As the U.S. oil and gas industry shifted gears from scarcity to abundance, many LNG import terminal projects were reconstructed as export terminals to alleviate an oversupplied U.S. gas market. Prices at the main U.S. natural gas trading and storage hub, called Henry Hub, emerged as a cheap, liquid, and reliable pricing benchmark for North American gas. Henry Hub now has sufficient volume and liquidity to serve not only as the U.S. domestic pricing benchmark but as a potential benchmark index for U.S. LNG export sales, often giving U.S. exports an advantage over more expensive oil-indexed LNG prices. The gas-on-gas indexed LNG sales, such as those tied to a Henry Hub spot market average, has reduced buyer exposure to price volatility in oil markets and allowed abundant natural gas supplies to decouple from geopolitically-driven inflation in oil prices. Recent flare ups in the Strait of Hormuz and their divergent influence on oil and LNG markets exemplify the benefits of gas-on-gas LNG prices.

The first wave of U.S. LNG export terminals differed from their global predecessors such as Qatargas and Atlantic LNG in that they were not underpinned by government to government dealings. U.S.-based and private developer Cheniere began the first wave of projects and created a template for all other private U.S. developers in which there was no direct government finance. Cheniere’s merchant template was mostly a function of the United States’ liberalized, market-oriented approach to energy. Now, large international oil companies (IOC) like ConocoPhillips and ExxonMobil, as well as smaller developers like Tellurian, have followed Cheniere’s market- oriented approach. But as Tellurian’s “equity/cost model” suggests, LNG finance for the next wave of LNG export plants could bring even more market flexibility, reducing the need for long run, final destination offtake contracts.

To secure project finance with less debt, smaller developers are selling equity stakes in projects that allow investors preferential access to the terminal’s LNG. The “equity/cost model” is allowing second wave developers to tap interest in the growing LNG market where rising liquidity is eventually expected to substitute for guaranteed multi-decade supply contracts. The new financing model presumably will lessen the risk that geopolitical events or a temporary recession will derail a particular project compared to other facilities. Large IOC players like Total are taking more of a portfolio approach to their LNG businesses, building up a variety of opportunities instead of dedicating output in a point to point manner from one particular gas field or terminal to one or two specific government-backed buyers.

American natural gas production is uniquely suited to act as backstop supply in an increasingly liquid spot market—allowing U.S. LNG to usurp market share from more geopolitically risky producers. These trends signal changes in geopolitical headwinds that ultimately favor the United States. However, China’s large role as a buyer in the global LNG market means any loss in economic growth in the country could put a damper on not only marginal demand for U.S. LNG but for LNG supplies from elsewhere such as Australia and Africa.

China is set to become the fiercest battleground for LNG sellers, hoping to benefit from Beijing’s rising concerns about air pollution and energy supply diversity. Natural gas demand in China is expected to soar to 450 bcm in 2030, up from 280 bcm in 2018. This opportunity has mobilized investment in every link in the global LNG supply chain. Not to be left out, U.S. sellers are considering new financing mechanisms that obviate the need for China to take an equity stake in export terminals. But the U.S.-China trade war remains a potent geopolitical force despite a liberalizing market. The United States’ role in LNG supply to China has been marginalized—only four LNG vessels have landed in the country since tariffs on the fuel went into effect in September 2018. Some analysts believe short-term effects on U.S. producers will be limited; but the trade war clearly delayed some U.S. developers from finding equity investors in 2018. Chinese buyers have turned to Australia, Mozambique, and Russia for long run natural gas supply.

In fact, Russia has become one of the beneficiaries from the U.S.-China trade war. Russia’s extensive natural gas pipeline network has been a critical component of European energy supply and European reliance on Russian gas persists because of the very favorable economics of piped gas to Europe compared to LNG. But Europe has also invested heavily in renewables and LNG receiving terminals, making it easier for Europe to limit growth in the percentage of Russian gas supply in its energy mix. Aware of this potential threat to its market share, Russia has moved to develop LNG infrastructure in the Arctic and Yamal regions (using the equity/cost model) to expand its flexibility and reach to other markets.

Still, Moscow’s overall natural gas export strategy shows that it still feels its pipeline networks are central to promote guaranteed offtake and reduce merchant risk. That is why it has been pushing for a natural gas pipeline connection to China. The Power of Siberia pipeline represents a concerted Russian effort to lock in the Chinese market. The two countries signed a 30-year sale and purchase agreement that will supply 38 bcma of China’s 280.30 bcma gas demand (2018). Russia is playing a game most other gas exporters cannot: a sustained emphasis on piped gas because it can physically reach disparate markets and undercut LNG prices while also building out LNG infrastructure to compete effectively in other parts of the liberalizing global market.

Russia is also drawn to the geopolitical benefits of pipelines, along with their favorable economics. Creating reliance on its gas through a point-to-point pipeline that Moscow controls, Russia maintains leverage on the energy security of its buyers. Natural gas, and the pipelines that transport it, can be tools of economic statecraft that accrue intangible geopolitical benefits to the supplying country, cementing relations in other spheres. Yet, despite its large position in both the pipeline and LNG market, Russia’s leverage vis-à-vis buyers weakens as more LNG volumes are traded on a liquid spot market. Russia could be forced to accept painfully low prices for piped gas if it seeks to maintain market share in the face of abundant global supplies.

As Saudi Arabia thinks about its future as a global energy supplier, it is also thoughtfully considering its role in global natural gas markets. Unlike Russia, which has a large position in both oil and gas markets, Saudi Arabia has in the past chosen to play a dominant role in oil and petrochemical markets. But changing conditions for the future energy transition has prompted the kingdom to think more broadly about its long-range strategy. Saudi Aramco’s recent deal with U.S. developer Sempra Energy for a stake in an LNG export terminal reflects a significant shift for the national oil company (NOC) and is a major commercial and geopolitical development. The state-owned oil giant agreed to purchase 5 MMtpa of LNG and a 25% equity stake in the planned Port Arthur liquefaction facility in Texas. Saudi Aramco’s decisions move markets and by agreeing to the same financial arrangement used in a commercialized U.S. LNG space, it has buttressed the liberalizing trend in LNG markets. If the world’s largest NOC eschewed a direct intergovernmental agreement for LNG investing and instead prefers to participate in the growing open market, it shows how strong the trend towards commoditization is in the future global gas market. Aramco’s acquisition is also geopolitical significant. Many countries in the region are oil and gas producers while Saudi Arabia relies heavily on oil to sustain the kingdom’s economy. As global oil demand slows in the coming two decades and LNG demand surges, diversification of energy assets is critical for Saudi Arabia to remain competitive with both regional rivals and other global energy suppliers that export both oil and gas. The investment also strengthens Saudi Aramco’s commercial ties to the United States.

In the face of LNG market liberalization and increased global competition, the U.S. diplomats seem to lack a clear international strategy. The capitalist system in which U.S. LNG developers operate precludes the Trump administration from acting unilaterally to increase the competitiveness of U.S. LNG in the global market. Industry commercialization means that governments could take equity stakes in fewer future projects, and federal subsidies for U.S. LNG are unlikely. Market liberalization is a double-edged sword for U.S. LNG developers—as the market becomes more competitive resulting in cheaper LNG closer to large Asian demand centers, some second wave U.S. sellers could struggle to achieve LNG price netbacks necessary to sustain profitability, potentially putting export volumes at risk. Even though the United States is in large part responsible for increased global competition and market liberalization, how competitive U.S. LNG shipments will be in this new market remains to be seen. The problem is sufficiently thorny that old fashioned ideas of the Texas Railroad Commission restoring production quotas is making the rounds in some natural gas circles. This is unlikely to help given the plethora of other available resources to meet demand worldwide.

While the Trump administration has limited options to boost future U.S. LNG volumes directly, an early end to the U.S.-China trade war would certainly mitigate some of the risks to current project development. U.S. LNG export sales would definitely be hit by any slowdown in Asian economies. And, U.S. LNG developers are still hoping there will be a rebound in LNG exports to China once a trade deal could be settled. The president’s team have also courted potential other customers for U.S. LNG but ultimately market forces and geographical price arbitrage between various destinations will determine demand for U.S. natural gas globally. Workers dependent on energy and agricultural trade in the U.S. Gulf of Mexico states, particularly Louisiana, are already facing economic hardship from the trade war. The longer the Trump administration continues to escalate trade tensions with China, the greater the risk for the U.S. LNG industry.