The LNG industry is finding new solutions to manage risk following last year's price surge where unhedged exposure into Europe ballooned to tens of millions of dollars per cargo.
The yawning gap between European LNG delivered-ex-ship and European pipeline gas in 2022 made clear the tangible basis risk between them and provoked industry clamor for more risk management tools. The CME subsequently launched the first LNG-settled derivative for Northwest Europe in October 2022 called NWM , settled against the monthly average of Platts Northwest Europe marker, which has seen significant volume traded. Traders finally have access to a like-for-like hedge for European-delivered LNG cargoes.
European LNG and gas hub prices diverge
The LNG industry has long had the habit of linking its cargo pricing to other commodity benchmarks. Brent-linked LNG has been the norm for long-term contracts for decades. However, European LNG has evolved and continues to do so. Until quite recently, the UK National Balancing Point was the primary pricing basis for European LNG deliveries, but it has been overtaken by the Dutch Title Transfer Facility.
Received wisdom in European gas markets has been that LNG is priced at a similar outright value to local natural gas hubs. However, time and again the global supply-demand economics have made the two markets diverge, creating significant basis risk when hedging and for physical cargo indexation.
Russia's invasion of Ukraine in February 2022 coincided with a period of extreme LNG discounts to TTF: at their steepest, on Oct. 3, 2022, Platts NWE was assessed at $28.664/MMBtu; TTF was at $58.214/MMBtu. For a standard 3.5TBtu LNG cargo, the spread between LNG and TTF was $103.4 million -- greater than the outright price of the LNG cargo at $100.3 million. That means to use TTF to hedge LNG on that day, the mis-hedged portion of the cargo was greater than the actual value of the LNG cargo and both of those numbers are greater than $100 million.
While this example is at the most extreme part of the market divergence, traders have communicated little appetite for even much smaller basis risk. On average in 2022, Platts NWE was $7.62/MMBtu lower than the equivalent TTF month, or $26.67 million per cargo.
When polled, a majority of Atlantic LNG traders and trading managers said a mismatch of up to $1/MMBtu between European gas and LNG prices would constitute a significant basis risk. The spread between front-month NWE and TTF was assessed wider than that $1/MMBtu threshold on 80% of pricing days between January 2022 and July 2023.
Managing risk between Europe and Asia
It is notable that European LNG prices can also be at a premium to natural gas.
In 2021, Platts NWE averaged a $0.0584/MMBtu premium to TTF. More recently, in July, Northwest Europe LNG was either flat or above TTF for six of 21 business days. This makes importing LNG uneconomical for buyers in Europe, immediately swinging unpurchased cargoes away from the region, and prompting some who purchased cargoes to book out. This leaves Europe more exposed to changes in demand in other regions. Were companies managing this risk by index-linking their cargo to European LNG prices, and hedging using European LNG derivatives and European gas hubs (buying LNG, selling gas), then hedging gains would theoretically offset physical losses, the cargo would more likely be imported, thereby providing Europe with LNG even if LNG prices move to an uneconomical level relative to TTF.
LNG players trade the spread between Platts JKM and TFU (TTF traded in $/MMBtu) to try to manage the east-west risk.
It is often talked of by analysts as a sign of arbitrage potential between the Atlantic and Pacific basins, despite the basis mismatch explained above. The spread is many things at once: a time spread (the settlement periods differ); a product spread (reflecting different qualities and quantity); and a location spread (one is inland gas, the other reflects LNG cargoes).
Nevertheless, a market uses the best available option. Once patterns of behavior are established, it often takes a seismic market change to unsettle them.
"TTF is extremely liquid, so it is easy for traders to know where the curve is because it is always trading," said an Atlantic-based broker.
The energy crisis may be that change: market participants have started to look at, and trade, the Platts NWE-JKM spread, which compares European LNG to Asian LNG. This removes both the product difference and the time difference, leaving just the locational difference, which is the part market participants are seeking to manage.
A cleaner hedge for European trade
CME's NWM contract has traded both as a spread to Platts JKM and TFU, highlighting the two main current use cases for the European LNG derivative.
The main challenge in developing an LNG-to-LNG derivatives market or a European LNG-to-European gas market is liquidity. It is likely via spread trading that this nascent market will grow, piggybacking off the greater volume traded in TTF and Platts JKM. In fact, CME's NWM has already shown impressive growth since its launch, with 785 lots trading. This dwarfs the volume traded on JKM futures contract in the year of its launch in 2012.
Two of the NWM trades were equivalent to a full cargo of LNG. This means the new contract has likely already been used to manage cargo risk into Europe. Several of the largest LNG market participants have traded the contract, according to sources with knowledge of the trades. TotalEnergies and Vitol claimed credit for the inaugural trade of the contact on its launch day.
"We realized we have been misled in that pipeline gas no more reflects the price of an LNG cargo," said Patrick Dugas, Global Head of LNG Trading at TotalEnergies, at a December 2022 industry conference. "We will have to find a way to move ... to a Northwest Europe LNG index."
The other trades were by five different trading houses and portfolio majors, sources said.
While the market considers multiple options to manage risk, this remains the only LNG derivatives contract for Northwest Europe that has traded to date.
Given the strong start of the new contract, this could be a risk management tool to aid the industry in having cleaner hedges and sidestep significant basis risk even at much smaller divergence levels than the striking levels seen in 2022.
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