China seen holding off LNG deliveries amid glut and high-cost domestic output

Next year, China takes delivery of a wave of new liquefied natural gas and is unlikely to default on the contracted imports in case it jeopardises its reputation with its partners

PUBLISHED : Sunday, 29 November, 2015, 11:00pm
UPDATED : Sunday, 29 November, 2015, 11:00pm

A wave of new liquefied natural gas (LNG) due to arrive on China’s shores from next year amid a gas glut will likely force the country’s oil and gas majors to hold off gas deliveries and cut high-cost domestic output, analysts say.

But they are unlikely to default on their long-term contractual natural gas import commitments worth hundreds of billions of dollars as that would jeopardise their reputation as reliable long-term purchaser partners whose commitments are key to successful development of big overseas gas export projects, the analysts said.

Instead, the domestic oil and gas majors will be more inclined to defer or cut their offtake volumes and pare high-cost domestic output to make room for imports, most of it in chilled and liquefied form carried by ocean-going tankers.

“China is still fairly new to the liquefied natural gas (LNG) procurement business. However, as a long-term strategic importer, politically and commercially China will not want to damage relations with its energy-supply partners, who should in turn make efforts to help China manage its supply requirements during this period,” business development manager at energy and transport consultancy BMT Asia Pacific, Andrew Bridson, told the South China Morning Post.

Defaults usually happen only under exceptional circumstances, such as natural disasters, war and equipment failure, which allow buyers to declare force majeure, freeing them from the obligation to take delivery and pay, he said.

Beijing has set a target for natural gas to contribute 10 per cent of the nation’s primary energy consumption by 2020, from 6 per cent last year, as part of efforts to fight chronic air pollution.

To protect state energy giants, which have suffered billions of yuan of gas import losses for years, Beijing has dragged its feet on cutting regulated domestic gas prices to align them with overseas prices following the plunge in crude oil by more than half since the middle of last year.

It finally announced earlier this month that average benchmark domestic non-residential gas price would be slashed by 28 per cent from November 20.

Non-residential gas accounts for around 80 per cent of China’s total gas demand.

The cut was needed to revive gas demand growth, which fell to 2.5 per cent in the year’s first nine months from 9.8 per cent last year and an average of 16 per cent over the past 15 years.

To save costs, many industrial gas users switched back to cheaper liquefied petroleum gas, whose prices were liberalised years ago.

Benchmark gas prices will still be slightly more expensive than some competing fuels unless oil rises above US$50 a barrel, according to a report by brokerage Sanford C Bernstein. The Brent oil benchmark traded below US$50 for most of this month.

“Gas [will still be] more expensive than fuel oil and coal but cheaper than liquefied petroleum gas, likely tempering an uptick from the sharp slowdown this year,” Barclays’ analysts said in a report. “A revival may rest more on the economic outlook and policy impetus.”

Beijing has also allowed buyers and sellers to set their own prices from November 20 up to 20 per cent below benchmark prices. They will also be allowed to price their deals up to 20 per cent above benchmark prices from November next year. This will effectively allow sellers to slash their prices by up to half the previous levels.

Global LNG imports have dropped 4.3 per cent year on year in the first nine months, as Japan and South Korea, the world’s two largest LNG importers, have cut gas usage owing to sluggish economic growth and the replacement of natural gas with nuclear energy for power generation, according to BMI Research, a unit of ratings agency Fitch.

The cutback has come at a bad time. Neil Beveridge, senior analyst at Sanford C Bernstein, estimates the global capacity to turn natural gas into liquefied form will grow by about 90 million tonnes per year, or 35 per cent of current demand, which would result in 20 million to 30 million tonnes of overcapacity annually up to 2018.

Bridson said Chinese energy majors are likely to pressure suppliers to raise flexibility on certain terms in their procurement contracts that may allow resale of some gas, renegotiation of the price, and reduction or offsetting of near-term delivery quantities.

“Much of the discussions taking place now will come to light in next year’s first quarter as buyers and sellers wait until after the winter season finishes, when prices peak due to heating requirements, and therefore can assess their sales or procurement strategy when they have a better idea on volumes,” he said.

China National Offshore Oil, the nation’s largest LNG buyer, around two months ago already offered to sell some of the LNG it has committed to take delivery of this year from Australia, according to commodities consultancy Platts.

Gavin Thompson, energy and resource industries consultancy Wood Mackenzie’s vice-president for China gas, said that in the face of additional gas supply in the next two to three years, major gas buyers such as PetroChina, China National Offshore Oil and China Petroleum & Chemical (Sinopec) are likely to seek contractual permission from the seller to reduce annual delivery volumes.

This typically is a 10 to 15 per cent cut although the volumes need to be made up via higher offtake in the later years of the 20- to 25-year contract terms.

Buyers like Chinese oil and gas majors, which are gas producers themselves, also have the option to cut or suspend production at their domestic high-cost fields, to make room for lower-cost imports, Thompson said.

“This year, this [field shut-ins] has not been an issue yet. Next year and 2017 will likely see bigger production cuts by Chinese majors in Sichuan province and Xinjiang Uyghur autonomous region to create some market space for import commitments,” he said.

While the contract terms are confidential, he said some contracts do not allow renegotiation on gas price formula – typically fully or partially linked to oil price, while others provide a window – for example every five years – for adjustments based on prevailing market conditions.

The contracts also typically have a “take-or-pay” provision that requires buyers to pay for a minimum offtake level, regardless of whether the buyer is able to take delivery of the gas.

On its strategies to cope with the gas glut, the spokesman for China National Offshore’s listed unit CNOOC said it is preparing next year’s gas production plan and can only disclose it early next year. Sinopec’s spokesman said its gas strategy is based on industry trends and market evaluation, without elaborating.

Thompson said the key to relieving China’s gas oversupply is the reduction of regulated prices and reform to allow market-based pricing so that pent-up demand is released.

Wood Mackenzie has estimated China’s gas demand growth could rise to 6 per cent to 7 per cent next year from 3 per cent this year if domestic gas price is cut by 15 to 20 per cent, and international crude oil averages US$60 a barrel next year.

Spot market LNG prices have fallen to around US$7 per million British thermal unit, from US$10 at the start of the year and US$20 early last year.

Beveridge forecasts the price to bounce back to over US$10 by 2017, and oil to get back above US$70 a barrel by the end of next year.

“We expect the glut to be followed by a famine,” Beveridge wrote in a report. “We estimate a 75 million-tonne-per-year deficit in LNG supply by 2025, which will require US$250 billion of investment between now and 2020.

“With no new LNG project being sanctioned, a new investment cycle should start in 2017 or 2018.”