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Can the Search for a Global LNG Benchmark End With a European or U.S. Natural Gas Contract? – Column
Editor’s Note: This column is part of a regular series by industry veteran Brad Hitch for NGI’s LNG Insight dedicated to addressing the complexities of the global natural gas market.
While the early LNG market mostly developed in Asia and the Middle East, the super-chilled fuel was first commercialized in the United States and Europe.
Many of the earliest contracts – particularly for the import of Algerian LNG to the United States – could not survive waves of American regulatory change or gas discoveries in the North Sea. By the time LNG imports began to be reconsidered at the turn of this century, the natural gas markets in North America and Northwest Europe had been completely transformed by forward and futures contract trading.
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This column, the second in a three-part series, considers whether one of the products born of that transformation, either Henry Hub in the United States or the Title Transfer Facility ((TTF) contract in Europe, could play the role of global LNG benchmark.
Over the last two decades, there’s been a marked increase in the integration of the global LNG market. Nowhere can this be seen more than in the changes in relative market share of North America and Northwest Europe. Between the years 2001 and 2010, their combined share of LNG imports grew from 15% to more than 20% – notwithstanding the fact that the global market doubled during the same period.
The shale revolution all but eliminated U.S. LNG imports after 2014. Between 2016 and 2021, U.S. exports grew from almost nothing to account for roughly 18% of the global market. Northwest Europe’s imports continued to hover around 15% of the market.
In considering whether this significant involvement in trade flows will propel Henry Hub or TTF to become the global LNG benchmark there are two questions that come to mind.
First, does either benchmark allow the LNG industry to manage its price and operational risk? Second, can either benchmark act as a price signal and trigger investments that the LNG industry needs?
When thinking about the utility of a price benchmark in risk management, the first consideration is whether the price ties directly to a liquid derivative market that can be used for hedging. The TTF and Henry Hub benchmarks both pass this test with flying colors.
Henry Hub is the world’s most liquid natural gas market contract and one of the most heavily traded commodity contracts in existence. Although the imposition of price caps on TTF could cause problems in the future, the Dutch instrument’s rapid emergence as the de facto European benchmark is quite impressive, and it should continue to provide sufficient liquidity to hedge LNG cargoes.
The second consideration is whether the benchmark can be used to create a price formula that can be replicated in the spot market. As noted in the first column of this series, in a market where gas demand from power generation must fit alongside renewables, buyers will need volume flexibility. The ability to minimize differentials between spot prices and longer-term price formulas will be ever more important.
As natural gas rather than pure LNG benchmarks, the ability to replicate a Henry Hub or TTF link will depend upon either benchmark maintaining a consistent and predictable spread to the LNG spot price. Unfortunately, the spread between spot prices and natural gas futures has been extremely volatile over the last few years. More recently, LNG prices in Europe were about $20 below the TTF benchmark, a shift from LNG trading at a premium to TTF as it has for many years.
In order for either gas benchmark to maintain a stable spread to LNG spot prices, its wholesale market will need to establish a fundamental link to the LNG market wherein the LNG price will set the gas benchmark or vice versa.
The European market has periodically set the spot LNG price over the last few years, but more typically the bid for LNG in Asia, the Middle East or South America exceeds the European wholesale price.
The reduction in Russian gas imports following the war in Ukraine caused European demand for LNG to skyrocket and created a situation where TTF set the price for LNG for a time. When the start of the armed conflict turned the reduction into outright bans, however, European regasification terminals quickly reached their practical throughput limits and the TTF to LNG spread blew out to record levels.
In order for TTF to maintain a fundamental link, LNG supply would have to be needed throughout the year and always be available in price and quantity that can help set the price in Europe. Although import terminal constraints were the problem in 2022, the biggest obstacle to a stable price differential in the long run is competition. In Europe, unlike in the traditional LNG markets, LNG ordinarily competes with local gas production and renewable power and is not always needed on the margin.
The U.S. gas market could establish a fundamental price link to LNG spot prices if U.S. LNG exports were consistently available and required to balance short-term LNG supply and demand.
The primary obstacle for the United States is to develop sufficient spare LNG liquefaction and terminalling capacity such that more LNG can always be purchased. Apart from a period of shut-ins during the pandemic, when global consumption dipped, LNG demand has kept U.S. export terminals running close to their available capacity.
Henry Hub could be on the LNG spot price margin more frequently as U.S. liquefaction capacity expands, but this will likely remain seasonal. Capacity would need to expand to the point of providing swing production during the winter months for price differentials to remain stable throughout the year.
Perhaps the best way to think about the comparative suitability of a European or U.S. gas benchmark going global is by considering the role of price signaling. Although they aren’t LNG contracts, an elevated TTF to Henry Hub spread signals a market condition that can be addressed by LNG investment – specifically in U.S. liquefaction, LNG tankers and European regasification. All three parts of the LNG value chain have seen renewed investment over the past year as that spread widened.
This highlights the fact that their use is an undoubted improvement over oil price indexation. But even so, neither delivers everything that one would look for from a global benchmark.
It is obvious that the TTF to Henry Hub will not give the correct LNG signal when Asian markets are tighter than those in Europe. What is less obvious is that it doesn’t directly address one of the key drivers of LNG price volatility – the lack of LNG storage.
This issue, and the role that it plays in reinforcing a “boom and bust” development cycle, will be addressed when we examine prospects for the adoption of a global LNG spot index in the third and final article of this series.
Brad Hitch has spent more than 23 years working in LNG and natural gas trading from London and Houston. He currently works as an adviser to new market entrants, and he has held senior trading and origination positions at Barclays, Cheniere Energy Inc., Enron Corp., Merrill Lynch and Williams. With experience that includes establishing one of the first LNG trading desks, he has participated in various stages of the global gas market’s evolution. During his time at Merrill Lynch, he worked as head strategist on the European gas desk and led an initiative to enter the LNG trading market. Prior to returning to Houston, he worked for Cheniere in London and was primarily responsible for establishing and managing a derivative trading function. He holds an MBA from the Wharton School at the University of Pennsylvania and a BA from the University of Kentucky.
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