Time for Return of Higher Slopes in the LNG Market?
Low oil prices and low slopes are a deadly combination for sellers. In the world ahead of us, with low oil prices and buyers stuck at slopes in the 11% range, the vast majority of sellers cannot
recover their costs for new projects.
The oil price war initiated by the Saudis and the massive demand destruction by COVID-19 mean we have a step change to a world of oil in the US$40-50/bbl range for some time, even
after the price war has settled and COVID-19 has passed. In this world, slopes of 10-11% do not work.
Buyers need to be realistic. LNG prices of US$4-6/mmBtu over the long term are not sustainable. We may well need to return to slopes of 12-13% to make the equation work
economically and psychologically.
But the buyers are intent on getting lower slopes. Slopes have been falling from the high of 15% to the 11% range. We had expected further erosion to the 10% range by late-2020. However,
COVID-19 and the oil price war have dramatically changed the equation. Low slopes are simply not viable anymore, at least not for new projects at today’s oil price.
Some buyers may prefer to buy on a JKM basis instead of accepting higher slopes. But any mid – to long-term contract based on JKM is likely to require a minimum price, probably on a Brent
basis, to offer downside protection and enable sellers to cover costs. Naturally, there should also be a maximum price to offer upside protection for buyers. This is especially applicable to all the
Qatar Petroleum, Novatek, and PETRONAS may well be able to offer lower slopes by relying on existing production and recent FIDs. However, it is next to impossible to expect new projects to
survive on low slopes. Eventually, buyers will suffer if new projects do not take FID.
It is time for a fundamental change of approach to LNG procurement. S-curves helped buyers and sellers come to an agreement in the past, with protection for both sides. A JKM-linked
formula with downside/upside protection seems the most relevant in today’s market. Oil indexation will remain an important element of the market, but at slopes which deliver a price that
justifies new LNG projects.
Virus vs. Price War: The Oil Market’s Ugly Mess
The world is watching the oil market in a state of shock. COVID-19 has destroyed demand. OPEC has destroyed the supply order by adding too much production.
To be sure, once April 1 arrives, the price can fall further to below US$20/bbl or even below US$10/bbl. Why is this happening, and what will come out of it? How much more demand will be lost? How long will this war go on for, and how far can prices sink?
I am sure that tolerating this pressure beyond three months is extremely hard and beyond six months may be impossible. The problem is that it is not enough to just agree to cut. Oil producers need to get rid of the inventory they are building now, which means a return to US$55-65/bbl price may be out of reach for a long while.
Can OPEC/Saudis increase production as they had threatened? Not really! Demand destruction means much lower crude runs for the refineries. If refineries do not want the crude, they will not buy it. Can all the crude go into storage? Surely not. The oil will have to stay in the ground!
Why did the Saudis initiate this price war?
First, they wanted to show the power and muscle of Aramco. They were fed up with trying to persuade everyone to collaborate.
Second, they wanted to teach the Russians a lesson.
Third, they wanted the world, and especially President Trump, to politically intervene. As President of G20, they will get a lot of political requests to halt the price war. Everybody will know how critical they are.
Fourth, the Saudis and the Russians wanted to see a slowdown in US tight oil activity. The current price collapse is likely to shave off up to 1 mmb/d from US crude output in 2020. But the initial impact will be small, as many have hedged up to two-thirds of their crude till late summer or later. US shale will not die. The infrastructure is there and so is the resource. Some producers will go bankrupt and someone else, probably one of the majors, will buy them out. It will re-appear more efficient and stronger in a year or two with higher oil prices.
We all need to remember this is not the first price war. This is actually the fourth one: 1986, 1997, 2015 and now 2020. All price wars were initiated by the Saudis getting fed up with others, before finally backing off after a few months, with some back and forth each time. This time will very likely be the same, except COVID-19 has changed the demand dynamics radically.
Which is more responsible for the oil price mess: COVID-19 or the Saudi price war? Clearly COVID-19.
Let us think of a scenario where the Saudis and Russians had actually agreed on the production cuts and avoided the price war. Where would oil prices be today? Probably not far off from where they are today: in the US$30/bbl range. With worldwide demand destruction of possibly 10-15 mmb/d which we are seeing now, the price would have tumbled anyway, even if a 3-4 mmb/d production cut had been agreed by OPEC+.