Liquefying a Market: The Transition of LNG to a Traded Commodity

9 Pages Posted: 12 Apr 2017

See all articles by Craig Pirrong

Craig Pirrong

University of Houston - Department of Finance

Date Written: Winter 2017

Abstract

The Liquefied Natural Gas (LNG) industry has grown significantly since it began a half‐century ago, and it will continue to diversify both its sources of supply and the contractual arrangements between suppliers and users. Economic theory says that contracting modes adapt to facilitate gains in efficiency, and that this process of adaptation responds to changes in technological, market, and regulatory factors. When an industry relies heavily on highly specialized assets with limited alternative uses, as is true of LNG, the use of long-term contracts (or vertical integration) will generally be more efficient than short‐term dealings. But once conditions begin to encourage vigorous competition among buyers and sellers, it becomes increasingly economical to rely on shorter‐term (and spot) markets for exchange. The history of the LNG industry supports these theoretical predictions, and illustrates the transition from one contracting mode to another. For most of its history, the specialization and scale of LNG assets dictated the predominant use of long‐term contracting. In recent years, however, market and regulatory changes have raised the demand for short‐term and spot contracting, which in turn has provided the impetus for a virtuous cycle of market liquidity. As buyers and sellers have become increasingly able to obtain or dispose of LNG in an active market, they have needed less protection against the opportunism of trading partners that long‐term contracts have provided in the past. Given this self‐reinforcing process, it is likely that the LNG market will soon look nothing like it did as recently as a decade ago. Buyers and sellers will rely on shorter‐term contracts, and the longer-term contracts that do exist will be linked to spot LNG prices rather than crude oil. Consumers and producers will also benefit from more flexible pricing that more accurately reflects rapidly changing fundamentals of supply and demand.

Suggested Citation

Pirrong, Craig, Liquefying a Market: The Transition of LNG to a Traded Commodity (Winter 2017). Journal of Applied Corporate Finance, Vol. 29, Issue 1, pp. 86-92, 2017. Available at SSRN: https://ssrn.com/abstract=2950841 or http://dx.doi.org/10.1111/jacf.12222

Craig Pirrong (Contact Author)

University of Houston - Department of Finance ( email )

Houston, TX 77204
United States

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