Long-term Contracts and Efficiency in the Liquefied Natural Gas Industry

Abstract

In many capital-intensive markets, sellers sign long-term contracts with buyers before committing to sunk cost investments. Ex-ante contracts mitigate the risk of under-investment arising from ex-post bargaining. However, contractual rigidities reduce the ability of firms to respond flexibly to demand shocks. This paper provides the first empirical analysis of this trade-off, focusing on the liquefied natural gas (LNG) industry, where long-term contracts account for over 70% of trade. I develop a model of contracting, investment and spot trade that incorporates bargaining frictions and contractual rigidities. I structurally estimate this model using a rich dataset of the LNG industry, employing a novel estimation strategy that utilizes the timing of contracting and investment decisions to infer bargaining power. I find that without long-term contracts, sellers would decrease investment by 27%, but allocative efficiency would significantly improve. Negative contracting externalities lead to inefficient over-use of long-term contracts in equilibrium. Policies aimed at eliminating contractual rigidities reduce investment by 16%, but raise welfare by 9%.

Keywords: Long-term Contracts, Spot Markets, Under-investment, Nash Bargaining, Contracting Externalities, Market Power, Liquefied Natural Gas

JEL Classification: D22, D23, L13, L14, L22, L42, Q41