Using a Market Value Concept to Facilitate Negotiation of Alternative Price Formulas 6 December 2006 Kaoru Kawamoto Osaka Gas Co., Ltd
Table of Contents 1. Background 2. Definition and Methodology Defining the market value of LNG price formula Methodology of evaluating its market value 3. Example of Evaluation S-curve formula indexed to crude oil price Linear formula indexed to natural gas price
Table of Contents 1. Background 2. Definition and Methodology Defining the market value of LNG price formula Methodology of evaluating its market value 3. Example of Evaluation S-curve formula indexed to crude oil price Linear formula indexed to natural gas price
Variation of S-curve S formulas Relative level among different formulas varies along crude oil price. LNG ($/MMBtu) C<B<A B<A<C A<B<C Formula CC Formula BB Formula AA 40 50 60 Oil ($/bbl)
Level of price formula varies along fluctuating oil price It difficult to negotiate on an expected crude oil price. As a result, sellers and buyers press their own subjective arguments. Finally, price formula negotiation often becomes deadlocked. LNG($/ $/MMBtu) Formula CC Formula AA Formula BB Oil ($/bbl)
Goal of this study : Develop a methodology for evaluating market value of LNG price formula Objective and quantitative methodology to compare different formulas would make it easier to agree between sellers and buyers. Buyer Seller Formula C Formula B Formula A 2.0 2.5 3.0 3.5 4.0 4.5 5.0 5.5 6.0 (cent/mmbtu)
Table of Contents 1. Background 2. Definition and Methodology Defining the market value of LNG price formula Methodology of evaluating its market value 3. Example of Evaluation S-curve formula indexed to crude oil price Linear formula indexed to natural gas price
S-curve formula can be decomposed into oil derivative LNG ($/MMBtu) k 1 k 2 Oil ($/bbl) = + Oil k 1 Oil k 2 Oil
S-curve formula can be decomposed into oil derivative LNG ($/MMBtu) = a SWAP Payment +b + k 1 k 2 Put Option Payment Oil ($/bbl) Call Option Payment Oil k 1 Oil k 2 Oil
Defining the market value of LNG price formula Market value of LNG price formula can be defined as the market value of crude oil derivatives replicating the formula. (A linear combination of SWAP, Call Option, and Put Option.) Market value of S-curve S formula for 3yrs : = a Oil SWAP for 3yrs + b Oil Call Option for 3yrs + c Oil Put Option for 3yrs
Liquidity in crude oil derivative market Market price of Futures and Option can be quoted from NYMEX. However, the liquidity in long maturity Option market is not enough. Future (SWAP) Call Option Put Option 1 st yr 2 nd yr 3 rd yr 4 th yr 5 th yr 6 th yr 7 th yr 8 th yr
Methodology of evaluating option prices Step1.Adjust parameter for price model ds / S = [ µ ( t) α ln St ] dt + σdz() t Step2.Generate probability distribution of future prices Step3.Calculate market value of options (1 st yr-) Probability Oil ($/bbl) 15 Call Option (Strike=30) 30 Forward Curve Put Option (Strike=15) 3 rd month 1 st year 3 rd year Future Enough liquidity No liquidity Option Market
Procedure of Evaluating Market Value of price formulas LNG 1 st yr Crude Oil Futures up to 7 th yr Crude Oil Options up to 1 st yr LNG 1 st yr Oil Financial Engineering Crude Oil Options over 1 st yr ahead Oil
Table of Contents 1. Background 2. Definition and Methodology Defining the market value of LNG price formula Methodology of evaluating its market value 3. Example of Evaluation S-curve formula indexed to crude oil price Linear formula indexed to natural gas price
Examples of evaluating market value of S-curve S formula Sellers and buyers are discussing upper kink point and high price band slope LNG (cent/mmbtu) slope=? kink point=? slope=? kink point=? slope=? slope=8 slope=5 200 15 kink point=? Oil ($/bbl) Buyer Seller
Drawing equivalent line chart from results High price band slope(a3) Evaluating date = August 1, 2003 ( WTI = 32 $/bbl at prompt) 8 7 6 5 4 3 2 1 0 Formula A 350 (cent/mmbtu) 345(cent/mmBtu) 340 (cent/mmbtu) 335(cent/mmBtu) 330(cent/mmBtu) 325(cent/mmBtu) Formula B 22 24 26 28 30 32 Upper kink point(p 2 ) Unit: $/bbl Formula A > Formula B Formula C = Formula B
Market value differs among evaluating dates High price band slope(a3) 8 7 6 5 4 3 2 1 0 Evaluating date = August 1, 2003 ( WTI = 32 $/bbl at prompt) Formula AA 350 (cent/mmbtu) 345(cent/mmBtu) 340 (cent/mmbtu) 335(cent/mmBtu) 330(cent/mmBtu) 325(cent/mmBtu) 22 24 26 28 30 32 Upper kink point(p 2 ) Unit: $/bbl High price band slope(a3) Formula BB 8 7 6 5 4 3 2 1 0 Evaluating date = September 27, 2006 ( WTI = 63 $/bbl at prompt) Formula AA 600 (cent/mmbtu) 560 (cent/mmbtu) 520 (cent/mmbtu) 480 (cent/mmbtu) 440 (cent/mmbtu) 400(cent/mmBtu) Formula BB 22 24 26 28 30 32 Upper kink point(p 2 ) Unit: $/bbl Formula A < Formula B on Aug 1 st 2003 Formula A > Formula B on Sep 27 th 2006
Application to linear formula indexed to natural gas Sellers and buyers are discussing slope and constant LNG (cent/mmbtu) slope=? constant=? slope=? constant=? slope=? Constant=? Natural Gas (cent/mmbtu) Buyer Seller
Drawing equivalent line chart from results Constant(b) 0-20 -40-60 -80-100 -120-140 Formula C 520 (cent/mmbtu) Formula B 600 (cent/mmbtu) 560 (cent/mmbtu) 0.8 0.85 0.9 0.95 1 1.05 1.1 Slope(a) 680 (cent/mmbtu) 640 (cent/mmbtu) 760 (cent/mmbtu) 720 (cent/mmbtu) Formula A Formula B > Formula A Formula C = Formula A Evaluating date = Sep 27 2006
Seasonality of take-up pattern affects market value of LNG price formula indexed to natural gas Natural gas price has seasonal variation (It is higher in winter). As a result, LNG procurement costs priced by natural gas indexed formulas are affected by the seasonal variation of take-up. Forward curve Crude oil ($/bbl) Monthly pattern of take up North American Gas (cent/mmbtu) JAN FEB MAR APR MAY JUN JUL AUG SEP OCT NOV DEC T ( Gas Price) < ( Gas Price) t= 1 t= 1 T
Equivalent line chart varies along the take-up pattern Case1. Take-up pattern = flat Case2. Take-up pattern = seasonal (30% higher in winter and 30% lower in summer than intermediate months) Constant(b) 0-20 -40-60 -80-100 -120-140 take-up pattern=flat take-up pattern=seasonal * 600 (cent/mmbtu) 560 (cent/mmbtu) 520 (cent/mmbtu) 0.8 0.85 0.9 0.95 1 1.05 1.1 Slope(a) 680 (cent/mmbtu) 640 (cent/mmbtu) 760 (cent/mmbtu) 720 (cent/mmbtu)
High price band slope(a3) 8 7 6 5 4 3 2 1 0 Comparing market value of LNG price formulas with different shapes or different indices S-curve formula indexed to crude oil price Formula AA 600 (cent/mmbtu) 560 (cent/mmbtu) 520 (cent/mmbtu) 480 (cent/mmbtu) 440 (cent/mmbtu) 400(cent/mmBtu) 22 24 26 28 30 32 Upper kink point(p 2 ) Unit: $/bbl Evaluating date = Sep 27 2006 Constant(b) 0-20 -40-60 -80-100 -120-140 Linear formula indexed to North American Gas take-up pattern=flat take-up pattern=seasonal * Formula DD 520 (cent/mmbtu) 680 (cent/mmbtu) 600 (cent/mmbtu) 560 (cent/mmbtu) 640 (cent/mmbtu) 0.8 0.85 0.9 0.95 1 1.05 1.1 Slope(a) 760 (cent/mmbtu) 720 (cent/mmbtu) Evaluating date = Sep 27 2006 Formula A = Formula D (take-up pattern is flat) Formula A < Formula D (take-up pattern is seasonal)
Conclusions 1. We have established a methodology of evaluating market value of LNG price formulas by breaking down it into crude oil derivatives. 2. This methodology makes it possible to compare different price formulas (different indices or forms), for example, S-curve formula indexed to oil price, linear formula indexed to oil price, and linear formula indexed to natural gas price. It is also possible to find formulas which are equivalent but have different indices or forms. 3. This methodology is for comparative evaluation of different price formulas, not for judgment on the appropriateness of the market value level for a price formula. 4. Next step is to establish a methodology of evaluating market value of LNG contract clauses other than price, such as flexibility in take-up quantity. Finally, we would like to establish allencompassing market value evaluation for LNG contracts.