China’s LNG policies and their increasing worldwide impact

China Economy
In this Sunday, July 15, 2018, photo, shoppers take escalator at the capital city's popular shopping mall in Beijing. China's economic growth slowed in the quarter ending in June, adding to challenges for Beijing amid a mounting tariff battle with Washington. (AP Photo/Andy Wong)
Penelope Warne
Opinion by Penelope WarneSenior partner & head of energy, CMS, and Louis Peng (Beijing Office)

China’s growing demand for non-contractual liquefied natural gas (LNG) will change the landscape in the next few years, influencing the global market, LNG prices, international LNG supply agreements and China’s domestic gas industry.

In 2017, China became the biggest driver of global LNG consumption growth and the second largest LNG importer in the world, second only to Japan.

According to Standard & Poor’s Global Platts Analysis, China’s LNG demand is expected to double by 2023, reaching 68 million tonnes per year. By 2030, China’s LNG demand is expected to surpass Japan’s, making China the world’s largest LNG consumer.

The promotion of the “coal to gas” policy in China’s power industry, GDP growth and the industrial recovery are pushing the country’s gas consumption to an all-time high.

Constrained by domestic production and the capacity to import gas via pipelines, China’s demand for LNG will become more urgent to compensate for the gap between supply and demand. This is especially the case in the eastern coastal areas of China, which are densely populated and far away from natural gas fields or pipelines.

China’s contracted LNG imports will lag behind the country’s expected demand for the next five years. By 2023, more than a quarter of the LNG demand in the Chinese market will not have been implemented through the signing of import contracts, so this is likely to push up the spot demand for LNG, and so demand will need to be met via the spot market.

The LNG spot market is favoured

China’s growing dependence on spot LNG purchases is making the country play an increasingly important role in the international arena and is profoundly influencing the global LNG market and prices.

China’s ability to solve the bottleneck of LNG production caused by an inability to meet gas demand domestically, and its ability to cope with the limitations of gas transportation via pipelines during the peak season for heating and gas consumption in winter, will greatly influence the seasonal fluctuations of global LNG prices.

From the perspective of the domestic market, import volumes from the spot market without fixed contracts have increased, despite fixed-term contracts being more advantageous. This will have a greater impact on the spot price.

Due to the rise of spot market demand and the increased number of practitioners actively participating in the spot market, competition for LNG trading in the downstream market will also intensify.

More Chinese companies are rushing to enter the LNG trading market, driven by the growth of domestic consumer demand, and the trading opportunities stemming from the difference between the LNG spot market price and the regulated central price or the oil-linked LNG contract price.

These Chinese independent market players have also signed a large number of LNG import contracts in the past. In 2017, total import volumes through long-term contracts by China’s non-state-owned enterprises/importers reached 500,000 tonnes, accounting for 1.3% of LNG imports by domestic companies. This number will jump to 4.42 million tonnes in 2020, accounting for 10% of these types of imports.

As state-owned LNG companies are reluctant to open their gas terminals to third parties, some Chinese independent importers would rather build their own LNG pipeline networks in spite of the capital expense, taxes and cumbersome approval processes in China to do so.

As competition intensifies, domestic calls for the liberalisation of the gas industry are growing. Relevant policies will soon develop and the flexibility of international supply agreements will increase. This is both an opportunity and a challenge for global LNG market participants.

Domestic policies and traditionally rigid LNG contracts are under pressure in China

In the context of the demand for gas increasing, state-owned natural gas giants are increasingly pressurised by the government to open gas terminals and pipeline infrastructure in order to increase supply security and cost-effectiveness for end users. In 2017, the utilisation rate of China’s LNG terminals was 65%.

As the proportion of LNG in China’s gas supply increases, there is an urgent need to introduce a local pricing system that better reflects the fundamentals of the LNG market.

This will inevitably have an impact on the traditional supply model, which is based on long-term contracts and the “take or pay” principle. Since the LNG price in long-term contracts is linked to other bulk commodities, this pricing system may result in a gap between the contract price at the time of signing and the market price at the time of delivery.

In a market with strict supervision and monopoly, the risk of a price difference between the long-term agreement price and the market price is still controllable. However, in a market where the downstream competition is becoming fiercer, and the fundamentals and price of the international spot market are becoming significant, the risks from price differences will increase.

This phenomenon in China is gradually challenging the global LNG traditional supply model, and the market prefers an independent pricing contract model which is short-term, flexible and of small-amounts, not linked to other related bulk commodities.