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Move Over Oil, It’s LNG

During this year’s G7 summit, Japan announced its vision of creating a LNG market to meet increasing energy demand. Natural resource markets are a foundation for trade and economic development. What is less well known is the close link between the natural resource markets and the currency markets.

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First, storage capacity must grow. The storability of crude oil makes adjusting supply possible — essential for a spot market. Likewise, more LNG tanks must be built so that supply can respond to price changes. It is commonly assumed that storing LNG is difficult due to extreme temperature requirements. However, just like crude oil, LNG storage is feasible if investment in suitable infrastructure is made.

Second, producers and suppliers must be able to trade LNG. The clauses restricting destinations that can be delivered to should be abolished or at least made more flexible. Transportation infrastructure should also expand to allow for changing demand.

Lastly, financial institutions must provide liquidity to facilitate transactions and a means to hedge risks. The construction of a LNG production base requires large investments and most LNG trade is based on a long-term contract with the oil price as a benchmark. The involvement of major electricity and gas companies made financing big LNG related investment possible. When the oil price was high, many new projects began. Therefore, the rising oil price was the major impetus for the expansion of the LNG production. However, the expansion of the market calls for the creation of a LNG price index, which reflects demand and supply globally.

The companies dominating the oil industry predominantly use the US dollar and changing the trading currency would require an appropriate market for risk hedging. LNG sales contracts are linked with the oil price and have served the industry well as the US dollar and the oil price are negatively correlated, providing a natural hedge. However, the current low oil price creates a huge gap between the future forecasts of sellers and buyers. Sellers typically anticipate the low price to continue but buyers do not. So contract negotiations based on the link to oil have become harder to conclude.

Delinking LNG from oil will be useful for new projects and will result in delinking from the US dollar. Multiple currencies should be used since contractors and oil companies are exposed to foreign exchange risk from construction activities. If the revenue stream can be matched with its underlying cost, risks can be further mitigated.

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