Dr Robert Ritz, Faculty of Economics & EPRG, University of Cambridge
Not so long ago, there was a widespread conjecture that gas prices around the world would converge, with international trade in liquefied natural gas (LNG) connecting the regional markets of Asia, Europe and the US. Indeed, since the early 2000s, LNG infrastructure investment has increased and trade has grown significantly. Contracting arrangements have become more flexible, and trade in short-term markets now makes up 25% of total LNG sales.
Yet gas prices around the world today vary widely: The average price of natural gas in 2012 was roughly US$16/MMBtu in Japan, $9 in European markets, but only $3 in the US. In short, the gas market appears far from global. Also, some industry observers argue that LNG exporters have been behaving “irrationally” by failing to engage in price arbitrage. For example, for Qatar’s short-term sales to the UK – rather than to Japan – some estimates suggest a forgone profit of up to $100 million per day.
The most immediate explanation for price divergence lies in transport costs. A simple perfectly competitive model predicts that the price differential between two regions served by an exporter is equal to the difference in transport costs – so netbacks (price minus transport cost) are the same. The problem is that this theory cannot explain recently-observed prices. For example, gas prices have been $10/MMBtu higher in Asia than in Northwest Europe but corresponding transport costs from the Middle East are approximately identical
This paper instead suggests that regional price differentials arise because of LNG exporters’ market power. In general, profit-maximization implies that a producer equalizes marginal revenue, net of the marginal cost of production and transport, across any two export markets. For an exporter with market power, the “arbitrage” process stops when its marginal revenues are equalized; it is entirely possible that this optimally leaves prices across markets far apart. This basic argument holds for almost any economic model of competition.
Incorporating market power rationalizes recent price divergences and trade flows by tracing them to differences in demand conditions. For instance, individual LNG producers may perceive lower demand elasticities in Japan – leading to higher prices – because of the nuclear power shutdown following the Fukushima accident. Also, Asian LNG buyers generally may be more concerned about “security of supply”.
What if the US becomes a large-scale LNG exporter? Our analysis makes clear that US and non-US prices will not necessarily converge as a result (even adjusting for transport costs). So any model-based analysis of the impact of US LNG exports is likely to be incomplete if it does not take market power into account.
We also discuss in detail how different features of the LNG market either limit the ability of other player, such as LNG buyers and third-party traders, to engage in arbitrage or create incentives that work against pursuing arbitrage in the first place. We conclude with a preliminary discussion of the potential effects of greater price arbitrage – in the future – on LNG prices, industry profits, and social welfare.
Keywords: International trade, limits to arbitrage, market power, natural gas, price discrimination