Record gas prices in Europe and Asia and volatile inter-basin spreads are making intense financial demands on traders to cover variation margin calls related to JKM derivatives hedging. Some smaller players are being frozen out of the market due to insufficient credit lines as the price-tag of individual cargoes has ballooned past $100 million. The two issues are distinct, but both arise from the unprecedented price volatility and outright high price levels in today’s market. The first dynamic is potentially the more worrisome for smaller players stuck with paying down escalating margin calls on hedges triggered by steep price gains.
For example, imagine a trader buys a fixed-price cargo for November delivery when JKM traded at $15/MMBtu and then re-sells it for $16/MMBtu on JKM index. The trader will have sold JKM derivatives to manage any potential price drop until cargo delivery – a typical hedging strategy. However, as the actual price of JKM escalates from $15/MMBtu to current levels of $32/MMBtu, the trader will need to finance a variation margin linked to that hedge of approximately $60 million to cover the spread. That is because while the trade on JKM index is going into the money, the JKM hedge is increasingly drifting out of the money. The issue is that the physical transaction does not settle until after delivery, but the variation margin call linked to the JKM derivative starts as soon as the hedge is executed.
While the cargo trade is making money, overall, the trader will still require a large enough balance sheet to cover escalating margin calls until both legs of the trade settle. The inability to consistently cover the variation margin every day could be enough to bankrupt or financially distress a small firm. There are rumors of smaller distressed LNG players in Europe and potentially Asia currently operating in the market that are facing this dilemma. Some players are even looking to sidestep exposures of this kind with the help of peers with bigger balance sheets than themselves. Some US offtakers are testing workarounds to avoid hedging-related exposure to different indexes by asking a counterparty to buy their Henry Hub-indexed cargo and sell it back to them on TTF index.
For offtakers with strips of cargoes loading every year, the cost of covering variation margin related to hedges on these exports soon mounts. Thus, a workaround could be an attractive proposition in today’s market. Other players cannot float the necessary standby letters of credit to their suppliers given the ballooning cost of LNG spot cargoes and these players are being frozen out of the market for now. There are similar rumors of certain Asia-based traders facing difficulties in issuing letters of credit
Meteoric JKM makes boil-off costs key
Among the unintended consequence of sky-high JKM is the degree to which it has elevated niche concerns like valuing boil-off gas. With JKM at $32/MMBtu, boil off gas costs on roundtrip voyages from the US to Asia can exceed $6 million – equal to or greater than the underlying roundtrip cost of $70,000/day freight. The effect of high boil-off costs was so pronounced that Atlantic Basin supply was incentivized to deliver to Europe rather than Asia in mid-September due to the boil-off savings. Escalating boil-off costs linked to high JKM briefly even closed the arbitrage with Asia for flexible US volumes through the whole of 1Q 2022, indicating that Europe would get all flexible cargoes especially in February and March.
The boil-off effect explains the brief uptick in Europe’s planned arrivals schedule and somewhat depressed freight rates, alongside several new vessels entering the market and plant outages limiting cargo availability. High boil-off costs are also incentivizing vessels to ballast using fuel-oil as cargo owners want to monetize every molecule of LNG, especially if heel volumes start getting sold high like last winter. However, the TTF-JKM spread has widened since then and Atlantic cargoes should have the ability to transit to Asia.
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