Mar. 2025
The Need for Flexibility
Flexibility in long-term LNG supply agreements is becoming increasingly important for several reasons:
- Rising uncertainty and volatility: The LNG market has seen extreme volatility due to external factors such as the COVID-19 pandemic, the Russia-Ukraine war, and decarbonization efforts tied to net-zero goals.
- Uncertain demand outlook: LNG demand has become harder to predict in terms of both volume and contract duration. Flexibility in contracts allows buyers to mitigate these risks.
- Portfolio optimization and LNG commoditization: For sellers, increasing volatility, the evolution of spot markets, and more trading activities offer opportunities to enhance the extrinsic value of contracts.
The market has shifted from simple, long-term point-to-point contracts to a dynamic and mature system—creating chances for significant gains.
For aggregators and portfolio players, particularly those with access to vessels and multiple offtake points (in FOB trades), flexibility is a crucial tool for optimization. Without such infrastructure, the potential benefits are reduced.
2. Types of Flexibility in LNG SPAs
Common (“Plain Vanilla”) Options:
- DQT (Downward Quantity Tolerance)
- UQT (Upward Quantity Tolerance)
- Diversion rights
These are standard contractual flexibilities.
Less Common (“Obscure”) Options:
- Pricing index and period flexibility: The ability to choose pricing mechanisms or indexation periods before delivery—rare in Asia, but valuable when included.
Flexibility terms vary significantly by contract and are subject to negotiation. For example:
- Asian and Australian LNG typically includes DQT/UQT.
- US LNG contracts, due to tolling structures, often include cargo cancellation rights (with fees).
Geographic differences matter: U.S. cargoes often include high diversion value between Asia and Europe, while Asian/Australian cargoes focus on intra-Asia flexibility.
Other flexibilities include delivery window selection, extension options, and heating value adjustments.
3. Valuation of Options (Flexibility) in LNG Contracts
Why Valuation Matters
As interest in contract flexibility grows, monetizing it can facilitate more transparent negotiations.
- Buyers requesting more flexibility will likely face a price premium.
- Conversely, sellers may offer discounts if buyers allow added seller-friendly terms.
Valuing flexibility helps:
- Make price comparisons more accurate than simply comparing headline prices.
- Benchmark contract competitiveness.
- Inform better decision-making.
⚠️ However, the valuation must be based on reasonable, experience-based assumptions. If done poorly, it can misrepresent the real value or distort the competitiveness of the base price.
Valuation Methods and Assumptions
Flexibility in LNG SPAs resembles financial derivatives:
- Call option analogy: UQT gives buyers the right to purchase additional LNG at a pre-agreed strike price (contract price), similar to paying a premium for a call option.
Valuation Techniques Include:
- Black-Scholes-Merton and its variants – applied to relevant option types.
- Spread options – e.g., DQT value based on the spread between futures and spot prices (Brent futures for oil-indexed contracts, JKM for spot LNG).
- Stochastic modeling & Monte Carlo simulations – account for volatility using historical (e.g., 2016–2020) and forecast data (2026–2030).
Valuation results vary by assumptions and market context, emphasizing the importance of case-by-case consideration during negotiations.
4. Valuation Results
Three methods were used:
- Forward Valuation – using forward curves.
- Historical Valuation – based on past price movements.
- Stochastic Valuation – using Monte Carlo simulations.
Key Takeaways:
- DQT, UQT, and cargo size variation options show similar values across all three methods.
- Historical valuation typically yields higher values than forward valuation, likely due to greater historical volatility.
- The choice of market reference (e.g., Brent vs. JKM) significantly affects valuation outcomes.
- Brent-based seller options showed low value in forward valuation due to flat futures curves—underscoring the limitation of this method for certain types.
- Seasonal delivery options lacked representation in stochastic models, which failed to reflect real-world summer-winter seasonality in LNG.
Each method has strengths and weaknesses; using multiple approaches is ideal.
5. Final Thoughts
Edi’s work highlights a key issue:
Buyers tend to favor stability, which makes it harder to assess the full value of options—despite pricing-related flexibility often offering the highest economic impact.
Another interesting point: the term “rights” (as in “diversion rights”) implies ownership of discretion, yet in practice, most such clauses require seller’s consent. So, does “right” truly apply here?
Finally, excluding data from 2021–2025 may limit the study’s relevance. Given the unprecedented price volatility during that time, omitting it could skew the results.
Even if forward prices for 2026–2030 seem reasonable, the exclusion of 2021–2023 data (peak volatility) makes the conclusions feel incomplete.
Was this exclusion to enhance credibility by avoiding abnormal data—or does it weaken the analysis?
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Reference: “Options Valuation in LNG Contracts” by Edi Saputra