Destination Clauses – Japan got it all messed up

Anyone following the current flurry of activity in the Asian LNG marketplace must be startled. The casual LNG observer might have the impression that it’s some contractual clauses that are at the heart of the problem. And that their modification – or even better their removal solves all ills of the world. 

That’s an almost fraudulent misrepresentation of how things stand for real. Those who entertain it either don’t have a clue of the inner workings of LNG and even energy markets. Or they are vicious fraudsters. 

Let’s pull one thing straight first. Japan is currently investigating destination clauses. Did anyone expect such an investigation 3 years ago? Certainly not, as Japan wanted all LNG they could lay their hands on in their terminals. The world was still in undersupply.

But now we are in oversupply. Those destination clauses – assuring them of stable supply when it was needed – become an economic burden.

Have those Japanese negotiators not known that whatever forms a contractual advantage may just as easily turn into a contractual liability? 

It always only depends on the state of the market. Plenty of LNG and you want to be able to find some of the contracted LNG off into the wider world. A scarcity of LNG and you want to be sure you can force the supplier to come to your place and not someplace that pays better than you are willing to.

This story of looking into Destination Clauses right now smacks a lot of Japan wanting to have its sandwich and eat it at the same time. You might say – fair enough. In the recent past, sellers were outrageous in their behavior and their demands too. Still, that does not make Japan a moral authority in LNG now.

Yet, their urge to game the market better is understandable. At least from an economic perspective. Most Japanese buyers had over-contracted long-term LNG during the years up to 2014. There was a feeling that there would never be quite enough of the stuff so it’s better to get what you can lay your hands on.

They fixed themselves quite an expensive sandwich in the process. While LNG prices globally were on the high side, this did not matter much. When everyone is in the same boat, one does bite the bullet and eat humble pie. 

But now that the world is basking in cheaper energy, those same utilities bingeing on expensive long-term LNG get their butts kicked.

And yes, destination clauses have become some sort of an oddity since the EU has eradicated them from contracts. This brought LNG (and of course pipeline gas) into the common market. Is the stance of Japan towards Destination Clauses comparable with what the EU did 10 years ago?

In the EU, it was the consequence of the general liberalization of the internal EU gas market. It was – at that time – well underway for many years. The removal of Destination Clauses was only one aspect of this general drive. Besides, the world at the time was on the cusp of a seller’s market. It was not market pressure that dictated those moves but rather a general desire to end restrictive practices. They wanted to force the old boys to break up their cozy structures. Those old players were not happy with those liberalizing tendencies at the time.

In Japan, there is no generalized market to speak of. Strangely, this investigation happens when Japanese utilities are buckling under the weight of the old contracts. And sellers cry foul. They fear for their Project Financing arrangements that have come under assault with lower prices. Pushing this a little further one might be justified in thinking that sellers want to ensure every single drop of LNG contracted to Japan goes there. So the utilities ease their coal binge a little and hence would not diminish the LNG market in the process.

But I digress.

How could we help hard-pressed Japanese utilities without breaking the bank then? Most term LNG going to Japan is Delivered Ex Ship (DES). This means that the seller controls the transport link. He hence passes ownership of the LNG at the flange of the receiving terminal. In such a case, the Destination Clauses don’t matter that much. One must have the contractual right to order the vessel to divert away. This is hard if you don’t own the vessel or title of the LNG. Strictly speaking, it’s the seller’s LNG until the terminal flange. Take or Pay (ToP) ensures that you have to take it if he shows up at your terminal at the agreed slot. He must show up and you must take it.

Of course, there is a problem if the buyer cannot take it as the tanks are full. He would have to pay for the cargo regardless. The seller is then stuck with a vessel that he cannot unload but which he needs to empty for the next cargo. A perfect stalemate then. What the buyer needs is less or no ToP. The seller can impossibly accept this. It breaks his Project Financing – which rests on the assumption that the buyer will always pay the agreed price – completely. Opening this is a can of worms.

What is sorely needed is cooperation between the seller and the buyer. And this is what this drive for the removal of Destination Clauses is really about. Japanese utilities want to be able to force sellers to redirect their vessels to other destinations if the buyer tells them so.

Many of them have established trading divisions to sell the excess LNG off into other markets. Sometimes as far away as Europe. This activity is in itself a huge drain of resources to them. 

Right now, diverting cargo away from Japan involves landing them there first. Then having them unloaded in a Japanese terminal. Then having them reloaded into a new ship to comply with the Destination Clause. Finally having the new ship go wherever it must go. 

This is very expensive. Plus it puts a huge strain on their planning departments. Those Japanese terminals are not built for this kind of thing.

Having the (theoretical) possibility to divert the cargo while it’s on the way to Japan or even better, to remarket it before it is even loaded at the producer’s terminal would make things a terrible lot easier and cheaper. Destination Clauses prevent that from happening. The only effective and safe (for the buyers) way to deal with that is if the Japanese government declares them unlawful. A bit like the EU did many years ago.

The utility buyers cannot break the news on this to their suppliers without problems – they must save face. It’s much easier if they can pretend that it’s not them but the public authorities who want this. They are merely complying with what the regulator, government, or whatever other authority asks them to. This little stratagem allows the utilities to tell their suppliers that this is some sort of Force Majeure that they must comply with. Thus please let’s take out the Destination Clause. It lets them save face while saving a buck. And it also lets the sellers save face while they wrestle with their lenders.

This is – of course – just a theory of mine. Nobody in Japan will ever admit this but it makes a hell of a lot of sense and I would do it would I were in their place.

Besides, to the sellers, it should not matter much to take the Destination Clauses out. As long as the buyers are happy to pay the pre-agreed price formula it should not matter to them where the cargo goes. The times when suppliers could manage the world market are over. Some suppliers have spot marketing arms that they fear will be outcompeted by those Japanese utilities. Those utilities are willing to undercut spot prices to get rid of cargo. This is, of course, toxic to spot sellers anywhere. Besides, Japan is currently rejigging its power production portfolio away from LNG and oil towards more coal. This means that LNG use is going down. Breaking the Destination Clause would help them a lot to drive this change.

Suppliers are in oversupply pains anyhow. They fear even more LNG on the world market from Japan which uses less of it. Japan keeps the pressure on prices intact by their actions which is good for them as a buyer.

Yes, I think that this time it’s serious. I also think that Japan uses this to apply pressure on suppliers not only to break the Destination Clause. They also want to lower price levels. Again, that can never be said in the open. This is much harder to acquiesce to by sellers as it threatens their economic models.