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The Global LNG Gamble

The Geopolitical Risks of LNG
Fortnightly Magazine - March 2005

aren't likely to fall any time soon, project developers are skittish about building a costly LNG supply chain without having firm confidence they'll be able to recoup their costs.

Thus LNG represents a dilemma. On the demand side, buyers need a diverse, reliable, and affordable supply, and they don't want exposure to risks they cannot manage. On the supply side, gas companies need firm commitments to sell their LNG for a good price, and they can't bear the panoply of risks themselves.

The result is most LNG cargoes coming into the United States are expected to be sold on a long-term, take-or-pay basis, with prices indexed in a way that ensures cost recovery and price stability. In this scenario, little excess capacity will exist to provide much supply flexibility. And that means geopolitical and risks come home to roost in the offtake market.

"You are putting choke points into your supply line," says Dr. Cyril Widdershoven, a strategic policy analyst based in Amsterdam. "If something happens at a choke point, the whole chain will be disrupted and there won't be enough capacity somewhere else to cope with the blockage."

Contract terms and risk-management instruments might eventually address some of the financial risks associated with possible supply disruptions, but thus far such mechanisms remain theoretical. How they might be structured and what they might cost is unknown.

"That is going to be one of the biggest challenges," says an LNG attorney who spoke to the Fortnightly on condition of anonymity. "Pricing and risk-allocation terms tend to be very confidential, and a standard model hasn't been developed yet."

The LNG industry's legacy of long-term transactions exacerbates the problem, because contracts have tended to be complicated one-off documents. No clear approach has emerged to develop standardized legal approaches to contracting and risk allocation. 3

risks, in particular, are difficult to address. "It's a hot topic because the cost implications of a force-majeure outage are enormous for an LNG train," the attorney says. "One LNG shipment represents a huge amount of money, and it's hard to imagine that a single entity could bear all that risk. Effectively you are importing a significant amount of risk that rolls all the way back to production fields in a country that might have a significant amount of political risk. There's no market solution sufficient to deal with that."

Political risk insurance is obtainable, of course, from such agencies as the U.S. Overseas Private Investment Corp. (OPIC) and the Multilateral Investment Guarantee Agency (MIGA). This product can address risks from events like terrorism or political upheaval, but generally it protects financial investments, not operating risks. As a result, even if the infrastructure in an LNG supply chain is covered by political-risk insurance, such coverage probably would be ineffective at protecting a utility from a supply disruption or cartel action.

Commercial insurance and hedging products might be able to address the issue, but such products don't exist today. Because the risks are novel and the potential losses enormous, developing such products on a custom basis likely will be costly and might