On September 5th, 2013, Latham & Watkins partners Michael P. Darden and Michael King gave a presentation in Tokyo, Japan on unconventional resource development in the US and the opportunities created by changes in the US gas market for investment by Japanese companies. The presentation was well attended by representatives from trading houses, oil companies, utilities as well as the financial sector.
In this Q&A interview, Darden and King offer highlights from their presentation. For more information, view their full presentation deck here.
How has the development of unconventional resources changed the US gas market?
Success in developing gas from shales has resulted in an overabundance of supply, which in turn has had a significant downward effect on the commodity price in the United States. This has resulted in certain shale basins being out of favor and certain companies having significant downward pressure on their stock prices. Unconventional resource plays that are gas prone tend to be less favored and the unconventional resource plays that are oil prone or gas liquids prone tend to be in favor. Almost all of the early shale development was in gas plays, so the producers that really got the ball rolling on shale have, in a way, been victims of their own success.
At the advent of shale plays, the supply and demand picture was very different. There was insufficient gas supply in the US, and gas prices were very high. At that time, we were talking about importing LNG into the United States. Now, because of this plentiful supply, one of the big developments in the industry is the potential export of LNG from the United States to other countries. It really has been a sea change over the last two to three years because of the success from an operational standpoint of the companies involved in shale plays.
What level of involvement does Japan currently have in the US unconventional resource market?
Japan has been fairly active when it comes to US unconventional resource plays. Most of the investments have been made through joint venture structures with first movers in the relevant basins.
Gas is critical in Japan because Japan has minimal domestic supply. Almost all of the gas in Japan is imported as LNG and is very expensive.The Japanese see that the United States has a very good, stable source of supply for LNG projects, and with the LNG export projects that are currently under development, there is a clear opportunity for long term supply stability. Further, Japanese investors are realizing that involvement in the upstream piece, actually getting involved in the production of gas, is a good hedge against the cost of the feedstock for LNG, making investment in the gas plays a smart move. We expect to see a lot more in the near future.
How does natural gas pricing in the United States differ from natural gas pricing in Japan?
Historically, oil prices and gas prices in the United States were linked. However, the availability of gas has de-linked these commodity prices, and now US gas pricing is based on supply and demand. The most relevant price index for gas in the US is Henry Hub pricing, which is based on quotes that are made on a monthly basis for the coming month. If there is an abundance of gas and the demand for gas is low, the quote at the beginning of the month is going to be lower. US gas prices are currently quite low when compared to oil prices.
On the other hand, Japan's natural gas pricing has been and remains tied to crude oil pricing- specifically, the “Japanese Crude Cocktail” or “JCC,” which is based on the prices of a basket of crudes. Because of the linkage between gas in Japan and crude oil, landed LNG and gas prices in Japan remain very high.
What trends are you seeing in Japanese investment in the unconventional resources market and what do you expect to see in the future?
We are continuing to see Japanese companies become equity participants in upstream gas plays and we think that will continue, but continued participation may be dependent on US governmental approval of more US LNG export projects currently under development, as well as FID (final investment decision) and completion of all or some subset of those projects.
Export of natural gas from the United States requires permits from the federal government. As of the date of this Q&A interview, four projects have received the requisite export permits, and there are almost 20 additional export license permit applications pending. However, even though receipt of an export license is a significant milestone for an LNG project, it still does not ensure that the project will be developed, as market forces will determine which of the projects will ultimately get to the finish line.
How is this relevant? The scenario that makes it interesting for additional Japanese investment in US unconventional resources is participation in the entire natural gas value chain. Firstly, participation in the US upstream provides a steady and reliable source of supply for LNG feedstock for export to Japan. Furthermore, assuming a Japanese company has a tolling arrangement for liquefaction of LNG in the United States, acquisition of US gas reserves at their current low prices allows significant profits to be captured in sales of LNG in Japan at JCC-based prices (effectively, JCC-based prices minus the sum of Henry Hub prices, liquefaction and shipping costs). However, if US gas prices ultimately go up, the US upstream investment provides a hedge against higher feedstock prices, and profit margins in sales of LNG in Japan can nonetheless be preserved.
Furthermore, there are fewer people looking at pure gas assets on the market as opposed to oil assets or gas liquids assets. The relative pricing for gas assets is currently quite favorable for buyers, so it is a good time to be buying gas reserves if one has a long-term view or if one has the ability to do something else with produced gas, such as participate in the export LNG value chain.
