BHP spots new LNG profits

BHP Billiton is certainly in a fighting mood. Not content with turning the iron ore market on its head, it's now making moves to reshape another Australian raw material market -- and smaller producers will once again bear the brunt of the fallout.

At a conference attended by Australian and Japanese business leaders in Darwin, BHP marketing executive Mike Henry said he favours a move toward pure market pricing for LNG rather than the current oil-linked pricing model that has been in place for decades.

As Japan is Australia's biggest export market, this was indeed a well-timed move. The Japanese have long campaigned for the link between oil prices and LNG prices to be severed because it forces them to pay higher prices for gas than Australia and the US.

There's also the fact that the link to oil doesn't necessarily make much sense anymore. The fundamentals for LNG and oil demand are moving in opposite directions, with the focus moving to gas as developing countries rapidly industrialise. So it's not a total surprise that the miner is advocating for free-market pricing.

But there's more to it than simply pandering to our Japanese neighbours or finally realising that oil and LNG don't necessarily pair well together.

It's more about self-interest than anything else. There is another big reason BHP is looking to sever the link now: the LNG market has developed enough for BHP to reap huge benefits from spot pricing.

Historically, LNG projects have been quite limited in number, so long-term high prices were a necessity to get the developments off the ground. But now more of the older developments are being uncontracted, with LNG being priced in the spot market. As this has occurred, spot demand has increased over the past few years.

In Japan and South Korea, two of our most significant LNG export markets, 80 per cent of LNG purchases are currently made through long-term contracts at fixed prices, but the remaining 20 per cent is bought in the spot market.

In addition, a number of import terminals are being built across Asia and the US to receive LNG as well as export it, meaning the ability to have a functioning spot market has improved considerably.

Henry's comments shouldn't surprise followers of the company, since it has also changed the way iron ore and coal are priced in a similar fashion.

BHP is a strong advocate for free-market pricing in commodities largely because of the benefits it brings. It is a market leader with tier-one assets across iron ore, coal, petroleum, and the North West shelf, meaning it will always be at the lower end of the cost curve. That means it will always come out on top where free-market pricing is concerned.

That's exactly what we're seeing in the iron ore market right now. BHP is pumping out iron ore, driving down costs and pushing the smaller, higher cost producers to the brink.

The bigger issue is making the spot market a reality. It's not like iron ore, where there's one country dominating the market and determining the spot price is straightforward. The demand for LNG is very fragmented across the globe, making it difficult to establish a spot market, at least in the near term. But over the next few years, if the market moves toward referencing a US or an Asian price, then it could develop.

And that spells trouble for some of BHP's competitors, who favour long-term pricing contracts because it enables them to develop new projects. The cost of developing an LNG project can be in the tens of billions, so without long-term contracts, new projects would struggle to get off the ground.

And that's exactly what BHP wants. There are very few companies that have the resources BHP has at its disposal. By making it more difficult for competitors to develop new projects, BHP will find itself in a very fortunate position indeed.