Determining the Value of LNG Deal Flex Components

Before we dive into the key things you need to do when understanding the impact of LNG deal flex components, let’s cover what flex components are, and why you should care.

The term ‘flex components’ refers to various contractual provisions that provide flexibility to buyers and sellers in LNG transactions. The options are designed to accommodate changes in market conditions, operational needs, and strategic requirements.

Things like price/location flex, volume flex, and DQT and UQT, are common examples; however there are a range of different options that can form part of an LNG deal structure. (For more information on the different flex options, see our ‘Understanding LNG Deal Flex Components – Your Guide to what they are and how they work’ article).

Assessing the value of a deal with flex options by assuming stable prices and variables (known as ‘intrinsic value’) can be challenging but not insurmountable. However, determining the total value of a deal, which includes the impact of various flex options under real world price fluctuations and volatility is significantly more challenging.

The process to determine 'total value’ requires advanced price modelling, a sophisticated LNG valuation engine, and analysis of numerous variables. ‘Extrinsic value’, the value derived from volatility, is the difference between total value and intrinsic value.

The chart below provides an example of intrinsic and extrinsic value across five deals. As can be seen, intrinsic and extrinsic value vary substantially with deal two having a small intrinsic value with extrinsic value making up the majority of the revenue, whereas deal 5 is almost entirely intrinsic. Therefore, accurately calculating value is critical for understanding deal profitability.

It may feel like a lifetime ago but cast your mind back to a time before COVID. LNG markets were considerably more stable. In this world, many players focused on the intrinsic value of an LNG deal (the value of a deal and any flex components under a static price model). Markets could be relied upon to behave (mostly) rationally and flex components were important but manageable.

Now fast forward to the present and we’re seeing unprecedented levels of volatility in markets driven by large scale supply chain interruption, global conflict, and economic and political uncertainty. All of a sudden, the tried-and-true methods of old no longer stack up.

In volatile markets, extrinsic value can be orders of magnitude larger than intrinsic value.

Reflecting these changes, where once these sorts of flex options were given away in order to get deals done, they are now being priced in, with their value needing to be justified. Additionally, the amount and complexity of the flex options within contracts has increased.

Given the material nature of some flex options, knowing when to exercise them (or not) can make or break a deal. For example, UQT and DQT options with caps/make-good/carry-forward clauses can be highly material but are complex to value and determine when to exercise.

Flex components can now represent 10x the base value of a deal or more. It’s now entirely possible for a deal with an intrinsic value of $3/MMBtu to have a total extrinsic value as high as $30 or $40 per MMBtu. Consider the scale of typical LNG deal volumes and very quickly you’re looking at a difference of billions of dollars over the life of a contract. At these sorts of numbers, individual deals can literally make or break companies and indeed, we’ve seen companies on the wrong side of deals in considerable financial distress in recent years.

Where once you could get away with focussing just on intrinsic value when assessing LNG deal viability, that’s now no longer sufficient.

So, what do you need to know to make sure you stay on the right side of an LNG deal?

1.??Determine the base value of the deal

To establish a profitability baseline, you must first analyse the base value of a deal (the value of a deal with no flex options under a static price model).

2.??Calculate the expected value of flex options

Model the value of individual flex options by identifying and analysing key variables of each option to determine their contribution to value.

3.??Consider the impact of one flex term on others

Not all flex components are mutually exclusive and exercising one flex term can either overlap (cannibalise) another option or ‘unlock’ additional flex options. For example, activating a UQT option to take an additional cargo can provide further location and volume flex options for that cargo (i.e. do you send the additional cargo to the US instead of Europe, and do you choose to increase or decrease the volume of that cargo?). Conversely, a DQT option can overlap with volume reduction from a volume flex option.

4.??Analyse all flex options during deal assessment

Simulating flex options (including volatility shocks) at deal analysis stage is critical to ensure you understand the full impact of the flex components associated with a deal. However, deal negotiations are rarely linear and negotiation around the inclusion or exclusion of additional flex options is common. Being able to model additional scenarios can therefore help you identify other flex options which you can negotiate for inclusion in the contract. Likewise, it’s vital to understand the impact of any counter-options proposed by the seller. Effectively simulating flex options helps ensure you are well-prepared once the deal is active, potentially making the difference between a highly profitable deal and a loss-making one.

5.??Make sure there’s enough flexibility in the deal

Especially in times of volatility, companies need to ensure their deals include sufficient flex options. These options not only help optimise profitability throughout the duration of the deal but also provide a way to navigate difficult situations. The last thing you want is to face unfavourable price conditions, or being a distressed buyer/seller, with no options to avoid or minimise losses.

6.??Regularly run deal simulations

Once the contract is in effect, in order to understand if and when to exercise your flex components, be sure to continue to simulate the flex options regularly and ahead of each new cargo delivery as market dynamics and prices change.

The chart below shows an LNG’s portfolio including the intrinsic and extrinsic split across 5 deals, 3 regions and monthly value over three years and highlights how powerful viewing an LNG portfolio in intrinsic vs extrinsic value can be. Understanding value and how it is distributed across different dimensions is critical to successfully analysing LNG deals and portfolios.

Determining extrinsic value in practice is challenging and requires a robust simulation and valuation engine, underpinned by sophisticated and proven quantitative models. For more information on the different types of deal value, and how to calculate them, see our article on ‘Understanding LNG Deal Flex Components – Your Guide to what they are and how they work’.

For additional support or guidance in this area, don’t hesitate to reach out to Lacima team.