(LNG) Arbitrage, Intertemporal Market Equilibrium and (Political) Uncertainty

Abstract

Since 2009, natural gas markets are characterized by large spreads in liquefied natural gas (LNG) prices between the United States (Henry hub) and Europe and Japan. Moreover these differences are forecasted to persist (at a lower level but still above transport costs) against the law of one price. This paper explores this persistence of apparent arbitrage by investigating an intertemporal competitive equilibrium under uncertainty. Investments of an individual arbitrageur must account (at least) for: (1) rational expectation that this arbitrage will be eroded over time by competitive agents’ similar investments; (2) risk of export regulations because governments may intervene and destroy this opportunity in order to protect the interest of local (i.e. U.S.) firms and consumers. The paper analyzes a corresponding stochastic and dynamic (partial) equilibrium that leads to a reduction in investments and implies persistence of apparent arbitrage. This is in line with forecasted but unexplained price differences.