Long-term contracts and efficiency in the liquefied natural gas industry

Nahim Bin Zahur

No 1518, Working Paper from Economics Department, Queen's University

Abstract: In many capital-intensive markets, sellers sign long-term contracts with buyers before committing to sunk cost investments. Ex-ante contracts mitigate the risk of under-investment arising from ex-post bargaining. However, contractual rigidities reduce the ability of firms to respond flexibly to demand shocks. This paper provides an empirical analysis of this trade-off, focusing on the liquefied natural gas (LNG) industry, where long-term contracts account for over 70% of trade. I develop a model of contracting, investment and spot trade that incorporates bargaining frictions and contractual rigidities. I structurally estimate this model using a rich dataset of the LNG industry, employing a novel estimation strategy that utilizes the timing of contracting and investment decisions to infer bargaining power. I find that without long-term contracts, sellers would decrease investment by 27%, but allocative efficiency would significantly improve. Negative contracting externalities lead to inefficient over-use of long-term contracts in equilibrium. Policies aimed at eliminating contractual rigidities reduce investment by 16%, but raise welfare by 9%.

Keywords: Long-term Contracts; Spot Markets; Under-investment; Nash Bargaining; Contracting Externalities; Market Power; Liquefied Natural Gas (search for similar items in EconPapers)
JEL-codes: D22 D23 L14 L22 L42 Q41 (search for similar items in EconPapers)
Pages: 86 pages
Date: 2024-01
New Economics Papers: this item is included in nep-com, nep-ene, nep-gth and nep-reg
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