by Henrik Vorloeper
Oil and gas like apples and pears
On 2nd March 2016 ENERPO students of the European University at Saint Petersburg listened carefully, when Sergei Komlev, Head of Contract Structuring and Price Formation Directorate, Gazprom Export explained Gazprom’s problem in finding the right price for its gas on the markets, especially in Europe. These are the four key-takeaways:
- Long-term gas contracts with oil-indexation are still dominant in Europe.
Gas markets are unique – how gas prices come into existence is complicated and difficult to compare with any other commodity market. Natural gas as an energy source has long been conceived as a substitute for other hydrocarbons, such as oil or coal, but as gas is not solid or a liquid, the commodity is not easy to trade so that a real global market with global price has not yet emerged. The main way to bring gas to the consumer is via pipeline, but LNG shipping has made trade increasingly flexible. However, both still lack sufficient infrastructure. Pipelines and LNG terminals require vast amounts of investment to be constructed and a hub-price based market does not provide the security of return for the supplier, which he needs for funding. The long-term contract (LTC) pricing system, in which gas prices are linked to oil price developments, remains the dominant pricing structure, as only LTCs guarantee demand and therefore a lower investment risks.
- Oil-indexation is outdated but there are no better alternatives.
Oil-indexation is essentially an outdated model. It is according to Komlev a comparison between apples with pears, but there are no better alternatives. For example, the next closer commodity to gas is coal, as both commodities are consumed for power generation. However, the demise of coal in the EU policy of climate protection is obviously not supportive to any future gas-to-coal indexation. The use of coal and gas as competing substitutes is diminished, while coal becomes increasingly irrelevant, gas will be increasingly used to support intermittent renewable energy sources.
- The maturing European market causes implications for the hybrid-system for gas pricing.
The so-called hybrid-pricing system for natural gas describes the two dominant models for gas price mechanisms, which is gas-to-substitute competition (e.g. gas prices indexed to oil prices) and gas-to-gas substitution (e.g. gas hub prices). Oil indexation, remains the dominant pricing mechanism globally and in specific on the Northern Asian market, where the vast majority of LNG supply contracts are oil-indexed. Hub pricing is increasingly becoming relevant in other regional markets, but a fully established model can only be found in the United States. The European market applies the hybrid-system, which is a combination of both oil indexation and hub prices, but they are interconnected from each other and do not exist parallel and independent from each other. In this model, there are two opportunities to purchase gas in Europe, one is via oil indexed LTCs and the other is buying gas on the hub. The hub price however, despite usually being lower than the contracted price, basically changes in a similar direction as contracted prices do, and thus do not fully reflect demand and supply realities. For this reason, there is currently no self-defined and fully independent gas price at any European hub. The current European hub prices reflect only the residual volumes of gas that comes in addition to LTC gas supply. In other words, the hub price appears to be a derivate of contracted prices. The implication for the supplier, which is in specific and issue for Gazprom, is the idea of European consumers to replace the existing hybrid-system gradually and in an “evolutionary way” to a market based on hub-prices, which means that LTCs remain in place, but consumers insist on more flexibility of LTCs. In this situation the supplier becomes the sole player to bear the risks and costs involved in softened contract conditions, which harm investment security. In the view of Gazprom, increasing the share of hub pricing in the European model would require just the opposite, the reduction of LTC flexibility.
- The European gas market is currently over-contracted and oversupplied.
The problem that Gazprom experiences at the moment is the fact that more flexible LTCs have already been implied in the European market, which is unfavourable for Gazprom for several reasons. First, the Take-or-Pay (ToP) obligations have been softened unilaterally, which means that the consumer has achieved the right to take less gas than contracted if demand is low and hence the consumer only pays the for what he consumes. With this, the guaranteed sales made by the supplier are consequently lower and thus the ability to fund investment becomes harder. Second, if demand is higher, the consumer is likely buy gas at the hub first, before they make use of contracted gas supplies. With this, there is no guaranteed income for the supplier even if demand increases. Third, non-EU suppliers have only restricted access to European hub markets, as the capacity to deliver gas via pipeline remains restricted. Fourth, the European market appears to be oversupplied with gas which drives prices down. This is on the one side related to the fact that the contracted volumes already exceed the total demand (“over-contracted market”), on the other hand, this allows an emerging group of market participants to offer gas on the European hub market without obligation and the responsibility to deliver and thus creates a market advantage over suppliers with contract obligation. Both of these circumstances have the effect to reduce gas prices in Europe, in which hub-prices continue to remain below contracted prices and as a result, creates a loop of gas price erosion.
In conclusion, the softening of the hybrid-system in Europe, with the means of more flexibility in LTCs will inevitably lead to the abolition of the hybrid-system itself. The emergence of a fully fledged hub market like the United States is not a recommended option as the market is still import dependent on only a few suppliers.