by Tsvetalin Radev, Athina Sylaidy, and Colin Chilcoat

The European Union’s Third Energy Package has become a reality, thus increasing the level of liberalization of the European energy markets. Moreover, the European Commission has launched an anti-trust lawsuit against Gazprom, as the Russian gas monopoly has allegedly been hindering competition in Eastern and Central Europe. The Gazprom-favored model (long-term contracts with a take or pay clause) is being challenged by the development of spot prices and increased gas liquidity in Europe. Yet, the EU’s securitization of supply goes hand in hand with Gazprom’s security of demand. The uncertainty reigning over the future of European markets—demand, legal and institutional frameworks—are natural concerns for the gas monopoly. The debate over contracts and pricing mechanism is at the very heart of the future of Russia-EU energy trade and relations.

Dr. Komlev argues the oil-indexed prices are more reflective of the market equilibrium than the recent anomalous hub prices in the US.

Dr. Sergey Komlev, Head of Contract Structuring and Pricing Directorate at Gazprom Export, addressed these concerns and more in his presentation on February 28, 2014 on price setting in the European market.

This report consists of two parts: a summary of Dr. Komlev’s arguments in favor of Gazprom’s current gas contracts and a transcription of the subsequent question and answer section that has been edited for length and clarity.

Existing Pricing Mechanisms

An understanding of the existing gas pricing mechanisms is key to understanding the current pricing debates and Dr. Komlev set right out to differentiate between the models. Oil-indexation dominates Gazprom’s long-term pricing agreements. This is a way of pricing a commodity by linking the price of gas to that of oil. It is an alternative pricing mode to the traditional supply and demand based methods. It should be noted that oil-indexation is the only form of pricing in Asia. North America tends to rely on supply and demand, exemplified by the Henry Hub price index. Australia employs a more “eclectic” model utilizing both long-term contracts (LTCs) indexed to alternative fuels and spot pricing on the FRC Hub. The “hybrid” pricing system, which characterizes the European market features primarily long-term oil/oil product-indexed contracts with a parallel functioning of the trade hubs. Of the four primary models, Gazprom has a demonstrated preference for the oil-indexed and hybrid systems.

There are, however, two emerging pricing systems gaining ground in Europe and Asia. The first links LTCs to gas indexes, utilizing hub pricng. It is Gazprom’s view that this system is not stable however, and eventually transforms into a purely hub-based model. Emerging model number two refers to LNG pricing. It also employs LTCs, priced on a base of Henry Hub indexes plus the tolling fees for gas liquefaction. Tolling fees for liquefaction refer to the agreed volumes of LNG and represent take-or-pay obligations in these LTCs. Gazprom takes a more neutral stance regarding this second model.

The Fair Price of Gas

The emergence of so many models owes to the fact that there is no global benchmark for natural gas prices. There are three different pricing centers: North America Europe, as well as Asia. The prices significantly differ at each of these centers, begging the question: “What is the fair price of Natural Gas?” Of course there is no definitive answer to this question as political, ideological, and geographical considerations must all be taken into account, but Dr. Komlev set to lay bare Gazprom’s reasoning behind what it believes to be fair pricing on the European market.

Gazprom supports non-discriminatory price indexation as an arguably natural extension of the market commonalities that exist between oil and gas. Among the commonalities, exploration and drilling technologies, cost structures, and an increasing convergence in end-use markets are the most relevant. Additionally, when compared to a broad range of commodities, oil-indexed natural gas prices exhibit similar growth. Dr. Komlev argues the oil-indexed prices are more reflective of the market equilibrium than the recent anomalous hub prices in the US.

Dr. Komlev suggests the strongest argument for oil-indexation concerns long-term investments and supply security. In short, price instability on European hubs undermines long-term investments, while oil-indexation allows for a greater degree of revenue planning and financing of large-scale projects.

The distinction between oil-indexed and hub price is important, but Dr. Komlev also stresses that their symbiotic relationship is what makes the hybrid pricing system ideal for the European market. According to Gazprom Export, hub prices are derivative of their own and other producers’ LTCs. Hub prices are not immune to supply and demand modulations, but rise and fall in tandem with oil indexes. The hybrid system places oil-indexed prices in the leading and dominant role, establishing a competitive market value; while hub prices have a balancing and subordinate role, imparting necessary supply and demand fundamentals.

Further comparison of the US and European pricing systems reveals underlying differences, which support the contrasting approaches to pricing. Liquidity (churn ratio) on the European hubs is significantly lower than that of their US counterpart. The smaller physical volumes open up the door for short-term arbitrage opportunities not seen on Henry Hub. Combined with the complexity of the supply chain hub prices alone fail to embody supply and demand fundamentals necessary to ensure fair market value.

Security and Flexibility

Considering the inherent weaknesses, Gazprom Export does not regard the traditionally lower hub prices as a viable and competitive benchmark for its LTCs. On this point, Dr. Komlev urges us to consider the worth of premiums such as security of supply and flexibility. The worth of security of supply is near impossible to quantify, but it does have value, most clearly demonstrated at times of gas shortages. Recent projects like Nord Steam and South Stream represent concerted efforts to further increase security of supply. In addition to security of supply, Gazprom Export believes flexibility is a quantifiable aspect of its LTCs. Purchases on market hubs are almost always completely inflexible; the buyer is required to take exactly the same volume of gas in each day of the delivery period. While allowing the buyers to match supply and demand, the added flexibility also enhances arbitrage opportunities; buyers may purchase excess gas at LTC prices and trade when the spot markets are high and vice versa. As natural gas prices continue to become more unpredictable, the security and flexibility offered in LTCs takes on more value.

The price discrepancy between hub and oil-indexed LTC prices is not only due to the aforementioned premiums, but also a result of direct and indirect enforcement of hub pricing. Several European regulators have enacted measures that introduce spot market components in gas pricing. Many have already linked regulated gas prices 100% to the spot markets. This does not sit well with key exporters like Gazprom whose margins are greatly affected. “Gazprom, via ex-post rebates and contract adjustments, acts as a major sponsor of European energy security by observing its historic obligations to deliver gas in an environment that poses a threat to the very existence of the LTCs.” Dr. Komlev offers the following analogy regarding the price mismatch: renting a car with a driver (read LTCs) carries more of a cost than driving that rental car yourself (read spot markets).

The Natural Remedy

In response to the European regulators Gazprom envisions three possible outcomes: 1) Adjust LTC prices to hub level while keeping oil-indexation in place 2) Completely abandon oil-indexation and introduce hub price tracking in the LTCs or 3) Gas-indexation remains along with traditional LTCs (hybrid pricing).

In the first scenario graduated indexing towards hub prices, removal of flexibility, and the establishment of price corridors may bring the price mismatch to a tolerable level. However, it is not without its drawbacks. The removal of mid-stream flexibility threatens European energy security. Gazprom is the major provider of supply flexibility to Europe and in the last decade the seasonal swing in daily deliveries of Russian gas has doubled. Complete abandonment of oil-indexation presents different problems for both gas suppliers and buyers. As oil-indexation is phased out, the take-or-pay clauses embedded in LTCs lose their function as a guarantee of demand security as buyers can dispose of excess volumes on the hubs with zero risk. While this is certainly advantageous for the buyer, Gazprom cannot accept such arrangements that lead to price manipulations.

Dr. Komlev suggests the strongest argument for oil-indexation concerns long-term investments and supply security. In short, price instability on European hubs undermines long-term investments, while oil indexation allows for a greater degree of revenue planning and financing of large-scale projects. Looking to the US once again, Dr. Komlev examines the depressing effects of the shale gas revolution on the US gas market, where producers like ExxonMobil are struggling to turn profits. Oil-indexation and LTCs are a proven instrument for surviving such market dips with supply security intact.

Looking to the US once again, Dr. Komlev examines the depressing effects of the shale gas revolution on the US gas market, where producers like ExxonMobil are struggling to turn profits.

Dr. Komlev and Gazprom see little rationale for a market overhaul: Oil and gas still compete in both the residential and industrial sectors; oil-indexation serves as a hedge against price manipulation; and liquidity on European markets is still insufficient to fairly price gas as an independent commodity. Furthermore, Gazprom predicts the oil-gas link will be reinforced in the future due to increased competition in the transportation sector. “Gazprom is the largest producer of dry gas in the world and believes that oil-indexation is the only way to secure the intrinsic long-term value of gas.”

After Dr. Komlev finished his presentation, the floor was opened up to students for questions.

Question: What is your view on the Gas Target Model in Europe? Isn’t it in fact dividing the internal market of Europe?

Dr. Komlev: I think this Target Model is supposed to come online this year, 2014, but is still a long ways away. If you look at prices of electricity, they are not converging but diverging. In a similar way if you look at end user prices in European countries, in Denmark prices are maybe 5 times higher than in Germany, thus there is no harmonization. I think that to a large extent plans to create common market – although we have nothing against that – are a little idealistic and naive. Market functions in natural gas are extremely complicated and even if you take the case of US where there are thousands of independent gas producers, the laws and regulations are present, the architecture of the market is there, but still the market is dysfunctional. Market reforms are extremely complicated and there is no recipe how to do them, especially when you have conflicting policies. For instance, on the one hand you are saying “we need to enhance competition and develop free markets” and on the other hand you are appealing towards sort of a planned economy. A prominent example of that is the reincarnation of the GDR in Germany in one single industry called renewables. There is a guarantee of purchase and the presence of a regulated tariff, so one can conclude that this is a planned economy. So you see on one hand you want to have free market forces and on the other you have a planned economy and they don’t match together. As a result there is a collapse of gas in power generation. So there are too many conflicting elements in what is called reforms in Europe. Therefore, at the moment they have produced a total mess, and I would like to underline that this is not my conclusion, but Europeans are admitting this themselves.

Question: If another Russian competitor like Novatek were allowed to compete on the European market would they use spot market pricing or oil-indexed? If so, how would this affect Gazprom’s strategy in the European market?

Dr. Komlev: Gas prices in Europe are not set up by supply and demand and do not represent market equilibrium. Although the influence of supply/demand is there, the base line of prices are set up by long term oil-indexed contracts because at the moment they dominate the market. Definitely, you can sell at hub or below hub prices right now and this price would be convenient for buyers. Novatek project has high costs and I do not think that it is in the interest of the company to damp their gas.

Question: Do you think the expected increase of US exports, with regards to LNG, will have a rectifying effect on the dysfunctionality of the US gas market and that prices will come close to other regions’ prices?

Dr. Komlev: It is very difficult to make predictions in the gas market. There was a study on the US and it showed that there are a lot of shale gas reserves, which will allow for domestic prices to stay at the current levels even if large volumes are dedicated to exports. I was asking US and EU consultants for their opinion on this price anomaly, “For how long will this price anomaly stay?” and from what I am observing, there will be no change of that trend prior to 2030.

“At the moment the only market where the US can deliver gas and make a profit is the Asian market, which will require additional transportation costs. So, I don’t believe that there will be huge inflow of inexpensive shale gas to Europe.”

In reality price adjustments may take place much earlier because the number of rigs drilling for dry gas are lowest for the last 20 years. Drilling for wet gas has only compensated losses in output of the dry gas wells. An increase in Henry Hub prices by $2 per MMBTU from their current level of $4.5 per MMBTU will make US exports to Europe impossible.

If we take a price of $6.5 from Henry Hub you have to add an additional $1 per MMBTU to bring the gas to a regasification terminal, then there will be additional cost of $3 per MMBTU for liquefaction, then additional $2 per MMBTU to transport the gas to Europe, and then maybe $0.5 per MMBTU for marketing the gas in Europe, so this adds up to a total of more than $13 per MMBTU. Hence, at the moment the only market where the

US can deliver gas and make a profit is the Asian market, which will require additional transportation costs. So, I don’t believe that there will be huge inflow of inexpensive shale gas to Europe.

Question: Last year Statoil switched its contracts, especially those targeting northern Europe, to hub prices. Do you think that was in their interest? And if it was, then why is it not in Gazprom’s interest?

Dr. Komlev: We (Gazprom) do not comment on the actions and policies undertaken by our competitors.

“My experience tells me there are certain media outlets that tend to twist our words so that Gazprom is presented in a negative light. It is also fueled by some geopolitical interests and I think there is nothing that could be done to change those perceptions.”

Question: Talking about a competitor on the gas market…How do think the competition, if we can call it like that, in the Southern Corridor between gas suppliers, namely Azerbaijan and Gazprom, is going to play out? Did you compete for market space at least initially, taking into account that Azerbaijan, which is using a pricing formula, would be able to undercut Gazprom? And are you planning any response?

Dr. Komlev: Commercial contracts are not released to the public. But the rumors that I have heard are that the contracts signed by the Azeris

with Europe are all oil-indexed. We don’t think that the creation of the Southern Corridor and gas deliveries from Azerbaijan will be able to change Gazprom’s position in Europe. However, if there is huge inflow of Iranian or Turkmeni gas, something may change. But let’s take a look at the Shah Deniz II field. It is one of the most complex projects in the world and operates two semi floating platforms. These platforms can only function when there is no wind and for roughly 30% of the year there is strong wind. Also, the gas is extracted and produced from a well that is 6km in depth. The platforms themselves require special heating system in order to prevent paraffin from firming. Another point is that if you take a look at TAP’s route, it is not going to Baumgarten (a major gas hub and transit point for Russian gas in Austria). In case it goes to Baumgarten we believe that there could have been competition with our gas. But instead it is going to southern Italy, where it will merely compensate for the nearly 10bcm in lost supply from Algeria. So, in reality it is not changing the balance and it is not bringing new volumes to the market, just compensating for those volumes that were taken away by the Algerians.

Question: You mentioned a couple of times negative perceptions in the West about Gazprom being the “bad guys”. Don’t you think that there is much to be done in changing those perceptions? And if you do, should that strategy be targeting high level officials or the wider public?

Dr. Komlev: My experience tells me there are certain media outlets that tend to twist our words so that Gazprom is presented in a negative light. It is also fuelled by some geopolitical interests and I think there is nothing that could be done to change those perceptions. You can spend a lot of time explaining Gazprom’s point of view, but it is a different question whether the people to whom you are explaining will actually listen. And we have decided that there are certain mass media representatives that are pointless to talk to because they will always deliver our messages in a misleading way.

“There is of course some positive change in perception, namely in understanding that the gas industry is special and oil-indexation is closer to Pareto optimal pricing than the existing malfunctioning market.”

Follow-up question: So, that goes to journalists. What about your activities in Brussels and the representative office that Gazprom has just recently opened there. Are you trying to tackle the issue by targeting high ranking officials?

Dr. Komlev: But public opinion is set up by journalists. Mindset of the Western experts is set up around mantras such as increased competition, free markets, transparency and so on. However, we have done a lot especially with regards to the European Commission to underline that gas is a special commodity and requires special treatment. For a while the EC had decided to outlaw oil-indexation in gas contracts, while in our view oil-indexation is vital to the success of the gas industry because it is a pure “market” remedy for market failure. There was also a report on pricing commissioned by the EC and the initial idea was to criticize oil-indexation as a major reason while gas prices are so “high” in Europe. When I looked at the report I found no mentioning of oil-indexation at all. According to the report, high prices stemmed from the different taxation schemes and the introduction of a number of new taxes. There is of course some positive change in perception, namely in understanding that the gas industry is special and oil-indexation is closer to Pareto optimal pricing than the existing malfunctioning market.

Question: Talking about European pricing, would you please say a few words on the dialogue between Gazprom and China, and why there is such a dispute over the pricing formula?

Dr. Komlev: There is no dispute over the pricing formula; there is dispute over the price level. And to be more precise it is business negotiations rather than dialogue. Deliveries of Russian gas to China will take place no earlier than 2018. At the current moment the prices on the Chinese domestic market are regulated – they are set by the government like here in Russia. The Chinese have to clearly state what the domestic price levels will be several years from now, in 2018, and it is not easy for them to do. There is no way that such an amount of gas that will be coming from Russia – 40bcm – would be completely subsidized. For instance, there was an estimate that Petro-China alone paid $42 billion in subsidies in 2012 to cover the differential between incoming and domestic prices. So the Chinese have to decide what the level of domestic and possibly regulated prices will be in 2018 – surely not an easy task. However, they also understand that without such a decision there will be no construction of pipelines. So, they have to make this choice; the clock is ticking.

Question: Is Gazprom aiming at high prices and oil-indexation because its current production projects such as Yamal are very capital intensive?

Dr. Komlev: If you have a long term project and you don’t have security of your cash flow then that, in itself, is an issue. Therefore, we support oil-indexation and in our view it is not only in the interest of Russian producers. If you take a look at the break-even-cost of Australian producers you are looking at $16/$17 per MMBTU and it will be only marginally profitable if the Australians are able to sell it on the Japanese market for $20 per MMBTU. Thus, it is also in the interest of consumers to pay a price that is supportive of the investment cycle in the gas industry. If your output price has gone up less than three times over the last 10 years you might be in trouble, as the inputs (labor, steel, chemicals, etc.) have gone up roughly three times and that means that you cannot resume your investment cycle. There is no reason to believe that prices based on supply/demand will be able to guarantee the prices needed to recoup the investment. Markets are not perfect; they need certain adjustment. In our view this adjustment comes in the form of oil-indexation, which is the best mechanism that does not require government intervention.

“[The Ukrainians] also understand that they might not be able to pay for the gas they are taking and that’s why they simply decreased the offtake. Quite a reasonable move on their side.”

Question: All of us are pretty much aware of the important role that Ukraine is playing with regards to gas deliveries to Europe and also the difficult relationship between Gazprom and Naftogaz over the last couple of years. How do see the fact the Ukraine has sharply decreased purchases of Russian gas in light of the current events?

Dr. Komlev: You have to consider the unusually warm weather in Ukraine at the moment. Therefore, there is less demand for gas. The winter season is pretty much over and [decreasing purchases] is quite a reasonable move on their side. They also understand that they might not be able to pay for the gas they are taking and that’s why they simply decreased the offtake. Quite a reasonable move on their side.

Question: Do you see Ukraine coming back to price levels of over $400 or do you think they will be able to stay at the current levels and keep the discount that Gazprom has provided?

Dr. Komlev: It’s a difficult question really. In fact the current contract allows us to come back to price levels of over $400 per 1000 cubic meters. But of course it depends on developments in Ukraine. Ukraine is paying for the oil and oil products it consumes. Some people are saying that even $260 is a high price as the price in the US gas is much lower. That is fine with us; if you want, you can go and buy gas from them.

Question: Could you comment on how coal plays a role in pricing schemes? How does cheap coal affect pressure on Gazprom to change the price formula?

Dr. Komlev: I believe in markets, but there should be selective and smart approaches to their functionality. There could be market failures and we have to take this into consideration. What really happened in the US is a price anomaly related to shale gas. Shale gas is extremely expensive gas, more expensive than conventional gas, but still we have very low prices because shale gas is a waste product of shale oil production. We live in a closely interconnected world and this price anomaly of cheap shale gas resulted in shale gas replacing, to a certain extent coal, in power generation in the US. But then US energy companies started to export their relatively cheap coal to Europe. Another example of this price anomaly could be found in the renewables sector. All this combined together to create a dreadful cocktail and resulted in a situation where you see conventional gas being squeezed out of the energy mix. And in our view we need to work towards resolving the effects of those chain reactions that distort the value chain by targeting the very core – the price anomaly itself.

Question: Why are there no fixed price contracts?

Dr. Komlev: No, there are fixed contracts in the end user market. We sell gas to our clients, which are large mid-streamers, they in turn sell to end users. End users usually have one year contracts with their mid-stream supplier at a fixed price. Maybe we will also start thinking about developing these short-term fixed-price contracts.

Question: I know that back in 2006 «Межрегионгаз» was operational for two years and also PM Medvedev was a big proponent of the gas exchange. What do think the future of the function of gas exchange in Russia is?

Dr. Komlev: To be honest, the only reason this exchange was set up was so that Mezregiongaz could sell gas at a price 4%/5% higher than that which was set by the Federal Commission for Tariffs.

“It may take [Iran] 5, 10 or even 15 years to develop [their gas] industry, but now their hands are tied because of the sanctions.”

Follow-up question: But this is a division of Gazprom, right?

Dr. Komlev: Yes, but in my view it is completely irrational to have any kind of exchange if there is no free market pricing. Again, if 90% of the prices are set up by the regulator, then obviously the price cannot diverge much from the one that the regulator puts forward. There is no need for such an exchange in a market that is dominated by regulatory decisions.

“If you ask my personal view, there is no need to build a pipeline to the UK, it is rather better to build additional capacity of LNG.”

Question: You have mentioned Iran and Turkmenistan. How fast and in what sense do you think their possible exports can affect European gas markets?

Dr. Komlev: With regards to Iran, although they have huge reserves, at the moment they are a net importer of natural gas. It may take them 5, 10 or even 15 years to develop the industry, but now their hands are tied because of the sanctions. Their assets are frozen, they cannot sell natural gas for hard currency, thus they are limited to barter deals.

Question: I have a question about South Stream and its proposed capacity of 63bcm, do you think there is a possibility that we might end up with less than that, and if so what circumstances might cause that to happen?

Dr. Komlev: Gazprom’s plans are to build secure routes to deliver gas to Europe that go around Ukraine. Currently, Ukraine transits 80bcm of natural gas destined for the European market, and we don’t know what might happen with those 80bcm. Of course we hope that everything will be fine with those deliveries. If we build a 63bcm capacity pipeline then we plan to use it. For example, last year, out of the 55bcm capacity of Nord Stream, we were only able to use 23bcm. But if we have both Nord and South Stream in place, this will give us more flexibility in going around Ukraine. In short, Gazprom’s plans are to have secure routes so we can deliver our gas to Europe.

Question: In recent press releases the expansion of Nord Stream was an object of much talk, with the possibility of targeting the UK as a driver behind that. Having in mind the National Balancing Point and the fact that spot trading is dominating the British market, do you think that Gazprom’s stepping more prominently into the British market would allow some of your EU partners to argue that Gazprom should move away from LTC and introduce spot prices on their markets as well?

Dr. Komlev: There have been discussions over construction of the new lines of Nord Stream; however, there are no details at the moment. If you ask my personal view, there is no need to build a pipeline to the UK, it is rather better to build additional capacity of LNG.

“By fighting with dependence on Russia gas politicians are shooting themselves in the leg.”

Question: How about increasing your storage capacity in Western Europe and setting up trading houses that will allow Gazprom to capture the high margins depending on the seasonality?

Dr. Komlev: It is a good idea. But so far Gazprom Export has been really conservative in the sense that we are not involved in hub trading at all. We are simply a large wholesale merchant/trader that delivers gas to a number of large customers, but are not involved in selling gas on short-term basis. But I think that it will be a real necessity for us to develop this kind of business, as we have our own storages and we can utilize the existing capacity. But I want to underline that in our view the current price mechanism is fair.

Question: A number of Gazprom’s contracts are about to be renegotiated. Do you believe Gazprom will be successful in maintaining its position in these contracts, considering that Gazprom is facing EU’s TPA (third party access) and a gradual move towards spot-pricing?

Dr. Komlev: At the moment there is really strong pressure and the problem is that our clients come to us and tell us “What can we do? If you don’t decrease prices we will go bankrupt.” And this is a consequence of EU’s policy to enforce certain price principles, which they believe are the best in the world, but the fact of the matter is that this is simply not true. I think that Gazprom is in a unique and very strong position. In 2013, Gazprom was the only reliable supplier of natural gas to Europe, all the rest failed; the Dutch also failed because there was a decision of the Dutch government to decrease output of the Groningen field by 20bcm. There is no one else but us and this is a result of the liberal reforms in the EU.

Follow-up question: But do you think that Gazprom’s position will be adequately taken into account?

Dr. Komlev: In short, by fighting with dependence on Russia gas politicians are shooting themselves in the leg.

Question: How about investing in technologies to convert cars or trucks from gasoline to gas?

Dr. Komlev: Europe decreased its consumption of gas between 2010 and 2013 by 30bcm. This 30bcm could be easily reclaimed if we deliver to the transportation sector. At the moment, the use of natural gas in the transportation sector is really insignificant, less than 2%. That presents a huge opportunity. Technologies for compressed natural gas have existed already for maybe 30/40 years but still the results are not there. In my view, the only breakthrough in the development of natural gas role in the transportation sector may come with the development of heavy duty trucks running on LNG and also bunkering. As a fuel, LNG gives the same benefits as diesel and the time of refill is significantly less compared with CNG. Also there is no need to carry heavy gas bottles in the vehicle, whose presence changes the aerodynamics and requires additional space.

Tsvetalin Radev and Athina Sylaidi are MA students in the ENERPO program at European University at St. Petersburg. Colin Chilcoat is an ENERPO alumnus and deputy editor of the ENERPO Journal.