Gas Pricing Model for Europe 2050
A View of Gazprom Export
Sergei Komlev
Head of Contract Structuring and Price Formation
Gazprom Export
The Hague, September 6, 2012
Thank you very much for inviting me to take part in CIEP Gas Day 2012 in the Hague. The subject of today’s discussion that
brought together the best of the Dutch gas industry is the roadmap 2050 for the European gas industry. An important aspect of
such a discussion is the pricing system for natural gas. Will the existing indexation to oil products (or to any other substitute to gas
energy commodity) persist in the future or will it be completely displaced by gas-on-gas competition? That is a question with
which, if it goes unanswered, our vision of the future will be incomplete. Today, there are few people in the industry who believe
that oil-indexation will continue by 2050. I personally have no firm answer to the question put above.
What I would like to do is to bring the discussion back to the realities of the contemporary gas market in Europe. Before moving
from A to B, you should clearly understand where you stand now. In other words, the question is: are the existing hub prices ready
to take over for oil-indexed prices in the long-term contracts? What will happen if a move to hub pricing will be accomplished right
away? Will we get to a genuine market price based on supply and demand as a result of this move?
In order for the European hubs to produce a sustainable price benchmark, they should meet two requirements:
Firstly, these prices should be a genuine barometer reflecting total continental supply and demand conditions in Europe and or at
least of large segment of it, say, of the North-West.
Secondly, hub prices should be self-sufficient, fully independent from the oil-indexed prices, not driven by the fundamentals of
another market.
Mainstream European analysts have no doubt as to the capability of the existing gas hubs to qualify for the job.
Gas hubs in North Western Europe already form one integrated market for natural gas, R. Harmsen and C. Jepma claim in their
European Energy Review article published in January 2011 (R. Harmsen and C. Jepma, North West European Market: Integrated
Already, EER, January 27, 2011). These researchers from the University of Groningen base their conclusion on the observation
that day-ahead prices at six North Western European hubs have moved in tandem since 2007. According to R. Harmsen and C.
Jepma, these hubs form one region where demand and supply are related to each other. The authors of the article do not go as far
as to affirm directly that integrated prices are ready to serve as benchmark for the long-term import contracts from the third
countries. The article also contains no hint as to how the integrated hub prices correlate with the long-term oil-indexed contracts or
if they are independent enough from these prices.
J. Stern and H. Rogers share no doubts as to the readiness of the existing hubs to take over for oil products as price indexes for
long-term supply contracts (J. Stern and H. Rogers, The Transition to Hub-Based Gas Pricing in Continental Europe, Oxford
Institute of Energy Studies, NG 49, March 2011, pp.6-7). In their March 2011 paper, they insist that there should be “a single
mechanism for pricing gas” and hub prices “accurately reflect changing supply and demand conditions”. And even with all their
imperfections, they argue, European hubs provide the best indicator of a market price which long-term contracts increasingly need
to reflect. Although J. Stern and H. Rogers do not base their argument on profound research, they claim that “in theory, as well in
practice” hub prices are driven by their own fundamentals and could be higher or lower than the oil-indexed prices. These analysts
in fact mean to say these two prices are independent from each other and exist in their own parallel worlds.
In a recent study of hubs, P. Heather from the Oxford Institute of Energy Studies gave his emphatic ‘yes’ answer to the question:
are European hubs already fit for the purpose of serving as a price benchmark (P. Heather, Continental European Hubs: Are They
Fit for Purpose?, Oxford Institute of Energy Studies, NG 63, June 2012, pp. 46). This categorical ‘yes’ though referred not to all of
the hubs but only to NBP and TTF. Others most probably will not be price makers but still be used for balancing physical portfolios.
Although the author of the report shares the same conclusion as his colleagues from the Oxford Institute of Energy Studies, an
acknowledgement that some hubs can be no more that the balancing points represents a deviation from the British mainstream
view.
The conclusion that we arrived to is that that the existing hub prices in Europe meet none of these requirements and do
not fit the purpose of being a single price maker.
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“Knowledge is power” – let me remind you of the Soviet era slogan. The Soviet Union
collapsed because it was not consistently following this slogan and based its decision
making on ideological dogmas rather than thoughtful assessment of the realities. “Be
aware of the unintended consequences of pursuing well intended goals”, was
mentioned today in one of the speeches.
The European gas market is very different from the American and Asian markets. In
fact, it represents a combination of oil-indexed long-term contract gas and short-term
hub-priced gas. Most important is that in Europe, two different pricing methods interact
with each other. The European pricing model is best described as “hybrid” – a term
originally coined by the Clingendael Institute in the Netherlands in 2008. Unfortunately,
a good start made by the Clingendael Institute received no continuation. There was no
dedicated research of the hybrid market model, or any major attempts to understand its
mechanisms since 2008. Indeed, with the blueprint of the future European pricing
model based on supply and demand, there seems to be no interest in looking
back for a reality check.
Thorough examination of the relationship between the contract and the hub prices
within the existing hybrid system differentiates our research from the mainstream
approach that sees no connection between the two or prefers not to notice them. We
summarized our notions in a chart below. To a large extent, we are doing the
‘homework” that Europeans should do themselves.
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Although hubs could be reasonably liquid and their prices aligned, it does not mean
that they serve as universal price indicators.
Movement towards supply and demand pricing cannot be accomplished right away
because the existing hub prices on the Continent are not a function of total supply
and demand. Although prices on hubs are determined by supply and demand, hubs
maintain equilibrium of only the residual volumes that remain after long-term oilindexed contacts meet the bulk of demand. Therefore, Continental hub pricing is not a
function of total supply and demand but a function of something quite different;
balancing and arbitrage of all kinds, between different contract pricing structures,
between contract and spot prices, between hubs, between the UK and the Continent.
It is important to note that due to insufficient interconnections between the Continental
hubs and the border off-take points provisions in the long-term contracts, pipeline gas
suppliers from the third countries are not able to sell large quantities on the hubs or
source gas on the hubs to meet their clients’ requirements in cases when they like the
hub prices. The ability of pipeline suppliers from the third countries to affect Continental
hub prices is nearly absent. Unless pipeline suppliers of gas obtain powers to affect
hub prices, these prices will still not become an indication of total supply and demand,
but rather of the residual gas volumes left after the bulk of demand is met by the longterm contracts.
There is another thing that we need to point out when describing the existing hybrid
model. Oil-indexation does not rule out competition. On the supply side, there was
already a lot of competition on the market between Russian, Norwegian, Algerian and
Qatari gas because all the major importers have several supply contracts and means
to optimize their portfolio of gas supplies coming from the third countries.
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Our investigation brings us to a second important and, in a way, unexpected
conclusion: that that the two pricing systems currently in place in Europe are deeply
interconnected and that hub prices are in fact derivatives of Gazprom’s long-term
contract pricing. And even more importantly – the more integrated the hubs are, the
stronger the link of hub prices with the oil market is.
That notion gives us a right to define the hybrid pricing system as a single, unique
mechanism. Under the existing model, oil-indexed prices play a leading and dominant
role, while hub prices play a balancing and subordinate role.
In the mature hybrid pricing system that emerged after 2007, the relationship
between hub and contract prices within a hybrid pricing model may best be described
by the mathematical term, “asymptotic”. The asymptote in our case is the distance
between the contract and hub prices.
Once the importers who typically hold long-term contracts with multiple suppliers have
exercised arbitrage options, they set up a ‘soft’ price ceiling or benchmark for the
whole market. Hub prices in a mature hybrid pricing system settle at a discount to
the contract prices. Hub prices may cross the contract price line occasionally, yet that
constitutes the exception rather than the rule. Hub prices are no longer seasonally
higher than the contract prices as it was in the past when winter spot prices tended to
be higher than the contract prices.
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That asymptotic relationship explains a paradox of the UK hub prices. UK prices are
formally completely ‘delinked’ but they are driven by oil indexes which is not the case
with the true supply-demand based Henry Hub prices. Moreover, our analysis shows
that NBP and TTF prices are not only reasonably aligned to each other but have a
strong positive correlation with Gazprom oil-indexed prices with coefficients of 0.75 and
0.79, respectively. Doesn’t this prove that these prices are not free enough but are
largely dependent on an oil-indexed contract price benchmark and are in fact
derivatives of Gazprom prices?
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Let me come to the contract and spot price diversion issue. The major reason for the
price diversion is the value of the flexibility provided by long-term pipeline suppliers.
Hubs offer standard lots with no flexibility. A good question is “what should be the price
for this flexibility?” Our analysis shows that a price for one storage cycle in Continental
Europe costs about two dollars per MMBTU.
A second reason why spot prices usually lag behind contract prices is the existence of
one-sided balancing on hubs. In the case of a short-term undersupply, it is more
convenient for wholesalers to use the existing long-term contract arrangements for
securing additional deliveries. In the case of oversupply, selling gas at hubs is a quickfix. A good example of a one-sided fix is the Finnish market, a "gas island” with lower
prices on a small hub than those coming from one single supplier under long-term
contracts.
The third reason for the diversion between hub and long-term contract prices is the
availability of flexible LNG that is rerouted from the USA, cheap gas from the UK that
arrives to the Continent through the Interconnector, or gas from storage that was
acquired at a time when contract prices were lower.
In the few cases when spot gas is more expensive than contract gas on the
Continental market, it is a result of the inadequate capacity of the gas infrastructure at
a time of strong demand for gas… like in February of this year. The more developed
this infrastructure is and the more integrated the EU domestic market is, the rarer will
be instances when spot prices rise higher than contract prices.
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Gazprom cannot accept a proposal to make contract and spot prices comparable
simply by lowering contract prices. In most cases, spot prices will respond immediately
by decreasing further. That is, any further decreases of oil-indexed contract prices
accomplished by decreasing the base price or increasing the component indexed to
hub pricing would result in a new cycle of downward adjustment in the spot price, as
shown in the chart. These adjustments in their turn trigger new requests for contract
price downshift. This self-propelled process of price erosion could be a dream to a
buyer, but is not acceptable for a supplier.
8
Elimination of oil-indexation and, thus, a two-tiered pricing system is not an appropriate
means of simplifying interactions between market participants on the Continent. The
move to 100% gas indexation in long-term contracts is unacceptable to gas producers
who have a firm obligation to be deliver (otherwise they are subject to fines) in
accordance with daily nominations coming from a buyer.
The chart on slide 9 illustrates a mechanism for predatory pricing in case of 100% gas
indexation. As I have already mentioned today, transitioning to gas-indexed contracts
will not change the balancing nature of the European gas market. As prices here are
not determined by the total Continental supply and demand, relatively small additional
volumes bought for dumping purposes could bring day-ahead prices down. Losses
from dumping by a cartel of buyers will be fully compensated the next day with a profit
when a lower day-ahead price from a previous day devalues the entire supply portfolio.
This predatory pricing is possible until volumes needed to lower hub prices reach the
size of the volumes consumed.
Producers from the third countries will be running an intolerable risk of gas price
erosion because there is virtually no force in Europe interested in preserving the value
of natural gas. Producers in the EU (Dutch and British) are definitely not interested in
selling gas below cost though it is lower than for suppliers from the third countries due
to their high transportation and liquefaction costs. Indigenous producers have easy
access to the hubs and can buy gas to meet their contract obligations when hub prices
drop too much. Production could be resumed in a swing mode when prices are higher
than their costs.
Pipeline producers from the third countries who do not have easy access to the market
hubs find themselves disadvantaged. Practically speaking, it is not possible for
Gazprom to agree with its clients that it will meet its contract requirements with gas
bought at the hubs when it is cheaper than contract gas. If the oil-linked benchmark
price ceases to exist, exporters selling gas under long-term contracts will be forced to
accept prices irrespective of how low they are without any leverage to influence these
prices.
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A summary of the fundamental differences between the two pricing models is
presented on Slide 10. One has to make a clear distinction between the models.
Continental Europe utilizes a multiplicity of supply prices. This contrasts with the USA
where there exists the one price (Henry Hub) and all other pricing is derived from it.
Portfolio optimization on the Continent falls upon the gas procurement managers who
evaluate and select from among the existing supply options.
To conclude, the demands by the hub pricing advocates that producers be fully
responsible for price risks in long-term contracts alter the fragile balance of interests
between buyer and seller. Pushing these demands will lead to nothing but the
demolition of long term supply contracts in their existing form. Indeed, if markets are
liquid enough (as mainstream analysts argue when pushing for hub-indexed pricing),
there is no need for long-term supply contracts. As a compromise, there could be longterm contracts with no flexibility and 100% take-or-pay. But is that what import
dependent Europe needs?
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THANK YOU FOR YOUR ATTENTION!