European Gas – The Oil Link ... The long Goodbye?
One of the consistent questions about the future of European gas prices is whether the direct indexation of natural gas prices to oil and oil products in long-term supply agreements is about to be broken.
THE EUROPEAN GAS market was founded on oil-indexed long-term contracts that were introduced for two main reasons: 1) Most producers are integrated oil firms, so investment in supply infrastructure was underpinned by exposure to a market they understood and a manageable amount of risk was carried;
2) It gave buyers comfort that gas, which was largely a substitute for oil products, would be consistently priced competitively (ie, cheaper) to those energy sources.
The resulting contracts were all
predominantly indexed to a basket of some or all of the following – Brent crude, heavy fuel oil and gas oil – with the indexation formulas usually taking these fuels prices with a 5 to 6-month lag.
Recent comfortable supply margins have re-ignited the pressure on the oil-indexed pricing link The prevalence of oil-indexation
across the European gas market has persisted largely uncontested until today, with the bulk of natural gas still being priced on this basis in most countries. The main exception is the UK, where the combination of a supply overhang and a dedicated push to introduce a market for natural gas resulted in a shift to market-based pricing for gas from the mid-1990s. The emergence of the UK benchmark national balancing point (NBP) contracts and sufficient liquidity in the spot and forward markets gave market participants the ability to move away from oil- indexed pricing by providing an
42 December 2010
alternative index for those long-term supply contracts. Important in this move, which brought considerable financial pain to some participants with large portfolios of oil indexed supply contracts, was the willingness of the UK government to address incumbent market power while introducing robust, transparent and regulated third-party access arrangements to the national gas transportation system. It was also important for the incumbents to embrace the market and be willing to renegotiate their supply contracts.
Supply Overhang Recent comfortable supply margins have re-ignited the
pressure on the oil-indexed pricing link. Throughout 2009, NBP market gas prices traded at an average 45% discount to the oil- indexed linked prices, with summer supply from the UK to the continent through the interconnector up 58% (2009 versus 2008). UK day-ahead gas prices, which averaged 53 p/therm in Q1 08, only managed to average 36 p/therm in Q1 10 despite the coldest winter in Europe in 30 years. The ability to source much cheaper market gas and turn down
supply under the oil-indexed contracts has become more than just tempting. Gazprom reported that the turn down in Russian gas was 20 bcm in 2009, as continental gas suppliers either only called on their minimum take under their long-term contracts or even called on less than minimum take (and would be required to pay contractual penalties). Gazprom, one of the more resolute defenders of oil-indexed
pricing, was obviously aggrieved at losing market share to LNG and announced in early 2010 that it was going to index the flexible volumes (above minimum take) to the spot market. The clear intention was to win back market share by making their customers indifferent to buying at the NBP or to calling under their long-term contracts. What the cold H1 10 told the market, particularly when combined with the supply incidents, was that oversupply cannot be taken for granted. The history of markets tells us that oversupply is transitory, often driven by the lumpiness of capital investment. But it is during oversupply that market pricing structures are often broken, as buyers seek a cheaper alternative. The real question is: when do we expect the supply to start to tighten in Europe and to drive parity or annual premiums to the oil-indexed price?
System Inertia Supply overhang and the emergence of a good spot market are necessary but insufficient criteria for a significant shift to
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