Hedging, Risk Management & Valuation of Long-Term Oil- Indexed Supply Contracts
By Carlos Blanco & Tamir Druz FOR THE PAST several decades, many natural
gas supply contracts in Europe have had pricing components linked to oil prices. This has been the case for both pipeline-sourced gas as well as marine-based deliveries of liquefied natural gas (LNG), although sometimes the applicable index is fuel oil or other petroleum products rather than crude oil. Some of the benefits of oil-linked gas pricing include price stability and a natural hedge against short-term gas price spikes, as well as the ability to hedge the formula components in swap markets. However, in recent years, many firms have been
moving toward hub-based index contracts. One driver for this shift has been the disconnect between utilities gas sales prices, which are often regulated, and their oil-linked purchase prices. This dynamic intensified with the decoupling of natural gas and oil prices since 2009, and many buyers have been attempting to renegotiate gas purchase contracts to include some degree of indexation to local gas hubs ever since. Today, companies can also buy and sell gas in
several highly liquid trading hubs such as the National Balancing Point (NBP) in the UK, the Title Transfer Facility (TTF) in the Netherlands and Zeebrugge in Belgium. Unlike oil-linked contracts, whose price is a function of global forces that determine oil prices, European gas hub prices better reflect the balance between local and regional supply and demand for the commodity. Despite the trend in recent years among producers and consumers to move toward gas hub index pricing1
,
many firms still have long-term oil-linked contracts in place, and several suppliers continue selling gas based on oil-indexed formulas. And indexation to petroleum prices has been especially persistent in LNG contract pricing.
Pricing Oil-Linked Gas Contracts The standard functional form for oil-linked gas
pricing is shown below: Fixed and Floating Gasoil and Fuel Oil Prices
Input P
P(0) A
Table 1. Formula Inputs & Quote Units Description
Gas Price
Fixed price component Gas oil coefficient
GO Averaged gasoil price GO(0) Fixed Gasoil Cost B
Fuel Oil coefficient
LSFO Averaged Fuel Oil price LSFO(0) Fixed Fuel Oil cost FX
USD/EUR rate Source: NQuantX
The formula components and its units are shown in Table 1 above. The parameters of the oil-linked price are shown in
Table 2. Oil-linked gas contracts often use an average oil price over a period ranging from 1 to 12 months. The lag variable is often used to apply the prior seasonal (yearly) average to the price for the following season
European gas hub prices better reflect the balance between local and regional supply and demand for the commodity
(year). The price validity period is used to set fixed prices for that period. The validity of the price brings stability in terms of costs during that period, but also increases the chances that the effective contract prices will not reflect prevailing market conditions.
Table 2. Averaging, Lag & Price Validity Period Parameters
Average Rule X Y Z
(x,y,z)
Averaging period (months) Lag (months)
Price validity period (months) The exposure to fuel oil and gasoil prices is a function Source: NQuantX
of the coefficients a and b, which can be thought of as the multipliers that convert the units of the original price quote (e.g. Metric Tonnes) into the quoted gas units (e.g. MWh).
March 2014 55
USD/tonne USD/tonne EUR/USD
Quote Unit
EUR/MWh EUR/MWh
USD/tonne USD/tonne
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