Guest column: Oil-based pricing represents a drag on the industry

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Energy prices do not generally conform to first principles of economics and this is particularly true for the international gas market.

With the exception of North America and the UK, the vast majority of internationally traded gas has traditionally been priced in relation to oil; oil products in the case of Europe and crude oil in the case of Asia.

However, since 2008, this mechanism – which has its origins in the fact that gas mostly replaced fuel oil and gas oil when it was introduced into European energy balances back in the 1970s and 1980s – has come under increasing pressure.

A decline in gas demand, caused by the recession, coincided with a surge of liquefied natural gas supplies from projects that started construction in the mid-2000s – partly to meet expected additional demand in the US.

This turned out to be much lower than expected, because of the shale gas revolution, which has significantly lowered prices and redirected LNG supplies towards Europe.

In 2009, all this resulted in reductions of 13-16 per cent in long-term contract exports of Russian, Algerian and Dutch gas to European customers compared with the previous year, causing some importing utilities to incur significant “take or pay” penalties.

The emergence of market hubs in the big, north-west continental European markets – partly fuelled by increasing quantities of LNG – has begun to provide an alternative, and far more transparent, price reference.

While depth and liquidity is significantly less than at the UK’s National Balancing Point, the German and Dutch hubs in particular are growing rapidly.

For most of 2009 and 2010, prices at these hubs have been about 50 per cent of oil-linked long term contract prices and fairly well correlated across north-west Europe, lending them credibility.

While these hubs fall short of a perfect reference price, they provide a much better reflection of market conditions than long-term contracts based on oil prices above $70 a barrel.

As a consequence, hub prices have increased their share in long-term contract indexation, with a reduction in the share of oil products. General price discounts and relaxation of take or pay obligations have also been reported.

Suppliers such as Gazprom have taken the view that these market conditions are temporary, demand is recovering, and short and long-term prices will converge in 2012-13, with oil linkage regaining its traditional pricing function.

The disappearance of the gas surplus by this date may be a reasonable assumption, but market conditions over the next two to three years could permanently change price formation.

The supply/demand dynamics of oil, which is principally a transportation fuel, and European gas which is principally a stationary fuel, are fundamentally different.

Insistence on maintaining the linkage with oil prices above $70 is likely to jeopardise both short- and long-term demand in the power generation sector (gas’s only significant growth market). Prospects are already uncertain because of renewables, coal (with carbon capture and storage) and nuclear on the one hand, and security of supply concerns on the other.

Algeria’s suggestion at the April 2010 Gas Exporting Countries Forum (GECF) meeting that exporters should reduce supplies to support prices, apparently met with no support from other big suppliers, although the Forum endorsed the principle of gas price parity with oil.

Not only is the GECF lacking key gas exporting countries (particularly in the Pacific), but those serving UK and US markets know that prices are set at the hubs. All this complicates progress towards a “Gas Opec”, even for those exporters whose goal is a price or volume setting cartel.

A transition to hub-based prices is often taken to mean the end of long-term contracts, but this is unlikely to be the case.

Existing contracts – some of which have more than two decades to run – will remain, but extensions and new contracts are likely to be of shorter duration and with much greater price and volume flexibility.

The question is how much change needs to be made immediately to price and/or volume flexibility in existing contracts, given the unwillingness of the biggest importing utilities to incur substantial take or pay penalties, or to risk losing customers to suppliers able to offer gas at lower prices.

A transition to hub-based prices has begun and seems likely to continue.

The gas surplus will disappear before 2015, at which point hub prices will rise significantly.

But continued linkage to oil prices on a formal contractual basis has no market logic, and the most likely result of individual or collective GECF efforts to enforce such linkage will be a reduced role for gas in European energy balances.

Professor Jonathan Stern is director of gas research at the Oxford Institute for Energy Studies

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