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Summary

After the liberalisation of the gas industry and gas prices, trading hubs have emerged in Europe. Although these hubs appear to be liquid market places fostering gas-to-gas competition, the efficiency of the gas market remains a topic of interest as a fair share of gas is still traded through long-term contracts with prices linked to the oil price while the number of gas suppliers to the European market is limited.

A number of recent research papers have attempted to analyse the European gas market and this post summarises their work. In short, they broadly found that:

  1. Oil price had a small positive impact on the gas price whilst coal price had no effect
  2. Changes in the concentration on the supply side did not affect the movement in gas prices
  3. The availability of gas in storage and the outside temperature negatively influenced the gas price
  4. The gas price was related to the production of wind electricity

Overall, in contrast to the often repeated assertion that European gas prices are dominated by a combination of oil and long term contract prices, the most recent studies indicate that the day-ahead gas prices are predominantly determined by gas-market fundamentals.

Introduction

The institutions of the European gas market have changed considerably in the last decade. Trading at gas hubs such as the National Balancing Point (NBP) in the United Kingdom and the Title Transfer Facility (TTF) in The Netherlands have gained rapid importance (Heather, 2012). Parallel to this development, the convention of explicitly linking the gas price to the oil price has lost importance. Because oil and gas were substitutes in many processes, oil indexation became the leading pricing mechanism for gas in the 20th and early 21st century in Europe. Since the gas market has changed significantly in recent years, however, gas-to-gas competition seems to have become the dominant price mechanism. Moreover, recent evidence shows that national gas markets in North-west Europe are increasingly integrated with each other, resulting in a North-west European market covering countries as the UK, France, The Netherlands, Belgium, Germany, Denmark, Italy and Austria (Petrovich, 2013).

Nevertheless, there are still concerns regarding the intensity of competition within the European gas market as the dispersion of reserves is concentrated while the number of suppliers is limited. If firms are able to exert market power, above-competitive gas prices may result which reduces consumer welfare.

Furthermore, the gas market faces periodical shocks in both supply and demand, which distort the gas prices. For example, the extremely cold weather throughout Europe in February 2012 led to a (perceived) tightness of the market supply. In addition, the Fukushima disaster and the consequent nuclear shutdown in Japan led to a substantial increase in Asian demand for LNG.

A number of different approaches to understand the factors behind gas prices have been used in the recent literature. Several authors have established long run co-integrating relationships between gas and oil prices (Villar and Joutz, 2006), for the US gas market. Some papers have emphasised the role of other supply and demand fundamentals, in particular for the short-run price development because energy commodities differ in fuel density and accordingly in production, transportation and environmental cost. Ramberg and Parsons (2012) show that the vector error-correction models typically applied in the co-integration framework do not perform very well in explaining short run gas price development. In another fashion, Nick and Thoenes (2014) investigated the effect of market shocks in a structural vector autoregressive (SVAR) model and found that temperature, storage and supply shocks lead to relatively short lasting effects on the gas price whereas oil and coal price shocks result in more persistent effects on the gas price.

With the strongly reduced share of explicit oil indexation and the reduced options for short run gas–oil substitution in North-west Europe, Stern (2009) states that the supply and demand fundamentals might have become more important for the development of the gas price at liberalised hubs.

Drivers of European gas prices

Over the last two years a number of different academic papers have looked at the main drivers of natural gas prices in European markets as both a reflection of historic assumptions and as an attempt to reflect the emergent trends. As a base they typically track the development of spot market gas prices at the TTF hub since this is the most liquid and mature trading hub in continental Europe (Heather, 2012). Moreover, the TTF appears to be strongly integrated with gas hubs in neighbouring markets such as the NCG in Germany and as a result, the prices on TTF and the other hubs show almost the identical pattern.

The day-ahead price is appropriate because it refers to one of the most liquid traded products which makes that the price of this product is strongly related to the underlying factors. The liquidity of the day-ahead products follows from the depth of this market, which is significantly higher than for the other products and hence, in the short run, fundamental supply and demand factors are especially important for the development of the day-ahead price. The fundamentals include the outside temperature, the macroeconomic development, the price of substitute fuels, the concentration in physical terms on the supply side to the European market, the expected level in global gas reserves and the development in renewable energy.

Most reporting in the literature finds no evidence of a strong tie between the spot prices of natural gas, crude oil and coal over the last five years. The development of the gas price is mainly determined by its own fundamentals. Though, a short-run link between the three energy commodities is present via arbitraging between oil indexed gas and hub gas as well as via fuel competition in the power market.

Despite being a fairly concentrated market, the changes in the daily gas price do not depend on the changes in the structure on the supply side. Overall, its concluded that the day-ahead gas prices are predominantly determined by gas-market fundamentals.

Global Gas prices
Global Gas prices

Price of Oil

A factor which may affect both the demand and the supply of gas is the price of oil. The price of oil is relevant because of substitution properties of gas and oil (Villar and Joutz, 2006). Substitution is primarily relevant in the electricity generation and the heavy industry. If the price of oil rises, burning gas becomes relatively cheaper, increasing the demand for gas which results in an upward pressure on the gas price. However, it has been argued that short-run fuel switching is hardly relevant any-more in West Europe because oil has virtually disappeared in most stationary energy sectors, maintenance of dual-fuel burners is expensive, tight environmental standards as well as the inefficiency of using oil in new gas burning technologies.

Oil Price

Even if the supply and demand dynamics of gas and oil differ and there is a lack of short run substitution, the price of oil influences the price of gas if the gas price is explicitly linked to the oil price in contracts, as was a common practice in Europe since the 1960s. The key question is how important this price mechanism still is for the West European market. The answer is somewhat difficult to obtain because most information sits in the private domain. The International Gas Union nevertheless estimates that the share of oil indexation in North-west Europe decreased from 72% in 2005 to 20% in 2013.

Because of the remaining oil-indexation contracts, traders try to arbitrage between spot and contract gas insofar this is possible given the minimum take obligations in these contracts (Stern and Rogers, 2014). If the gas spot price is below the oil-indexed contract price, the demand at hubs for spot priced gas will increase whereas demand for oil indexed gas decreases. This will increase the price of spot gas. Consequently, buyers with long term contracts try to decrease their nominations up to the minimum take obligation resulting in lower upstream production and total market supply. The opposite mechanism holds if the gas spot price is above the oil-indexed contract price.

Because of these remaining arbitrage possibilities, the price of oil remains a variable in the pricing of European gas with the spot price of Brent oil being the most relevant crude oil price for the West European market.

Market Structure

Although a large numbers of traders are active on the gas hubs like TTF, the supply to the gas market is concentrated because of the limited number of producers. The main sources of supply to the North-west European market are ‘indigenous’ production in The Netherlands and UK as well as imports from Russia, Norway, Algeria and LNG, primarily coming from Qatar.

MarketStructure
Daily average market share per country per year

This supply can be distinguished in inflexible and flexible supply (Timera Energy, 2013). Inflexible supply of gas include pipeline-contract gas up until take-or-pay volumes, destination-inflexible LNG cargoes (mainly into Southern Europe) and indigenous production which do not seem to respond to hub price signals in practice.

While these tranches may have some flexibility (e.g. to allow for seasonality), they generally flow irrespective of the absolute level of hub prices and have therefore no primary impact. The flexible supply of gas consists of pipeline-contract gas between the take-or-pay and maximum annual contracted volume, uncontracted pipeline import flexibility from mainly Norway and Russia and flexible LNG supply.
The limited number of producers of gas to the European market raises some concerns on the degree of competitiveness of the gas market. Typically, the production and export in one country is dominated by large state-controlled companies. This gives rise to concerns regarding oligopolistic market behaviour and profound effects following supply disruptions. If firms hold a strategic position, they are able to execute market power resulting in prices above the competitive level.

In terms of industry structure the gas market is commonly described by a Cournot configuration as the market trades in the homogenous good gas, prices observed are above marginal costs, quantity is the strategic variable and a limited number of firms supply the market.

Storage

Storage of gas plays an important role for hub prices as storages can be used for inter-temporal arbitrage. The theory of gas storage states that the level of inventories affects the difference between spot and futures gas prices.

Due to the fact that the consumption of gas is seasonal while the production has generally more limitations to adapt its levels accordingly, storages can be used with these inventories being filled in the summer for use in the winter. Traditionally, storage capacity in Europe is mainly used to smooth out the seasonal demand shape. The storage facilities demand gas in the warm period of the year when gas is injected and they become suppliers in the colder periods as gas is withdrawn.

Storage
Difference between current filling grade and the average seasonal filling grade of the past 3 years for the countries Belgium, France, Germany, Italy, the Netherlands and the United Kingdom

Technical restrictions on injection and withdrawal result in some inflexibility of storage facilities to respond to price signals in the short term. However, many storages currently under construction are being built for short-run arbitrage opportunities between spot and contract gas (Stern and Rogers, 2014). Considering that most storage facilities largely operate on a yearly planned cycle, Cartea and Williams (2008) argue that deviations from the expected storage cycle are most relevant for spot price development. If inventory levels are lower than expected, storage operators demand a higher price and vice versa for storage levels above expectations.

The countries that possibly influence the TTF price through their storage facilities are: Austria, Denmark, France, The United Kingdom, Germany, The Netherlands, Belgium, and ItalyFig. 5 clearly shows two peaks in the beginning of the time period of analysis. The first two peaks are the winters of 2011 and 2012 respectively, which were relatively mild, while the winter of 2013 was colder than average. The winter of 2014 was a very mild winter, even more than the winters of 2011 and 2012. Storages were 13% more filled compared to the 3-year average.

Resource rents

A factor which is specifically relevant for a market of natural resources is the resource rent. According to the resource-depletion theory of Hotelling (1931), the price of a resource is based on the actual costs of production and the resource rent. This rent is the value of having a stock of assets now which can be used in the future. The conclusion of this theory is that the net price of a natural resource grows with the rate of interest.

This is, however, not generally observed in reality which can be explained by the presence of other factors affecting the price, in particular related to extraction costs, market structure and uncertainty. Extraction costs are decreasing over time, due to technological progress, which depress prices. The market structure has a strong influence on price as in the case of imperfect competition a tendency exists to keep production below the optimum rate which has an upward effect on prices. Finally, uncertainty about the total size of the natural resource stock is clearly a factor that influences the price.

Nevertheless, the relationship between the market price of a resource and the marginal natural resource rent is expected to be positive (Faber and Proops, 1993). The higher the resource rents, the higher the market price of the natural resource. These authors find a number of factors that influence the level of resource rents, such as the availability of the natural resource, the technical progress in natural resource extraction as well as the time preference and the length of time horizon of decision makers

Demand factors

Natural gas is the primary source of heating in North-west Europe and as such, demand from residential and commercial users mainly depends on the temperature. Gas consumption is higher in the cold autumn and winter periods and lower in the warmer spring and summer months. This gives rise to a profound seasonal pattern in the gas price in North-west Europe. As alternative fuels for heating are typically limitedly available, gas demand related to heating is inelastic. In the long run, however, people are able to switch from heating source and, consequently, the long run demand depends on relative fuel costs.

Several industrial sectors use gas as primary input into their production processes. Accordingly, their gas demand depends primarily on the level of economic activity in the short run. In the long run, industrial end-users have more options to switch from a gas-fired production plant to other fuels.
Moreover, a considerable part of electricity in North-west Europe is generated using natural gas as input. The demand for gas by gas-fired electricity generators depends primarily on the price of gas relative to other fuels used for electricity generation, in particular coal. In addition, the price of CO2 emission, resulting from the European Emissions Trading Scheme, affects the relative cost of gas fired generators to coal fire generators as the latter emits significantly more CO2 in the production of electricity. If the price for carbon credits increases, gas-fired generators move down in the power generation merit order, likely at the expense of coal fired plants, thereby increasing the demand for gas from the power generation sector.

The importance of gas in electricity generation varies per country. In The Netherlands natural gas accounts for the largest share in power generation, while in France it has a negligible share due to the intensive use of nuclear energy. Mainly driven by EU and national policies, there has been a vast increase in the share of renewables in electricity generation. This holds in particular for Germany, where the ‘Energiewende’ has resulted in a dramatic change in the energy mix. Renewables typically have very low marginal costs and have a lower position in the merit order than gas fired power plants. Demand for gas from the power sector is therefore reduced by the rise in renewable capacity in electricity generation

Supply shocks

In addition to the above fundamental factors, we have to control for a number of incidental shocks to the market. Supply disruptions can have a profound impact on hub prices. Because production is concentrated within a limited number of producers, disruptions in the supply of one company can lead to increased supply from more expensive sources or a decrease in total market supply. Given that demand is relatively inelastic in the short run and the flexibility of the remaining sources of supply is somewhat limited this can lead to sharp increases in spot prices at hubs following supply shocks.

In particular we include a dummy for the extremely cold temperatures throughout North-west and East Europe from the 31st of January until the 19th of February 2012. Gazprom was unable to meet the dramatic rise in demand for gas leading to shortages in a number of countries. Moreover, Russia alleged Ukraine of gas theft (Henderson and Heather, 2012). In addition, we include dummies for the Fukushima disaster and the consequent nuclear shutdown in Japan which have led to a substantial increase in Asian demand for LNG.

Conclusion

Fundamental factors affecting demand or supply in the gas market have significant effects on the movements in the day-ahead gas price. Although the price of gas is still related to the price of oil, this linkage is not strong anymore. Moreover, the high degree of concentration on the supply side of the gas market does not affect the gas price, suggesting that the market prices are not distorted by a lack of competition.

The work of Hulshof, van der Maat and Mulder (2016) indicates that the policy measures implemented in the North-west European countries to introduce competition in wholesale gas markets and to integrate these markets by reducing cross-border barriers appear to have been successful in realising an efficiently working gas market. These effective policy measures are related to the capacity-allocation mechanisms and congestion management as well as investments in cross-border capacity. Policies to further integrate national gas markets within Europe may extend this gas-to-gas competition to a larger region. These policies may contribute to realise a fully integrated European energy market as it is pursued by the European Commission (EC, 2015).

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References
  1. B. Petrovich : European Gas Hubs: How Strong is Price Correlation?
  2. Villar, J., Joutz, F., 2006 : The relationship between crude oil and natural gas prices
    D.J. Ramberg, J.E. Parsons :The weak tie between natural gas and oil prices Energy J., 33 (2) (2012), pp. 13–35
  3. S. Nick, S. Thoenes What drives natural gas prices? : A structural VAR approach Energy Econ., 45 (2014), pp. 517–527
  4. P. Heather : Continental European Gas Hubs: Are They Fit For Purpose?
  5. J. Stern, H.V. Rogers The Dynamics of a Liberalized European Gas Market: Key Determinants of Hub Prices, and Roles and Risks of Major Players
  6. Timera Energy, 2013. A framework for understanding European hub pricing. 〈http://www.timera-energy.com/uk-gas/a-framework-for-understanding-european-gas-hub-pricing/〉
  7. K. Hotelling : The economics of exhaustible resources
  8. Faber and Proops: Natural resource rents, economic dynamics and structural change: a capital theoretic approach
  9. Daan, van der Maat & Mulder : Market fundamentals, competition and natural-gas prices

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