50 Years of Gas pricing

Much of the gas traded across boarders is sold at prices linked to those of crude oil. When gas was first brought to market as a commercial fuel in the 1960s, as an alternative to home heating oil, it made sense to price it against its substitute. It also made sense from a more subtle reason; oil was used as an independent price arbitrator for Dutch gas in the 1960s and then for Algerian and Norwegian gas in the 1970s because neither side could influence the supply and demand for it. The system continued as Russian gas came to Europe in the late 1970s, but as the economics changed, valuing one commodity in terms of another now seems bizarre.

Britain has had competition based upon supply and demand since deregulation of the energy industry in the 1990s. The fuel is traded at the National Balancing Point, a virtual hub. Similar arrangements are now spreading across north-western Europe at the virtual Title Transfer Facility (TTF) based in Zeebrugge (Belgium) and NetConnect Germany (NCG) and Gaspool in Germany. The model these markets based themselves on is America’s Henry Hub in Louisiana, where nine interstate gas pipelines meet and from where the North American benchmark price is set.

Prices movements of Gas and Oil

Chart showing the movements oil and gas in the Brent, NBP, TTF and Zeebrugge markets

Fixed prices drive European Gas

The majority of continental European gas is priced upon longer term fixed contracts indexed to oil. A more competitive market would doubtless make gas cheaper by breaking that link to oil. This will be hard to bring about given the strong vested interests in maintaining the status quo. Gazprom,Russia’s huge state-run gas producer and supplier of 25% of Europe’s gas, is strongly opposed to dropping oil indexation. A tussle is under way between it and the continent’s big buyers. One opinion holds that gas must eventually become a global product like oil, with regional price differences closing as more gas is shifted in the form of LNG, others reckon that this will never happen.

Gas producers are naturally happy as a result of the high prices resulting from oil indexation, arguing that without them, the economies of large scale gas production would not work. Oil producers themselves are also keen to maintain prices around $100/barrel. Recent comment by the Saudi Oil Ministry supports this and indications are that their large domestic infrastructure products require a price higher than $90/barrel to be sustainable. There are however good reasons for all concerned to want competitive gas prices; a reduction in regional volatility and allowing both producers and consumers access to broader and more flexible markets.

How comparable is North America to Europe?

If the “shale gale” blowing through America can be replicated worldwide, the huge surpluses it would bring could hasten the advent of a global market. However, the wind blowing through North America may take on an entirely different hue to that which may eventually come through Europe. Shale Gas has flooded the market with cheap gas in North America and the potential for this to be a long term market change are quite apparent. European Shale Gas is far less developed and a factor in favour in the continuation of oil-gas indexation in the European sphere is that it is an effective protection against major exporter’s monopoly power. Those that refute the move away from oil indexation also point to historical, institutional and geological reasons for continuation of the status quo. Broadly, they state, that the main exporting companies will never be as the American gas market with its thousand of producers, shippers, traders and consumers trying to optimize daily their portfolios of contracts. History and geology matters, resource endowments, property rights on subsoil, industry ownership, infrastructure and operations simply are not that fragmented in Europe. The European upstream market cannot escape the fact that it is definitively concentrated. Markets must not only be transparent and liquid; they must be “deep,” with many interested buyers and sellers. So when we think that gas indexed contract will be more efficient, we must not forget that efficient spot markets can easily be distorted by a concentration of market power in the hands of one or more sellers or buyers. There are undoubtedly large dominant positions in the upstream market. But as in many national gas markets in Europe there is a small oligopoly in the supply business, gas-to-gas price competition does not provide defensible price indicators.

Where to from here

North America, Europe and Asia represent three distinct phases with varying degrees of supply and demand dynamics and constrains. A large glut of gas on the markets accompanied by a ready supply of LNG should see a continued decoupling of gas from oil prices as prices are driven down and liquidity up. It is in no way certain that suppliers would naturally be driven to withdrawal from oil indexed contract without an alternative or compelling reason. Certainly, the next decade will present some unique opportunities and challenges.

Links and references

The Economist

http://www.energypolicyblog.com/2008/06/29/why-would-oil-indexation-in-gas-contracts-survive-in-europe/

http://www.oilandgasuk.co.uk/economic_report/gas_prices_delink_from_oil.cfm

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