Is the price friendship between oil and gas over?

natural_gas_1In the ‘60s years natural gas started to gain importance and to be consumed in large quantities, therefore a natural gas market was established. Natural gas market developed on a regional basis, in opposition to the oil market which evolved on a global scale. This was due to the difficulties in supplying natural gas all over the world. Thus, in different geographic areas, gas markets progressed according to different principles.

In particular, in United States and UK price level was determined on the basis of “hub markets”, whilst in continental Europe the “long-term oil indexed gas price” was adopted, instead in the Soviet area there was a state-regulated price model (Stern, 2012).

Gas hubs are physical or virtual points where natural gas is exchanged between buyers and suppliers, thus there is an interaction between supply and demand, which, in turn, determines the price. If the number of the transactions on the hub is high, it is said to be “liquid”.

In opposition to this trade mechanisms, there are the long term supply contracts, which consist in agreement negotiated with producing countries (e.g. classical European suppliers are Russia, Norway, the Netherlands or Algeria), that last many years (i.e. up to 30). During the duration of the contract, the consumer takes the obligation to withdraw a certain quantity of gas and the supplier furnishes the agreed quantity on the basis of the price negotiated.

It is said that consumer assumes the volume risk, whereas the supplier takes the price risk. This risk sharing agreement is expressed in the so called  TOP (Take or Pay) clause, which states that the consumer is obliged to withdraw a minimum quantity of gas every year and if it does not take it, it must be paid as well.

When these kind of contracts were introduced, natural gas was considered to be a good and direct substitute of heating oil, therefore it was almost an obvious consequence to link gas price to that of oil, because it was seen as its closest substitute.

Another important reason to link gas and oil price was found in the fact that, at that time (’60-’70 years) there was already a developed and transparent oil market, therefore it was seen as a warranty to establish gas price on the basis of a clear mechanism not suspected to be influenced by the parts involved in the contract. But, on the other hand, the price connection between oil and gas is not linked with the fundamentals of natural gas sector and, after 1998 when OPEC decided to adopt the IPE Brent as price reference for oil (i.e. a financial product), natural gas price became subjected to the speculations of the financial market.

The main reason to adopt long term agreements is that they are supposed to offer an acceptable level of security to gas companies in order to perform investments in huge and capital intensive infrastructures, such as pipeline, development of basins, storages and so on.

This kind of agreement has undisturbed dominated the European gas market for more than forty years until about 2005.

Around 2005, gas hubs started to be developed in Europe, except for NBP (i.e. National Balancing Point in UK) which started its operations in the middle of ‘90s, and up to 2007-2008 continental European gas hubs did not expressed price levels significantly different from oil-indexed contracts and their liquidity was limited.

After the 2008 this condition drastically changed as a consequence of the general economic downturn and due to some specific issues (Bianco et al., 2014):

  • Economic downturn caused a reduction in natural gas demand, with the consequence of increasing volumes on the market;
  • Such as natural gas, also electricity demand decreased and electricity generators tried to sell on the gas market part of their ‘‘take or pay’’ quota, in order to reduce financial losses;
  • Because of the strong development of unconventional gas extraction in USA, a huge quantity of liquefied natural gas (LNG), originally directed in USA, was diverted towards European and Asian markets.

Given this situation, power generators, which are among the larger consumers of natural gas, tried to sell part of their TOP on the gas hubs, gas suppliers tried to react to the drop in consumption offering increasing quantities of spare volumes on the hubs and also LNG operators adopted the same strategy to sell the volumes originally directed to USA.

All this caused an increase of liquidity on the hubs and, according to the general market law of equilibrium, the prices sharply decreased and decoupled from oil-indexed contracts. In fact, oil-indexed price continued to increase, because oil price increased, showing an uncorrelated behavior.

All this has meant that, from 2008, the usual commercial environment for European gas companies has been subjected to a number of new (and difficult to predict) forces, which have exacerbated the problems of reliance on the relatively rigid oil-linked price formulae in long term contracts (Stern, 2012).

From 2008 up today, many renegotiations of oil-indexed natural gas supply contracts are in progress, because consumers see very low prices on the gas hubs if compared with the level of their contracts, therefore they try to obtain better conditions for their furniture.

In the meanwhile, small power operators and natural gas wholesaler started to buy natural gas volumes on the hubs benefiting from very competitive prices and large operators, which in most of cases have significant oil-indexed supply contracts in their portfolios, to avoid the displacement from the market, offered their power plants or gas quantities in line with the price level of the hubs, suffering huge financial losses.

This situation has generated a great confusion, because hub prices have been perceived as “more convenient” with respect to oil-indexed formulas, but the fallacy of this equation is rather evident, because there is the mistake of confusing price formation with price level (Stern, 2012).

Thus the assertion that, when the gas supply/demand balance tightens, gas prices will “recouple” with oil prices, reflects this confusion.

A tight supply/demand balance will certainly result in higher prices, but there is no necessary relationship between the latter and oil related price levels (Stern, 2012).

In my opinion, this is certainly true from the theoretical point of view, but from thenatural_gas_2 practical point of view it might be considered a “rule of thumb” that the oil-indexed gas formulas represent the highest limit for price level. If gas price on the hubs should exceed oil-indexed formulas, it does not make any sense for large consumers to purchase on the hubs due to the complex issues connected with the physical delivery; on the contrary it results more convenient to sign a long term agreement to obtain a stable furniture, even though less flexible.

It can be said that, at moment, energy markets in general and gas market in particular are in a period of transition and a new equilibrium is expected to be found after the economic crisis, when the demand of energy is expected to rise again.

Many analysts are thus concerned about the future price level of natural gas and the related price formation mechanisms.

For some of them, i.e. (Stern, 2012), the price level will be expressed directly by the interaction of demand and supply on the gas hubs and long term oil-indexed contracts will be abandoned, because they do not reflect the economic fundamentals of natural gas sector.

On the contrary other analysts, i.e. (Standard&Poor’s, 2012), think that the current condition is only transient and when there will be a recover of the demand the prices will come back on the pre-crisis level.

It can be concluded that the price friendship between oil and gas is weakened, but it is difficult to think that it will be broken.

(c) Vincenzo Bianco

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