The Changing Fundamentals of Global Gas Markets – Europe as the Battleground?

IMGXYZ2727IMGZYXGlobal gas consumption still trails behind oil and coal. Yet, demand for natural gas has grown substantially over the last three decades, outpacing the growth of demand for oil. The International Energy Agency (IEA) projects gas consumption to grow 42 percent by 2030.

There are currently two mechanisms for pricing natural gas: oil indexation, which links gas prices to oil, and a spot market or hub-based model, in which the price of gas is determined by market competition. Oil indexing emerged in Europe in the 1960s, and spread to Asia, where it remains the prevalent model. Spot market pricing developed in the United States and began to spread in Europe in the 1990s, after the liberalization of the UK natural gas market. In the past couple of years, Europe’s gas market emerged as the battleground of an increasingly intense competition between these two pricing mechanisms.

To launch his new report Natural Gas Pricing and Its Future: Europe as the Battleground, Anthony Melling discussed the background and potential outcomes of the competition between the two natural gas pricing mechanisms. Carnegie hosted Melling, along with Deloitte’s Branko Terzic, Vello Kuuskraa of Advanced Resources International, Hidehiro Nakagami of Tokyo Gas, Mikhail Korchemkin of East European Gas Analysis, Chris Goncalves of Charles River Associates, and Carnegie’s Adnan Vatansever, to discuss the report and its wider implications.

Background and Impact of Europe’s 2009 Gas Crisis

The price of gas purchased under European long-term contracts is tied to the price of oil. In 2009, several conditions converged to create an over-supply of natural gas. Large quantities of gas sold under short-term contracts at commodity prices became available, in some cases selling for half the price of oil-indexed gas. As a result, incumbent wholesalers—who had long-term contracts with producers that forced them to pay high oil-indexed prices— found themselves unable to charge their customers an amount close to what they paid for the gas. Unable to sell the large amounts of gas they had contracted for, they ended up owing billions of dollars in penalties to the producers.

The crisis had an impact not just in Europe, but in other parts of the world as well. It affected gas sales revenues, which are essential to the governments of Russia and Algeria, both of which are proponents of oil-indexing. The crisis was also felt in Asia, where the oil-index model remains dominant.

Implications

Currently, many producers are still selling gas at oil-indexed prices while others are selling at market value. While there is little doubt that more producers will eventually move to using spot market prices, oil-indexed producers are not giving up without a fight. The issue of which pricing model to use will have wide-ranging implications:. 

• Resource Development: The reigning pricing model will affect the development of major gas resources. For example, oil-indexed prices provide a relatively stable cash flow, which encourages the development of new gas resources. It is not clear whether gas developers, if faced with the need to sell gas at spot markets, will perceive greater investment risks than they did so far.
   
• Fuel Consumption: The price of gas determines whether or not it is competitive against other fuel sources, which affects consumption. A change in the gas pricing model has the potential to reshape the patterns of interfuel competition and gas consumption in Europe and internationally.
   
• A Bridge: A change in the pricing model could also determine the role of gas as a bridging fuel in the transition toward a low-carbon economy. If prices become more competitive, natural gas is more likely to be adopted as an energy source by consumers.

Future Outlook 

Melling outlined the possible ways in which the ongoing competition between oil-indexation and market-based pricing might be resolved.

• Dramatic Revolution: This approach would entail a repeat of the 2009 scenario, with another oversupply of market-priced gas triggering urgent renegotiations of oil-indexed contracts and leading to a sudden shift away from the oil-index model to the market-based model.
   
• Negotiated Revolution: In this scenario, oil-indexed purchasers would jointly negotiate a switch to commodity market pricing with the key producers.
   
• Evolutionary Transition: In a third model, producers and purchasers might organically move toward market pricing at a more gradual pace.

Natural Gas in Power Generation

In the United States, 17 percent of the energy consumption for electric power generation currently comes from natural gas, as opposed to 51 percent from coal, 21 percent from nuclear power, 9 percent from renewable energy sources, and 1 percent from petroleum.

Natural gas carries multiple advantages for electricity generation, both in the United States and in Europe: it is available, deliverable, and significantly cleaner than coal in terms of carbon dioxide emissions.

If gas is to play an increasing role in power generation, natural gas contracts must respond to the needs of competitive electricity generators, Terzic stated. He argued that for power generators in Europe, spot gas supply agreements (GSAs) are preferable to long-term, oil-indexed ones.

• Under long-term contracts, generators may be obligated to either face high take-or-pay penalties or to buy large volumes of gas, which they must then sell at a loss. Under a take-or-pay contract, buyers pay a penalty if they fail to buy the volume of gas they had originally committed to purchasing. Given such penalties, spot GSAs based on market prices are less risky for power generators. 
   
• The benefit of spot GSAs for power generators will help spot gas contracting continue to gain ground in Europe, Terzic predicted. However, he added, long-term, oil-indexed GSAs are such a long-standing fixture that they will not completely disappear from European gas markets in the foreseeable future.

Unconventional Gas in the United States and Europe

In the United States, the availability of shale gas has changed the outlook for natural gas, effectively mitigating fears of impending natural gas shortages. Unconventional gas, such as shale gas, accounts for more than 60 percent of all U.S. gas production.

In order to realize the potential impact of shale gas on European markets, producers must first resolve several important questions, Kuuskraa said.

• Size and quality of resources: Europe’s largest gas shale resources are located in three main deposits, and the highest potential gas shales may be located in Poland, where the resource quality appears to be higher. However, with its larger and more closely spaced faults, which may inhibit gas production by acting as water conduits, Europe’s gas shale geology is more complex than North America’s. This makes production more difficult and complicates production estimates.
   
• Technology and infrastructure: European producers must expand the infrastructure to efficiently drill, develop, transport, and store gas.
   
• Environment: Kuuskraa emphasized the importance of “green development” in developing shale gas reserves, including reducing surface impact, capturing methane emissions, and assuring environmentally safe wells and hydraulic fractures. Hydraulic fracturing is used to increase the rate at which gas can be extracted from a well, but it carries the potential for contaminating water supplies with chemicals or waste fluids.
   
• Operating costs: European producers would have to overcome significantly higher capital and operating costs, which are currently at least two times those in North America. Fortunately, costs tend to decrease over time, Kuuskraa pointed out.

Russia and Gazprom

Gazprom, which sells gas to Europe in long-term take-or-pay contracts based on oil-indexed prices, has seen a steady loss of market share in Europe over the last decade.

• Contract rules: Gazprom will not be able to export larger quantities of gas unless it reexamines its contract rules, which currently keep prices artificially indexed to the price of oil rather than reflecting the supply and demand realities of the European market. Indexation and renegotiation rules must be adjusted to reflect those realities, Korchemkin said.
   
• New pipelines: Gazprom’s pipelines investment program does not reflect the market situation, Korchemkin said. Despite its declining market share and dropping demand for Russian gas in Europe, Gazprom is set to build 25,000 kilometers of new pipelines. This pipeline system expansion will require significant amounts of capital, ultimately making Russian gas less competitive in the European market.
   
• Domestic price of gas: Russia’s domestic gas prices are heavily subsidized. Increasing Russia’s domestic price of gas is not a realistic solution to offset Gazprom’s shortfalls in the European market, Korchemkin said. Russian industry, including steel production and the chemicals sector, is plagued by low energy efficiency. An increase in the domestic price of gas would hurt the competitiveness of domestic industry, potentially pushing some sectors out of business.

Natural Gas in Asia

The natural gas market in Japan and Asia in general is highly constrained, compared to the more liquid markets in the United States and Europe, Nakagami said.

• Demand: The demand for liquid natural gas (LNG) in Japan, Korea, and Taiwan is projected to grow through 2030. China's demand for LNG will depend partly on whether Russia and Central Asia become swing producers between Europe and Asia, using their spare production capacity to increase or decrease supply, thus balancing the markets, instead of supplying the majority of their gas to Europe.
   
• Supply: China is believed to have significant shale gas potential, and exploration and production are already underway in several areas. However, uncertainty over political and environmental consequences makes the future of Chinese shale gas development unclear.
   
• Market-based pricing: The growing influence of hub-based, or market based, pricing in Europe also affects Asia, where oil-indexed gas prices remain the dominant mechanism. When hub prices are significantly below oil-indexed prices, a large price differential emerges between Europe and Asia. Because regional markets are connected through LNG, hub-based pricing will become more influential in Asia in the future, Nakagami predicted.