Long-term Gas Contracts

Transcription

1 Global Risk & Trading Long-term Gas Contracts Preparing for a New Paradigm By Cantekin Dincerler, PhD Christian Lins, PhD Johannes Schmitz, PhD

2 For decades, oil products have been the basis for pricing long-term gas contracts. But recently, this link has broken down. Major utilities, like Germany s EON, Italy s Edison, and France s GDF Suez, are all trying to renegotiate their contracts with gas suppliers to link their purchases to less expensive wholesale gas market prices. In response, gas producers have made some concessions. But we believe the gas industry needs to prepare for the likely case that the oil-gas link will soon be a thing of the past. There are a number of structural reasons why oil prices could play a smaller role in long-term gas contracts in the future, as indexes based on commodity baskets grow in importance. For starters, European regulatory changes have accelerated market liberalization. As a result, wholesale gas markets have become much more liquid. In addition, the present gas value chain is no longer sustainable. In fact, we estimate that midstream players are being forced to bear risk capital requirements that will significantly exceed the size of their earnings, because the gap is widening between long-term gas contracts based on oil prices on the procurement side and wholesale gas market pricing on the sales side. Midstream players are suffering the most from squeezed margins today. But all members of the gas value chain share a common interest in creating a new paradigm one that will redefine roles and interfaces to make the overall risk-return distribution more efficient and sustainable. Indeed, midstreamers present struggles could serve as a valuable catalyst for producers diversification strategies in Continental Europe, which could ultimately be crucial for such producers long-term growth. This article examines how large a share of long-term gas contracts could become based on gas wholesale market prices and on commodity basket indexes in the future. It then suggests broad strategies for different players in the future gas market, offering insights into how their roles, and their long-term gas contracts, could change. The End of an Oil-Gas Link Legacy For more than 30 years, oil products served as the basis for pricing long-term gas contracts, primarily because oil was viewed as a relatively liquid market that was less prone to market manipulation by individual players. Oil indexation was considered to be a pragmatic approach Exhibit 1: Oil and gas markets are no longer synchronized, altering traditional risk ownership in the gas value chain RISK OWNERSHIP TRADITIONALLY Producer (Oil long-term contracts) Midstreamer $ $ Consumer (Oil long-term contracts) Price risk (oil) Oil indexed Volume risk Credit risk Oil indexed Price risk (oil) RISK OWNERSHIP TODAY Producer (Oil long-term contracts) $ Midstreamer Consumer (Hub gas) Price risk (oil et al.) Oil indexed Volume risk Credit risk Price risk (oil/wholesale gas spread) Hub-based natural gas Price risk (oil) source: Oliver Wyman Copyright 2012 Oliver Wyman 2

3 to facilitating the bankability of a large investment project, as the gas and oil markets were largely in sync. During this time, the commercial risks in the gas value chain resided primarily with their natural owners: Upstream gas producers owned the price risk through oil indexation. Midstream utilities assumed the volume and credit risk associated with downstream consumers. Downstream consumers, meanwhile, were exposed to the price risk passed from midstream players. Since 2009, however, the gas-oil link has broken down in the wholesale gas spot markets as well as in the forward markets. Wholesale gas markets have become more liquid, offering consumers and utilities an alternative to the traditional long-term gas contract. As a result, risk has been redistributed throughout the value chain: As gas prices in sales contracts are increasingly based on wholesale gas market prices, a mismatch between prices on the supply side and the sales side is developing, creating significant price risk exposure for midstreamers. The breakdown of the oil-gas link is not likely to be only a temporary phenomenon. Regulatory changes in Continental Europe have created a network of increasingly liquid wholesale gas markets where prices are based on short-term fundamentals rather than on the global oil market. As a result, oil and gas markets are less synchronized. For example, wholesale gas prices are rising much slower than crude oil prices, which have surged above $100 per barrel. This decoupling is due in part to a glut of natural gas, which is widening the spreads between oil-indexed gas and wholesale gas market prices. Most industry experts expect the natural gas markets to remain oversupplied for the next three to five years. The reasons for this include: Europe is likely to remain a preferred destination of liquefied natural gas surplus production, China plans to increase its indigenous production, and huge liquefied natural gas projects in Qatar will soon come on line. New Pressures on the Gas Value Chain These structural changes are putting pressure on midstreamers margins and increasing risk capital requirements throughout the gas value chain in two ways. First, risk capital requirements are rising in response to more volatile commodity prices. Second, the widening gap between long-term gas contracts based on oil prices on the procurement side and wholesale gas market pricing on the sales side is raising risk capital requirements not only for midstreamers but also across the entire gas value chain. Consumers are increasingly insisting on using currently lower wholesale gas market prices as the pricing reference for midstreamers price offers. As a result, midstreamers are being forced to sell natural gas at rates closer to wholesale gas market prices and to negotiate with producers to reduce the minimum amount of gas tied to oil-indexed prices that they must take. Midstreamers suffered from a huge decline in gas demand volumes from 2008 to Most recently, in the first half of 2011, many have experienced squeezed margins because wholesale gas market prices have been as much as five euros per megawatt hour less than the prices in their long-term gas contracts. At the same time, more risk capital is being deployed throughout the gas value chain without creating additional value. To cope with more volatile oil and gas prices, upstream gas producers are being forced to deploy three times as much risk capital as they did in Downstream consumers must keep almost twice as much risk capital in reserve. Midstreamers risk capital requirements have ballooned by 4.5 times because of their exposure to widening gas-oil price spreads. Copyright 2012 Oliver Wyman 3

4 While the risk/return ratio of producers and consumers remains somewhat balanced, the new risk capital requirements for midstreamers seem unsustainable in the long term: Risk capital requirements significantly exceed their earnings. Indeed, midstreamers almost certainly face stagnant or declining earnings in the near future. In the short term, midstreamers believe they need to renegotiate contractual terms with gas producers in anticipation of a realignment of the risk and return distribution along the value chain. In the long term, however, all members of the value chain share a common interest in redefining roles and interfaces to make the overall risk-return distribution more efficient and sustainable. To establish a fair and stable solution for all stakeholders, it is critical that gas producers and midstreamers share a common perspective on what the future of long-term gas contracts should look like. In particular, gas producers and midstreamers should reach agreement on the following questions: How big will the share of long-term gas contracts be in the future that will be based on gas wholesale market prices versus contracts which will be linked to oil indexes or other commodity (basket) indexes? What role will the different players in the gas value chain play, and what will the future business model for midstream players be? Exhibit 2: Risk-return in the stylized gas value chain (in /MWh, illustrative) PRODUCER MIDSTREAMER CONSUMER GAS-FIRED POWER STATION TOTAL OF VALUE CHAIN Long position in oil product index Short position in oil product index Long position in oil and hub gas Long position in power Short positions in oil indexed products and emissions Long position in oil product index Risk Capital in EUR/MWh x x x x Risk Capital in percent of EBITDA 178% 51% 78% 42% 68% 95% 52% 104% Risk Bearing Capacity Maintained, despite higher volatilityx Significantly stretched given higher volatility and LTC/hub gas decoupling Maintained, as power prices highly correlate to hub gas Stretched, given overall volatility increase & contractual mismatches oil-gas link intact 2009-Present oil-gas link decoupled Source: Oliver Wyman analysis based on publicly available data and a simplified gas value chain Copyright 2012 Oliver Wyman 4

5 The Shift to Long-Term Gas Contracts Based on Gas Wholesale Market Prices and Commodity Basket Indexes Long-term gas contracts based on oil or other commodity indexes will be sustainable only if there is a natural demand for them. We estimate that the demand from consumers in Continental Europe, excluding France and the Iberian Peninsula, for long-term gas contracts that are based on oil or other commodity indexes will be less than 30 percent of total demand. Most of these customers could request contracts which are indexed to commodity baskets or to power prices rather than based on the traditional gas-oil link. With the breakdown of the link between oil and gas prices in the wholesale market, many consumers see gas wholesale markets as the natural basis for their gas contract prices. To estimate the overall market potential for long-term gas contracts indexed to other commodities, we therefore have to examine the potential demand from consumers who are interested in diversifying their gas price risk. These are mainly power producers and large industrial companies for which gas is a major part of their overall cost structure. For example, small to medium-sized operators of gas-fired power plants, which currently account for 28 percent of natural gas demand in Continental Europe, may want to switch long-term gas contracts to indexes based on power, coal, and carbon emissions to hedge their margins. If percent of these companies convert to commodity basket indexed contracts, such contracts would account for seven to 15 percent of natural gas contract volume overall. In particular, power producers without extensive trading operations or diversified portfolios could manage the margin between the price of power produced and the cost of gas as feedstock more effectively with a structured long-term gas contract based on power price indexes or commodity basket indexes containing coal and carbon emission prices. Natural gas intensive industrial companies like chemical manufacturers and steel producers, which account for 35 percent of natural gas demand in Continental Europe, could be a second group of customers interested in long-term contracts based on commodity price indexes. If 30 to 50 percent of this group shifted to such contracts, this would be the equivalent of an additional 10 to 15 percent of Continental Europe s overall natural gas demand. Fertilizer companies, for instance, for which natural gas accounts for percent of their costs, have a strong incentive to diversify their price risk in their energy procurement portfolio. This could be achieved by structuring contracts so that they are based on a basket of different traded commodities, such as coal, oil, power, and carbon emissions. Long-term gas contracts based on such a basket of commodities could reduce earnings volatility substantially. Changing Roles in the Gas Value Chain As the structure of pricing mechanisms in the gas market evolves, we expect that the roles of midstreamers, gas producers, and financial players in the gas value chain will also need to change significantly. Midstreamers In the future, midstream players will continue to rely on the scale and scope of their customer base and infrastructure assets. They will also need to develop their capabilities in originations and sales and in optimizing their contract and asset portfolio. Midstreamers can no longer count on profits from the spread between long-term gas contracts on the procurement and sales sides that were based on oil-pricing regimes. In fact, they will come under increasing pressure in the short term as some producers try to cash out existing contractual positions. Copyright 2012 Oliver Wyman 5

6 The challenge, then, is for midstreamers to convince gas producers that they can provide a valuable role in the gas value chain even in liquid markets. This new role will probably deliver lower returns than experienced in the years from 2004 to But ultimately, midstreamers may face less risk if they focus on areas in which they can create value. We see four major areas where this will be possible: Providing market access: Midstreamers can capture sales margins by assuming a role as a market access provider. Today, second-tier players, marketing organizations, and gas producer joint ventures are grabbing a larger share of this market. As a result, the midstreamers role is coming under pressure. However, midstreamers should be able to leverage their unique capabilities, long-term experience in the gas markets, and their existing customer relationships to maintain an important position in the market. Originating commodity basket indexed contracts: There is a natural demand for commodity price indexed contracts from consumers and an interest from producers in realizing this market potential, to diversify risks across the gas value chain. Midstreamers should be uniquely positioned to originate these customized long-term contract deals with industrial companies and power generators, by leveraging their relationships and capabilities. The contractual agreements between midstream players and producers would stipulate profit and risk sharing to the mutual benefit of customers and producers. Optimizing infrastructure: Midstreamers portfolios of various customer segments and geographies, as well as their access to key infrastructure elements like gas pipelines and storage capacity, allow them to leverage their scale to capture portfolio effects for volume risks, such as minimizing the so-called takeor-pay levels in procurement contracts. Midstreamers can also utilize storage and pipeline assets to hedge the embedded flexibility in their contracts with customers. In turn, midstream players can assume more risk and hence strengthen their position vis-àvis gas producers. Exhibit 3: Risk-return in the stylized gas value chain (in /MWh, illustrative) GAS DEMAND CE BY END USER SEGMENT SHARE OF MARKET FOR NON-GAS INDEXED LTC POTENTIAL INDEX RATIONALE Power producers 28% x 31% 7%-15% Power CO2 Coal Reduce large spark spread risk Interesting for small/mid-sized power producers lacking portfolio effects Industrials 35% x 34% 10-15% Oil For consumers where gas is large part of cost structure: Reduce outright gas short position Achieve portfolio effect through index mix Residentials & SMEs NA NA 37% x 0% ~0% Total Σ=100% Σ=17-30% Source: Oliver Wyman research, EIA International Energy Outlook for 2015, BP Statistical Review of World Energy 2010, Reuters, Bloomberg Industrials segmented by Basic Chemicals, Petroleum and Coal Products, Primary Metals, Food, Agricultural Chemicals, Paper, Nonmetallic Mineral Products, Other non-gas LTC share assumed to range between 0% and 40% Copyright 2012 Oliver Wyman 6

7 Taking positions: Finally, midstreamers can begin to take market price risk positions. If producers want to enter non-gas indexed long-term contracts exceeding the volume that would fit the natural demand on the consumers side, then midstreamers can opt for a long position in the spreads of oil and spot-market gas prices, for example. However, this would require midstreamers to develop a view on market prices and the pricing level that reflects the risks assumed. They would need to consider their risk appetite carefully, especially since the margins coming from other parts of their business could limit their natural capacity to bear additional long-term price and spread risks. Gas producers Gas producers, meanwhile, will need to weigh the short-term advantages of capitalizing on current contractual terms against potential long-term business opportunities with midstreamers. Exploiting profits from today s oil-indexed long-term contracts may appear rational at first glance. But a collapse of key Continental European midstream companies may not only severely disrupt economic and political relationships, it could also impede an array of strategic development opportunities. After all, midstream players increased interest in revising long-term oil indexation practices, if combined with the effort necessary to introduce other commodity basket indexed long-term gas contracts, could offer an alternative way for gas producers like Gazprom, Norway s Statoil, and Algeria s Sonatrach to diversify their gas and oil price exposure by gaining exposure to other commodities. That is in line with some producers growth plans in important markets of Continental Europe. Gazprom, for example, intends to diversify its trading operations into other commodities, assets, and value-adding services like structured deal origination. Greater exposure to other commodities, it expects, could have a smoothing effect on its earnings, given its current heavy reliance on oil-indexation. Gas producers could also achieve a higher return per unit of risk taken by extending their profitable trading operations, growing their export businesses, and diversifying their contractual portfolios. Financial players Hedge funds, banks, and trading companies could also play a more important role in the gas value chain in the future. As long-term oil indexed gas contracts become Exhibit 4: Risk capital along the value chain under different index compositions (in /MWh, illustrative) PRODUCER MIDSTREAMER CONSUMER GAS-FIRED POWER STATION TOTAL OF VALUE CHAIN Alternative index composition More flexible contract terms Alternative index composition Long position in diversified commodity portfolio Short position in diversified commodity portfolio Long position in oil and hub gas Long position in power Short positions in powerindexed gas and emissions Risk Capital employed today Source: Oliver Wyman analysis based on publicly available data and a simplified gas value chain Copyright 2012 Oliver Wyman 7

8 less popular with midstreamers and end consumers, speculative players like hedge funds, investment banks, and trading companies might become interested in entering into deals with producers that allow them to diversify their risks. This, however, would require outright position taking and would come at a charge for the producers. Summary Renegotiating long-term gas contracts with the aim of rebalancing the risk and return positions of players across the value chain, particularly between producers and midstreamers, is vital to improve the risk-bearing capacity of the entire gas value chain in key Continental European markets. Regional differences across Europe will add to the difficulty and complexity of this process, as market participants hold conflicting views and interests. Nevertheless, it s clear that the present gas value chain cannot be sustained. Midstreamers, gas producers, and consumers should reevaluate what mix of gas wholesale market price indexes, oil indexes, and commodity basket indexes would better serve all stakeholders, taking into account portfolio and asset peculiarities. Since 2005, we estimate, the amount of risk capital required by midstreamers has jumped by 47 percent, to five euros per megawatt hour. The amount of risk capital required for the entire gas value chain has nearly doubled, to 14.7 euros per megawatt hour. To bring the risk-bearing requirements in the gas value chain back to a sustainable level, gas producers and consumers need to consider changing the composition of the indexes that serve as the underpinnings of longterm gas contracts as well as the contractual clauses. Our research shows that employing an alternative index composition that includes the wholesale prices of gas, power, and coal could reduce a midstreamer s risk capital requirements by 44 percent, to 3.2 euros per megawatt hour. Further adjustments in contract structures should also be considered for midstreamers to maintain the viability of the business model and for the gas value chain to remain sustainable. One option would be to make gas contracts more flexible, while providing midstreamers with incentives to develop the market for more commodity basket indexed contracts. The contracts could cover shorter terms and could contain risk-sharing agreements that take into account the widening gap between long-term gas contracts based on oil prices on the procurement side and wholesale gas market pricing on the sales side. They could also contain an adaptation of the minimum levels of gas that midstreamers must take from gas producers. For these changes to happen, midstream players must first persuade producers that it is in their own best interest to reach a solution with long-term viability. To do that, we advise midstreamers to highlight how their futures are integrally linked to the long-term growth of gas producers and their diversification strategies in Continental Europe. Copyright 2012 Oliver Wyman 8

9 About the Authors Cantekin Dincerler, PhD Partner, Global Risk & Trading Practice, Oliver Wyman Cantekin Dincerler, PhD, is an Istanbul-based Partner in Oliver Wyman s Global Risk & Trading Practice who focuses on energy and basic materials clients. His expertise lies in the areas of risk modeling, management, and organization for industrial and trading firms operating in these sectors. Recent projects have involved developing mitigation plans for global commodity markets, designing and implementing risk management frameworks, and advising on strategy. Christian Lins, PhD Associate, Global Risk & Trading Practice, Oliver Wyman christian.lins@oliverwyman.com Christian Lins, PhD, is a Zurich-based Associate in Oliver Wyman s Global Risk & Trading Practice. He specializes in designing and implementing trading and enterprise risk management systems, with a special focus on commodities. Recent projects have focused on design, development, and implementation of enterprise risk management frameworks, risk-adjusted value measurement systems, and commodity derivative valuation and forecasting models. Johannes Schmitz, PhD Partner, Global Risk & Trading Practice, Oliver Wyman johannes.schmitz@oliverwyman.com Johannes Schmitz, PhD, is a Düsseldorf-based Partner in Oliver Wyman s Global Risk & Trading Practice. He provides advice on strategic decision making, risk management, and organizational topics to corporations as well as to commodity trading, energy, and retail organizations. Recent projects have involved establishing trading organizations for energy companies, designing enterprise risk management systems, redesigning energy wholesale organizations, developing hedging frameworks, and benchmarking risk management and trading practices.

10 About Oliver Wyman Oliver Wyman s Global Risk & Trading Practice enables the world s top industrial corporations and commodity trading organizations to gain competitive advantages by assisting them with managing risk across their businesses more effectively. By working with global leaders in a broad range of industries, our practice has developed unique capabilities that help industrial corporations and commodity trading organizations create value and maximize their performance by making risk-adjusted strategy, investment, and capital allocation decisions. Oliver Wyman is a global leader in management consulting. With offices in 50+ cities across 25 countries, Oliver Wyman combines deep industry knowledge with specialized expertise in strategy, operations, risk management, organizational transformation and leadership development. The firm s 3,000 professionals help clients optimize their business, improve their operations and risk profile, and accelerate their organizational performance to seize the most attractive opportunities. Oliver Wyman is a wholly owned subsidiary of Marsh & McLennan Companies [NYSE: MMC], a global team of professional services companies offering clients advice and solutions in the areas of risk, strategy and human capital. With 52,000 employees worldwide and annual revenue exceeding $10 billion, Marsh & McLennan Companies is also the parent company of Marsh, a global leader in insurance broking and risk management; Guy Carpenter, a global leader in risk and reinsurance intermediary services; and Mercer, a global leader in human resource consulting and related services. For more information, please contact: Cantekin Dincerler, PhD Partner, Global Risk & Trading Practice, Oliver Wyman cantekin.dincerler@oliverwyman.com Christian Lins, PhD Associate, Global Risk & Trading Practice, Oliver Wyman christian.lins@oliverwyman.com Johannes Schmitz, PhD Partner, Global Risk & Trading Practice, Oliver Wyman johannes.schmitz@oliverwyman.com Copyright Oliver Wyman. All rights reserved.