How to Resolve Price Mismatch Problem?
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- Bernard Farmer
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1 How to Resolve Price Mismatch Problem? Sergei Komlev Head of Contract Structuring and Price Formation Gazprom Export Third European Gas Price Structuring and Market Liquidity Forum, Berlin January 28, 2014
2 Gas Hub and Oil-indexed Prices Still Bound Together (TTF) Source: Bloomberg, Gazprom export TTF from January 2010 to December 2013 versus: r Brent 1st month futures 0.69 Brent 1st month futures - 3 months moving average 0.80 Brent 1st month futures - 6 months moving average 0.86 Brent 1st month futures - 9 months moving average 0.85 ZMB 2
3 Gas Hub and Oil-indexed Prices Still Bound Together (NBP) Source: Bloomberg, Gazprom export NBP from January 2010 to December 2013 versus: r Brent 1st month futures 0.69 Brent 1st month futures - 3 months moving average 0.79 Brent 1st month futures - 6 months moving average 0.84 Brent 1st month futures - 9 months moving average 0.83 ZMB 3
4 Gas Exported to Europe is Predominantly Oil-indexed Reuters published a report in March 2013 demonstrating that only 34.8% to 37.7% of all major European gas supplies are now priced off trade hubs. Gazprom Export estimate for imported gas % 4.8% 2.3% The American research company PIRA Energy Group came to the same conclusion as Reuters in its own February 2013 study, which estimated that roughly 2/3 of European gas consumption is still oil indexed. ACER November 2013 Market Monitoring Report states that Oil prices is still the main determinant of wholesale gas prices in Europe (p.180). Higher oil prices in 2012 put upward pressure on hub prices (p. 179). Three out of the four major suppliers of gas to Europe still support oil indexation as means of preserving intrinsic, long-term value of gas. 17,0% 3.2% 1.7% 14.5% Gazprom oil-indexed Algeria oil-indexed Qatar oil-indexed Qatar hub-indexed 39.5% 72.7% 17.0% Norway oil-indexed Libya oil-indexed Norway hub-indexed Gazprom hub-indexed *Excluding Baltic and CIS countries and including Turkey ZMB 4
5 USD/mmbtu Tandemic and Asymptotic Contract and Hub Price Behavior Hub prices are not independent: they are, in fact, derivatives of the contract prices that set a baseline trend for their behavior. Supply and demand only mutate their changes Hub prices will generally fall below contract prices because gas delivered under long-term contracts offers greater supply security and delivery flexibility 0 BAFA import price, Germany TTF (ENDEX), 1st month Sources: Bloomberg, BAFA ZMB 5
6 Contract Gas is a More Valuable Product than Hub Gas Even on a tight gas market of 2013, intervals when contract gas was cheaper than hub gas were brief ZMB 6
7 Mismatch Between Contract Price and Hub Price Money Hub price is higher than contract price Contract price Hub price is lower than contract price Hub price Time ZMB 7
8 Regulators Impose Hub Pricing as Industry Standard Country Effective from Obligation to Sell Gas at Hubs Poland Suppliers to initially sell 30% of the previous year s volume through the bourse Suppliers to initially sell 55% of the previous year s volume through the bourse Obligatory Introduction of Spot Component in Regulated Price Hungary Obligation to sell gas on regulated market at 70% hub-indexed prices Obligation to sell gas on regulated market at 100% hub-indexed prices European regulators are obsessed with perspective of Italy Regulated gas prices to be 20% linked to spot Regulated gas prices to be 100% linked to spot Belgium Oil-indexation of final gas prices must be decreasing gas capped at 35% prices by decree Oil-indexation of final gas prices is phased out France Government formula applied to GdF SUEZ prices is 36% spot-linked Way of gas index linkage PGNIG has to consider OTC and GASPOOL prices when putting the offers PGNIG has to consider OTC and GASPOOL prices when putting the offers TTF TTF TTF TTF Zeebrugge Zeebrugge TTF ZMB 8
9 Direct and Indirect Enforcement of Hub Pricing Leads to Price Mismatch Governments and regulators enforce hub indexation Promotion of unfair competition ( free-riding ) Importers End-users $/mcm Contract Prices Hub Prices Obligation to sell gas at hub-based price Introduction of spot component in end-user regulated price National regulators Key gas importers responsible for national energy security are deprived of their legitimate margins when forced to sell gas to end-users at hub indexes Free riders able to source small volumes of hub gas prosper. They produce no gas, have no import contracts and do not pay full cost for seasonal storage and structuring of deliveries ZMB 9
10 2008 Q Q Q Q Q Q Q Q Q Q Q3 ZMB Q Q Q Q Q Q Q Q Q Q1 Germany: Positive Spreads between End-Users and Hub Prices Euroct/kWh, excluding taxes Household consumers Mid-size industrial consumers Small industrial consumers Large industrial consumers
11 Ways of Resolving Price Mismatch Problem Price mismatch problem leads to margin squeeze of the mid-streamers. It forces Gazprom to make a tough choice to terminate contracts with the existing clients or bring profitability back to the midstream operations at its own expense. Gazprom via ex-post rebates and contract adjustments acts as a major sponsor of the European energy security by observing its historic obligations to deliver gas in the environment that poses a threat to the very existence of the long term contracts. There are different ways of resolving price mismatch problem. Adjusting contract price to hub level while keeping oil indexation in place: 1. partial indexing to hub prices 2. introduction of the price corridors that bring price mismatch to a tolerable level 3. decreasing Po to hub level but keeping oil/oil acceleration in the formula 4. removing flexibility from the contracts Complete oil de-indexation and introduction of hub price tracking in the long-term contracts ZMB 11
12 Intrinsic Premium for Security Supply and Flexibility reproduces Contract/Hub Price Mismatch Price Making contract and hub prices comparable simply by lowering contract prices leads to a new cycle of downward adjustment in the spot prices Period 1 Period 2 Period 3 Period 4 Period Х ZMB 12
13 Explanation of the Contract-Hub Price Gap: Contracted Gas Offers Greater Supply Security Contract with flexibility MAQ Assumptions Arbitrage opportunities between BAFA and TTF for the period 1 July November 2012 under the following assumptions: gas in required quantities is available on the hubs; additional cost of delivering gas to final place of consumption is not included Flat contract without flexibility ACQ Additional profits from arbitrage enhancement (USD/mcm) % of flexibility Average profit Maximal profit 15% 20% 25% We can also assume that the amount of the fine that Gazprom must pay if it fails to meet its clients obligations is a suitable proxy for the supply security and delivery flexibility premium embedded in the long-term contract price ZMB 13
14 Explanation of the Contract-Hub Price Gap: Contracted Gas Offers Enhanced Delivery Flexibility Cost of Seasonal Flexibility Average cost of full-cycle gas storage (assumes that over the year the volume of gas pumped into underground storage equals the volume of withdrawals) US$21.45/mcm Cost of Short-term Flexibility Additional transportation capacity payments for flexible capacity (7,000 hours of flexibility) US$13.7/mcm ZMB 14
15 MCM/d Removal of Flexibility Threatens Energy Security MCM/d seasonal swing MCM/d seasonal swing 0 Gazprom is a major provider of supply flexibility to Europe s seasonal swing in Russian gas daily deliveries doubled Source: International Energy agency database ZMB 15
16 Dumping by Buyers Cartel in Case of 100% Indexation q s qs qs qs q s qs In the case of 100% gas indexation, any take-or-pay obligations on the buyer s side lose their function as a guarantee of demand security because buyers can dispose of excess volumes on hubs with no risk to their revenues Q s Volumes purchased for dumping on hubs Q c Volumes consumed Dumping persists until Q s = Q c
17 Market Failure in Gas Industry does not Justify Pricing Model Change Oil linked pricing in the gas market a synonym for competitive pricing has proved to be a very successful principle for constant market development, reasonable pricing, adequate gas production and the timely development of the natural gas infrastructure. By and large, it is generally understood that the long term contracts with oil linked pricing will remain the key reference for gas prices. This should provide producers and investors in production and infrastructure with adequate securities to develop and implement new projects. However it will have to allow for increasing gas-to-gas competition and reflect to a greater extend seasonal variations in prices and the greater significance of spot markets. Source: United Nations Economic Commission for Europe (UNECE) Gas Centre report on the Security of National Gas Supply in the European Part of the UNECE Area. 10/09/2003. P.14. Joaquin Almunia, EU Commissioner for Competition: While market conditions in the past may have justified the use of oil indexation, the competition directorate's analysis [is] that the development of the spot gas market and the fundamental changes in the global market wrought by the surge in shale gas production [means] that those justifications are no longer held. Oil indexation does not respond to the fundamentals of the market, to the interplay between supply and demand that should exist in a market and that we want to exist in our internal market. Source: Answers to a written parliamentary question by MEP 12/09/2012 ZMB 17
18 The Rationale for Oil Indexation Prevails European politicians, regulators, and academics claim that gas has lost its link to oil once and forever. This is not true. The days of oil indexation are not over. Oil and gas compete in the residential sector and industry. One third of houses in Germany still use oil products for heating Even though there is not much demand-side substitution between oil and gas in power generation, there remains more than a virtual relationship between the two fuels Merit order puts oil products and gas in the same category of fuels used in peak or semipeak periods of consumption Oil products serve as a reserve fuel for many power plants and industrial applications should gas supplies be interrupted The oil-gas link will only be reinforced in the future due to direct competition in the transportation sector from gas-fueled vehicles and the use of LNG as bunker fuel ZMB 18
19 Energy Mix in EU-27 Oil/gas link is not obsolete and responds to the fundamentals of the market 23,6% 21,9% Energy mix in EU-27, MMtoe 1175,6 1103,3 319,5 287,1 371,1 364,1 484,9 452,1 31,5% 31,4% 36,4% 32,8% 42,2% 40,1% 14,5% 10,5% 13,3% 12,5% 96,7% 93,8% 18,8% 15,6% 4,7% 4,4% 24,1% 26,0% 34,0% 36,2% 34,8% 39,2% 5,0% 6,7% 5,7% 6,8% 7,2% 8,9% Total Industry Transport Households 28,6% 27,5% Adjusted Energy Mix in EU-27, MMtoe 1175,6 1103,3 319,5 287,1 371,1 364,1 484,9 452,1 38,5% 39,4% 43,6% 41,4% 43,1% 40,6% 15,8% 11,1% 96,8% 93,9% 20,0% 16,4% 23,0% 21,5% 12,5% 11,5% 10,8% 12,5% 9,1% 9,9% 6,6% 6,6% 9,3% 4,3% 5,9% 5,8% 7,8% 9,5% 5,6% 7,8% 6,6% 8,4% 6,3% 9,0% 3,9% 8,1% 10,6% Total Industry Transport Households Natural gas Oil products Coal Electricity and heat Nuclear RES Biofuels Others Natural gas Oil products Coal Nuclear RES Biofuels Others Data source: Eurostat, IEA ZMB 19
20 Natural Gas & Petroleum Products as Competing Fuels: Industry Oil/gas link is not obsolete and responds to the fundamentals of the market Total consumption, mtoe Petroleum products Natural gas Others Consumption of fossil fuels, mtoe Petroleum products Natural gas Coal Share of petroleum products in consumption Share of natural gas in consumption Share of petroleum products in consumption of fossil fuels Share of natural gas in consumption of fossil fuels Country EU % 28.8% 20.2% 55.6% Germany 4.0% 31.7% 8.0% 63.7% Turkey 5.9% 30.6% 8.9% 46.1% Italy 11.6% 30.9% 21.5% 57.4% Poland 6.4% 19.7% 11.9% 36.6% UK 15.8% 34.8% 25.8% 56.8% France 16.5% 28.3% 28.5% 48.9% The Czech Republic 5.0% 24.6% 8.5% 42.4% Hungary 3.1% 35.3% 6.1% 69.8% Austria 8.5% 25.4% 19.0% 56.4% Slovakia 2.5% 22.0% 4.8% 42.4% Data source: Eurostat, EU 27 Energy Balances, 2011 ZMB 20
21 Natural Gas & Petroleum Products as Competing Fuels: Commercial & Residential Sector Total consumption, mln toe Oil/gas link is not obsolete and responds to the fundamentals of the market Petroleum products Natural gas Others Consumption of fossil fuels, mln toe Petroleum products Natural gas Coal Share of petroleum products in consumption Share of natural gas in consumption Share of petroleum products in consumption of fossil fuels Share of natural gas in consumption of fossil fuels Country EU % 32.8% 30.6% 64.1% Germany 23.1% 30.6% 41.7% 55.2% Turkey 17.1% 25.8% 27.7% 41.9% Italy 12.3% 50.6% 19.6% 80.4% Poland 10.3% 16.7% 20.0% 32.3% UK 7.3% 54.5% 11.6% 87.0% France 20.4% 26.0% 43.7% 55.5% The Czech Republic 3.8% 34.9% 8.5% 78.6% Hungary 4.9% 52.6% 8.2% 88.6% Austria 16.7% 20.3% 44.5% 54.1% Slovakia 2.0% 40.4% 3.8% 78.4% Data source: Eurostat, EU 27 Energy Balances, 2011 ZMB 21
22 Rigs Natural Gas Rigs Natural Gas Production (MMcm/d) Liberalized Markets Drive Dry Gas Industry into Comatose State Making it Subject to the Largest Market Failure in the World Gas Shales Oil/Liquid Shales Sources: Pace Global, Baker Hughes and EIA. Data shown for the U.S. Natural Gas Rig Count Natural Gas Production In a properly functioning market costs exceeding revenues should lead to reduced investment and declining production, particularly with shale gas wells that experience first-year production decline rates of percent. However, natural gas behaves differently from other commodities and therefore displays an irregular response to underlying changes in supply and demand. Natural gas production grows while natural gas rig counts and average spot prices have decreased substantially. ZMB 22
23 Free Markets Fail to Support Long-Term Investments in Gas Industry Major depressing factors that affect hub-priced gas prices: In the USA and UK, associated gas deliveries play a secondary or auxiliary role compared to oil deliveries. Gas as byproduct of oil and gas liquids production is not a self sufficient commodity. Although the volumes of natural gas global exports are only 4 times lower in US$ value than the sales of oil, the financial markets have disregarded natural gas as an attractive hedging instrument. As a result gas price is not supported by the financial markets like many other commodities. USA financial markets principally futures markets enable producers to lock in profits for years ahead. Low cash prices now do not discourage producers that sold today s production several years ago at much higher and profitable prices. As a result, supply to price adjustment mechanisms do not function properly. Almost all gas markets outside of North America lack the level of competition and liquidity to create market mechanisms to fairly price gas as an independent commodity. History of gas industry is a history of persistent fight with the market failure of various kind. Oil Indexation is a natural remedy to that failure that should be preserved in the interest of gas buyers and sellers. It is the only realistic solution to price mismatch problem too. ZMB 23
24 THANK YOU FOR YOUR ATTENTION! ZMB 24
25 Market Commonalities Argue in Favor of Similar Pricing Structures for Oil & Gas Oil and gas continue to share many commonalities; price indexation is a natural extension of this Similar exploration and drilling technologies Similar cost structures Increasing convergence in end-use markets World Oil Consumption World Gas Consumption Other, 12.5% Other, 12.5% Transport, 5.50% Non-energy use, 16.5% Industry, 9.3% Transport, 61.7% Non-energy use, 16.5% Other, 48.80% Industry, 9.3% Industry, Transport, 34.90% 61.7% Non-energy use, 10.80% Other includes agriculture, residential, commercial and public services, and non-specified uses. Source: IEA. ZMB 25
26 The Fair Price for Gas Oil-Indexed Gas is Not Overpriced Compared to a Broad Range of Commodities The price for a significant portion of traded commodities has grown 3-4 times over the last decade Oil-indexed gas has grown in line with other commodities, while hublinked gas has lost some of its value Oil-indexed prices are competitive market prices, and are more reflective of market equilibrium than their hub derivatives Source: Bloomberg Average prices, ratio to 2001: in 2010 in 2011 in 2012 Metals: 2,9 3,2 2,8 Zinc 2,4 2,4 2,2 Steel 2,4 2,6 2,4 Aluminum 1,5 1,7 1,6 Nickel 3,3 3,6 2,9 Tin 4,7 5,6 4,9 Agricultural crops 2,2 2,7 2,3 Wheat 2,2 2,6 2,7 Corn 2,0 3,0 3,0 Cotton 2,0 2,8 1,8 Cocoa 2,9 2,8 2,3 Orange juice concentrate 1,7 2,0 1,6 Chemicals 2,5 3,2 3,3 Ammonium nitrate 2,7 3,9 4,6 Potassium Chloride 2,8 3,7 3,9 Methanol 1,8 2,2 2,2 Rubber 2,6 3,2 2,5 Oil and oil products 3,1 4,3 4,5 Brent 2,9 4,0 4,1 Gas oil 3,2 4,5 4,7 Fuel oil 3,0 4,0 4,2 Diesel 3,4 4,6 4,8 Natural gas: 2,0 2,6 2,6 Henry Hub, USA 1,1 1,0 0,7 NBP, UK 2,0 2,9 3,0 LNG, import in Japan 2,6 3,5 3,9 BAFA 2,2 2,8 2,9 Coal 1,6 2,0 1,8 ZMB 26
27 Variety of Gas Prices, no Global Benchmark 30 Energy Commodity Prices by Calorific Value, USD/mbte (July 2013) 26, ,1 19,4 21,2 17, ,2 10,1 10,7 5 3,9 3,9 0 HH TTF (1st month) Sources: Bloomberg, BAFA, World Bank NBP (1st month) BAFA Gas import, Japan Brent (1st month) WTI (1st month) Coal (CIF ARA) Gas oil (1st month) Electricity (ICE, Base, 1st month) ZMB 27
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