How to Resolve Price
Mismatch Problem?
Third European Gas Price Structuring and
Market Liquidity Forum, Berlin
January 28, 2014
Sergei Komlev Head of Contract Structuring and Price Formation
Gazprom Export
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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
Source: Bloomberg, Gazprom export
Gas Hub and Oil-indexed Prices – Still Bound Together
(TTF)
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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
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Gazprom Export estimate for imported gas 2012
39.5%
17.0%
14.5%
1.7%
3.2%
17,0%
4.8% 2.3%
Gazprom oil-indexed Norway oil-indexed
Algeria oil-indexed Libya oil-indexed
Qatar oil-indexed Norway hub-indexed
Qatar hub-indexed Gazprom hub-indexed
72.7%
27.3%
*Excluding Baltic and CIS countries and including Turkey
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.
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.
Gas Exported to Europe is Predominantly Oil-indexed
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Tandemic and Asymptotic Contract and Hub Price
Behavior
0
2
4
6
8
10
12
14
US
D/m
mb
tu
BAFA import price, Germany TTF (ENDEX), 1st month
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
Sources: Bloomberg, BAFA
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Even on a tight gas market of
2013, intervals when contract
gas was cheaper than hub gas
were brief
Contract Gas is a More Valuable Product than Hub Gas
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Mismatch Between Contract Price and Hub Price
Contract price
Money
Time
Hub price Hub price is lower than
contract price
Hub price is higher than
contract price
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Country Effective
from
Obligation to Sell Gas at Hubs Obligatory Introduction of Spot
Component in Regulated Price
Way of gas index
linkage
Poland 11.09.2013
Suppliers to initially sell 30% of the
previous year’s volume through the
bourse
PGNIG has to consider
OTC and GASPOOL prices
when putting the offers
01.01.2014
Suppliers to initially sell 55% of the
previous year’s volume through the
bourse
PGNIG has to consider
OTC and GASPOOL prices
when putting the offers
Hungary 01.10.2011
Obligation to sell gas on regulated market
at 70% hub-indexed prices
TTF
01.10.2013
Obligation to sell gas on regulated market
at 100% hub-indexed prices
TTF
Italy 01.04.2013 Regulated gas prices to be 20% linked to
spot
TTF
01.10.2013 Regulated gas prices to be 100% linked to
spot
TTF
Belgium 01.01.2014
Oil-indexation of final gas prices must be
capped at 35%
Zeebrugge
01.01.2015
Oil-indexation of final gas prices is phased
out
Zeebrugge
France 01.01.2013 Government formula applied to GdF
SUEZ prices is 36% spot-linked
TTF
European
regulators are
obsessed with
perspective of
decreasing gas
prices by decree
Regulators Impose Hub Pricing as Industry Standard
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Promotion of unfair competition
(“free-riding”)
Governments and regulators enforce hub
indexation
Introduction
of spot
component
in end-user
regulated price
National regulators
Importers End-users
Obligation
to sell
gas at
hub-based
price
$/mcm
Hub Prices
Contract Prices
• 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
Direct and Indirect Enforcement of Hub Pricing
Leads to Price Mismatch
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Euroct/kWh, excluding taxes
Germany: Positive Spreads between End-Users and
Hub Prices
-1
0
1
2
3
4
5
2008
Q1
2008
Q2
2008
Q3
2008
Q4
2009
Q1
2009
Q2
2009
Q3
2009
Q4
2010
Q1
2010
Q2
2010
Q3
2010
Q4
2011
Q1
2011
Q2
2011
Q3
2011
Q4
2012
Q1
2012
Q2
2012
Q3
2012
Q4
2013
Q1
Household consumers Small industrial consumers
Mid-size industrial consumers Large industrial consumers
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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
Ways of Resolving Price Mismatch Problem
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Price
Period 1 Period 2 Period 3 Period 4 Period Х
Intrinsic Premium for Security Supply and Flexibility
reproduces Contract/Hub Price Mismatch
Making contract and hub
prices comparable simply
by lowering contract
prices leads to a new
cycle of downward
adjustment in the spot
prices
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Contract with flexibility
MAQ
ACQ
Flat contract without flexibility
Assumptions Arbitrage opportunities between BAFA
and TTF for the period 1 July 2010 - 30 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
Additional profits from arbitrage
enhancement (USD/mcm) % of
flexibility 15% 20% 25%
Average profit
7.99 10.66 13.39
Maximal profit
15.16 19.05 22.78
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
Explanation of the Contract-Hub Price Gap:
Contracted Gas Offers Greater Supply Security
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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
Explanation of the Contract-Hub Price Gap:
Contracted Gas Offers Enhanced Delivery Flexibility
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0
100
200
300
400
500
600
MC
M/d
Gazprom is a major provider of supply flexibility to Europe s seasonal swing in Russian gas daily deliveries doubled
Source: International Energy agency database
1998-2005
80-100 MCM/d
seasonal swing
2005-2013
100-220 MCM/d
seasonal swing
Removal of Flexibility Threatens Energy Security
Dumping persists until Qs = Qc
Volumes consumed
Volumes purchased
for dumping on hubs Qs
Qc
qs qs qs qs qs qs
Dumping by Buyers’ Cartel in Case of 100% Indexation
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
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”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
Market Failure in Gas Industry
does not Justify Pricing Model Change
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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 semi-
peak 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
The Rationale for Oil Indexation Prevails
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Energy Mix in EU-27 Oil/gas link is not obsolete and responds to the fundamentals of the market
Data source: Eurostat, IEA
5,0% 6,7% 5,7% 6,8% 7,2% 8,9%
24,1% 26,0% 34,0% 36,2% 34,8% 39,2% 4,7% 4,4% 13,3% 12,5% 42,2% 40,1% 14,5% 10,5%
96,7% 93,8% 18,8% 15,6%
23,6% 21,9% 31,5% 31,4% 36,4% 32,8%
2006 2011 2006 2011 2006 2011 2006 2011
Total Industry Transport Households
Energy mix in EU-27, MMtoe
Natural gas
Oil products
Coal
Electricity and heat
Nuclear
RES
Biofuels
Others
1175,6 1103,3 319,5 287,1 371,1 364,1 484,9 452,1
5,6% 7,8% 6,6% 8,4% 3,9% 8,1% 10,6% 4,3% 5,9% 5,8% 7,8% 6,3% 9,0% 6,6% 6,6% 9,3%
9,1% 9,5% 9,9% 11,5% 10,8%
23,0% 21,5% 12,5%
12,5%
43,1% 40,6% 15,8% 11,1% 96,8% 93,9% 20,0% 16,4%
28,6% 27,5% 38,5% 39,4% 43,6% 41,4%
2006 2011 2006 2011 2006 2011 2006 2011
Total Industry Transport Households
Adjusted Energy Mix in EU-27, MMtoe
Natural gas
Oil products
Coal
Nuclear
RES
Biofuels
Others
1175,6
1103,3 319,5 287,1 364,1 484,9 371,1 452,1
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Oil/gas link is not obsolete and responds to the fundamentals of the market
30.1
82.7
174.3
Total consumption, mtoe
Petroleum products
Natural gas
Others
30.1
82.7
35.9
Consumption of fossil fuels, mtoe
Petroleum products
Natural gas
Coal
Country
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
EU-27 10.5% 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%
Natural Gas & Petroleum Products
as Competing Fuels: Industry
Data source: Eurostat, EU 27 Energy Balances, 2011
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70.7
148.3
233.1
Total consumption, mln toe
Petroleum products
Natural gas
Others
70.7
148.3
12.2
Consumption of fossil fuels, mln toe
Petroleum products
Natural gas
Coal
Country
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
EU-27 15.6% 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%
Natural Gas & Petroleum Products
as Competing Fuels: Commercial & Residential Sector
Oil/gas link is not obsolete and responds to the fundamentals of the market
Data source: Eurostat, EU 27 Energy Balances, 2011
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150
200
250
300
350
400
450
500
Rig
s
Gas Shales Oil/Liquid Shales
40
540
1040
1540
2040
2540
500
700
900
1100
1300
1500
1700
Na
tura
l G
as P
rod
uctio
n (M
Mcm
/d)
Na
tura
l G
as R
igs
Natural Gas Rig Count Natural Gas Production
Sources: Pace Global, Baker Hughes and EIA. Data shown for the U.S.
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 50-85 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.
Liberalized Markets Drive Dry Gas Industry into Comatose State Making it Subject to the Largest Market Failure in the World
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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.
Free Markets Fail to Support
Long-Term Investments in Gas Industry
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THANK YOU FOR YOUR ATTENTION!
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• 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
Transport, 61.7%
Industry, 9.3%
Non-energy use, 16.5%
Other, 12.5%
World Oil Consumption
Transport, 61.7%
Industry, 9.3%
Non-energy use, 16.5%
Other, 12.5%
World Gas Consumption
Transport, 5.50%
Industry, 34.90%
Non-energy use, 10.80%
Other, 48.80%
World Gas Consumption
“Other” includes agriculture, residential, commercial and public services, and non-specified uses. Source: IEA.
Market Commonalities Argue in Favor of Similar
Pricing Structures for Oil & Gas
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• 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 hub-
linked 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
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
The Fair Price for Gas Oil-Indexed Gas is Not Overpriced Compared to a Broad Range of Commodities
Source: Bloomberg
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3,9
10,2 10,1 10,7
17,0
20,1 19,4
3,9
26,9
21,2
0
5
10
15
20
25
30
HH TTF (1st month)
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)
Energy Commodity Prices by Calorific Value, USD/mbte (July 2013)
Sources: Bloomberg, BAFA, World Bank
Variety of Gas Prices, no Global Benchmark