Natural Gas Pricing and Its Future

Europe as the Battleground

Oil-Indexation - 1962/3

• 1962 – Commercial quantities of natural gas forced a re-think

- Nota de Pous

• Prices based on “Netback Value” of alternative fuels, gasoil

and heavy fuel oil - from the burner tip backwards.

• It was recognized even at this stage that gas-on-gas

competition needed to be avoided.

• Agreements between the State, DSM, Shell & Exxon

formalized in 1963, & Gasunie established.

Oil-Indexed Pass Through

Producers

Wholesalers/

TransmissionCompanies

DistributionCompanies

Residential /

Commercial/Smaller Industrial

GazpromStatoilGasterra

Shell/Exxon

E-On, Wingas,RW E, VNG,Thyssengas,

BEB, EWE,Schleswag,

SFG, HGW, etc.

Stadtwerkes(about 500)

End-users

Key Contract Terms

Oil-indexed (GO/HFO)Duration: 20 years + 85% Take or Pay

Price renegotiaion clause

Oil- indexed (GO/HFO)Duration: 1-5 yrs (avg)75-90% Take or Pay

Entit ies

Price and Volume risk pass-through

Oil- indexed (GO) +Fixed Charge

Duration: 1-3 yearsFull Requirements

Regional

Transmission/Distribution

Companies

Large Industrials,

Chemicals,Generators

Oil- indexed (GO/HFO)Capacity Charge

Duration: 3-10 yrs (avg)Full-Requirements

Seller takes pr ice r isk and Buyer assumes volume r isk up to ToP

Buyer takes price risk, Sellers assume volume

r isk down to ToP

End-Users pay

Burner-Tip

Prices

Netherlands Household Energy

1963 to 1990 – Expansion & Linkage

• Across Europe, industry lobbied for lower prices.

• Margaret Thatcher (PM 1979-1990)

• UK gas privatization (1986) and liberalization:

– Privatized and unbundled British Gas,

– Allowed TPA to infrastructure, under Network Code,

– Introduced competition into all market sectors.

Who Spoiled the Party?

Commoditization of Gas

• Early 1990’s - Liberalization frees the gas field development log-jam.

• 1994 - Oversupply and hyper-competition. Producers lobby for connection to Europe.

• 1995 - Commodity markets begin to replace oil-indexation. British Gas in trouble.

• 1996 - British Gas unbundling, starts renegotiating oil-indexed deals to spot prices.

• 1998 – UK/Zeebrugge Interconnector. Commodity markets become connected to Europe.

Defending European Markets

• Incumbents observed the UK, and feared “contamination”by market-priced supplies.

• 1998 First gas flows were long-term contracts.

• Incumbents used their entrenched monopoly positions to manipulate access to supplies.

• Increasing spot supplies were “mopped up” by incumbents who expected flows to decrease as UK ran out of gas.

The “Middle Ground”

• Oil-indexed contracts have Max. Annual Qty. (Typically

115%) and Min. Bill Qty. (Typically 85%).

• Three market conditions:

– Undersupply, Middle Ground & Oversupply

• Continental incumbents operate profitably within the

Middle Ground or, better still, undersupply.

• Rule Number One - Avoid oversupply at all costs.

• 1988 EU Single Energy Market COM (88)238

• Gas Transit Directive (Council Directive 91/296/EEC of 31

May 1991)

• EU Directive 98/30/EC

(Gas Directive)

• Directive 2003/55/EC,

the second EU gas directive.

• Third Energy Package (2009/11)

1: EU Legislation

2: Contagion of European Markets

3: 2000-2008 – Supply/Demand Error

300

350

400

450

500

550

600

650

700

750

800

Bcm/yr

EU 2020 Baseline $61 EU 2020 Baseline $100

EU 2020 NEP $61 EU 2020 NEP $100

Eurogas 2007 Reference Case - OECD Europe

High Economic Growth Case - OECD Europe Low Economic Growth Case - OECD Europe

OECD 2002 - Bcm OECD 2004 - Bcm

4: Over-Committed Supply Position

Supply Source BCM BCM Notes

Indigenous Production 185 Excludes Norway

Pipeline Supplies Contracted: 321.1 Excludes Indigenous Contracted

Algeria 40.5 ACQ

Azerbaijan 6.6 ACQ

Iran 10 ACQ

Libya 8 ACQ

Norway 86 ACQ

Russia 170 ACQ

Other Committed Pipeline Supplies: 25 ACQ

Norway to UK 25 Vesterled/FUKA/Langeled/FLAGS

LNG Supplies (Oil Indexed Long Term) 56 Outturn number

LNG Spot Availability 15 Outturn number

TOTAL SUPPLY AVAILABILITY (2009) 602.1

The Anatomy of the Collision

• 2008 Recession – Demand falls

7% in 2009.

• Spot gas supply increases – More

contracted pipeline supply,

• LNG supplies surge.

• EU gas directives increasingly

effective.

• Second-tier suppliers gain market

share.

• Market priced gas supply increases,

oil-indexed supplies fall.

The Producers’ Revenues Fall

• Gazprom and Sonatrach fared worst of the producers, with

both governments heavily reliant on gas revenues.

• Russian gas exports were

significantly below take-or-pay

levels, but FSU customers were

clearly facing economic

hardship,

• Several major wholesalers

including E.ON, ENI, Gas

Natural, Botas reportedly owed

$Billions in minimum bill

payments to Gazprom and

Sonatrach at October 2009.

Wholesalers Face $Billions Penalties

Oil-Index Fights Back

• Prices negotiated down in competitive market areas.

• Suppliers make concessions on volume.

• Oil-index survival strongly assisted by cold winter 2009/10,

unscheduled outages of pipeline and LNG supplies, and some

demand recovery in 2010.

• Market ≈ balanced Q2’2010

How Long Will Oil-Indexation Survive?

• Angela Merkel (EEX Leipzig - 19 August 2010) called for an

end to oil coupling of gas prices. “This link is no longer

needed. Therefore, I'm happy to hear that the exchange is

working to develop a gas index that would make an

independent price formation possible.... This is a step

towards more competition in the energy market”.

• Putin (Sochi - 25 Sept 2010) “What makes a company more

profitable? To be flexible, make concessions and retain the

whole market share – or to be tough, not give in and accept a

loss of market share? Gazprom’s management has opted for

toughness, and so they will continue on this path.”

The Road Ahead?

• Dramatic Revolution – Oversupply, causing urgent

and revolutionary re-negotiations.

• Negotiated Revolution - Oil-indexed purchasers

negotiate a switch to commodity market pricing with

the key producers.

• Evolution - Oil-indexed contracts fall away. All new

volumes at market prices.

• EU legislation-driven change. And this depends on

their ability to identify the next big tool, and their

willingness to use it.

• Combination of the above.

Implications for ROW

Branko Terzic

Natural Gas Use in Power Generation

Vello Kuuskraa

Unconventional Gas: An Exportable North American

Revolution?

Hidehiro Nakagami

Mikhail Korchemkin

Christopher Goncalves