Putting a Price on ENERGY International Pricing Mechanisms for Oil and Gas Energy Charter Secretariat 8 th Russian Petroleum & Gas Congress/ RPGC 2010

Putting a Price on

ENERGY

InternationalPricing Mechanisms

for Oil and Gas

Energy Charter Secretariat

8th Russian Petroleum & Gas Congress/ RPGC 2010

Moscow

Gas Day 24 June 2010

Ralf DickelRalf DickelDirector Trade and Transit Director Trade and Transit Energy Charter SecretariatEnergy Charter [email protected]: + 32 2 775 9840Tel: + 32 2 775 9840

Gas Price Formation on Spot Markets

and under Long-term Contracts

ENERGY CHARTER SECRETARIATСЕКРЕТАРИАТ ЭНЕРГЕТИЧЕСКОЙ ХАРТИИ

Putting a Price on

ENERGY


for Oil and Gas

Energy Charter Secretariat 2

The 1991 Energy Charter Declaration:

Title I Objectives:

“Within the framework of State sovereignty and sovereign rights over energy resources and in a spirit of political and economic co-operation, (the signatories) undertake to promote the development of an efficient energy market throughout Europe and a better functioning global market, in both cases based on the principle of non-discrimination and on market-oriented price formation, taking due account of environmental concerns.”

Putting a Price on

ENERGY


for Oil and Gas


Publications by the ECS

Free download at www.encharter.org

Putting a Price on

ENERGY


for Oil and Gas


Structure

1. Elements / explanations of gas price formation

2. Regional differences3. Recent developments

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ENERGY


for Oil and Gas


What are we talking about? Avoiding misunderstandingsWhat do we mean by a market?

A system where transactions along the chain are determined by the commercial decisions of the partners in the chain?

or in a more narrow sense:A market place where supply physically meets demand (inclusive of facilities for storage, unimpeded transport to and from the market place) and a transparent price discovery mechanismPrimary supply and demand or including secondary supply/demand

What kind of transaction?On a market place?A bilateral transaction (single or longer term)?An internal transaction (crossing a border), price for taxation purposes

What transaction point / reference point for the price? Where in the chain?

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Standard Textbook Price Formation

(Capacity limit)

Volume

Price

Demand curve

Supply curve(cost of supply)

PC1

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Non-standard Theoretical Aspects

Resource (and energy) economics are often different from standard economics of manufacturing ,e.g.:Risk and High Specificity of Oil and Gas Investment: Transaction Cost TheoryThe Character of a Natural Resource: Ricardian RentFiniteness of Resources: Hotelling’s TheoremProducing Companies and Resource Owners: Principal-Agent TheoryInelastic Demand Combined with Supply Restrictions: Cournot-Nash-FormulaMarket Imperfections/Externalities: Pigou Taxes and Coase Theorem

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Pricing of Non-Renewable Energy Resources: RICARDIAN VS. HOTELLING RENT

(Capacity limit)

Hotelling rent

Ricardian rent

Volume

Price

Demand curve

Supply curve(cost of supply)

Cost-oriented price

Replacement value-oriented price

PC1PC2

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Futures Market

Derivatives markets have existed for a long time. In the US, Chicago Board of Trade was created in 1848, trading agricultural derivatives.Developed as an instrument to hedge price risk.Modern energy futures trading starting in the late 1970s.A futures contract is an agreement between two parties to buy, or, sell an asset at a certain future time for a certain price.

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Comparison of Spot/Forward/Futures/Options/Swaps

Contract Spot Forward Futures Options Swaps

Trading OTC OTC ExchangeOTC/

ExchangeOTC

Financial Derivatives

No Yes Yes Yes Yes

Physical Delivery

Yes (Yes) (No) (No) (Yes)

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Range of Demand Perception

Range of Capacity Perception

Capacity (million bbl/d)

Perception of low demand, high

capacity

“real” case

Perception of high demand, low capacity

Price

($/bbl)

Speculation: The Influence of “Perception”

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Structure



Putting a Price on

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Domestic Supply or Gas Import Matter for Price Formation

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Regional Differences from the Customer’s Point of View

• Different sector models:US:

– gas on gas competition (dto UK)gas on gas competition (dto UK)– Henry Hub passed on to Residential/Commercial Henry Hub passed on to Residential/Commercial

(customers with inelastic demand)(customers with inelastic demand)– Supply by individual players into the market placeSupply by individual players into the market place– LNG: under self contracting and flexibility with claw LNG: under self contracting and flexibility with claw

back clausesback clauses– Even captive customers can rely on reaction by Even captive customers can rely on reaction by

production side on price signals (security of supply and production side on price signals (security of supply and demand reaction)demand reaction)

Continental market West– Demand aggregation for imports, via LTCsDemand aggregation for imports, via LTCs– Working of LTCs based on sales to residential/ Working of LTCs based on sales to residential/

commercial, small industry with gas oil and fuel oil as commercial, small industry with gas oil and fuel oil as alternatives (if only contestability)alternatives (if only contestability)

Continental market East- Increase to EU netted back level- Subsidies on gas and oil

Japan, Korea– Chain passing on the import price, complete import Chain passing on the import price, complete import

dependence dependence

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Structure


2. Regional differences

US / UKContinental EU (West / East)LNG

3. Recent developments

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North America / UK

US, UK: market places / spot prices:- The market place: Henry hub / UK NBP- Spot, forward, futures, derivatives- Churn of about 100 / 15 - Speculative influence- Coinciding with US, UK as banking places!!- Link with (crude / fuel) oil price?- Impact on import price- Implications for customers

- Large industry / power: benefits of playing the market

- Res + com: suffer from inelastic demand/ no benefit from oversupply

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Structure





Putting a Price on

ENERGY


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LTCs: The Groningen Concept

Developed by Nota de Pous (Note to Parliament in 1962)For exports:

Pricing:• Replacement value principle (no cost-related

approach)• Net-back value, netted back from replacement value• Regular price review, if no joint solution => arbitration• Price risk and reward for seller, marketing risk for

buyer • Protection against arbitrage by buyer

Volumes and risks:• Long term supply vs. off take obligation based on

minimum pay: dedication of certain volumes of reserves vs. commitment to market defined volumes

• Secure supply at marketable prices against reliable sales volumes at maximum highest marketable price

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Pricing After Groningen

Pricing developed by new contracts and by price reviews based on Groningen concept:

• NL as “trendsetter”, later also Troll• Heavy fuel oil share decreased, the share of

light fuel oil increased (now about 60-65%)• Algerian exports partly pegged to crude oil

(Algerian crude oil parity campaign early 80s)

• More recent: a small share of coal or electricity indicators, gas-to-gas price indicators (at the expense of HFO).

• Arbitration was seldom invoked=> comparable price levels and similar

pegging

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LTC: Indexation by Producer

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Gas pricing in Ukraine 2005-Gas pricing in Ukraine 2005-20102010

• Until 2005 the bulk of Russian gas supplied to Ukraine was delivered as barter payment for transit services for Russian gas. In 2005, Ukraine paid a notional $50/1000m3 for Russian natural gas, Russia paid 1.09$/1000m3/100km.

• 2006 – “First gas crisis”; transportation and supply deal split: agreement between Naftogaz, Gazprom and RosUkrEnergo; price set at $95/1000m3 for 2006 and $130/1000m3 for 2007;

• 2009 – After “Second gas crisis”;10-years agreement between Gazprom and Naftogaz, gas imports priced at “European netback level” , special reduction by 20% for 2009;

• April 2010 – “Gas for Fleet” agreement between Presidents Medvedev and Yanukovych; Ukraine received $100/1000m3 discount (by cancelling custom duties in Russia) if the price according to the formula is above $333/1000m3 or 30% if the price is lower in return for an extension of the stay of the Russian Black Sea Fleet.

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Structure





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Long-term Contracts in LNG Trade

Sale and Purchase Agreement (SPA)Long term contracts – traditional pattern - 20 years or longerRisk sharing – buyers take volume risk (take-or-pay), sellers – price risk (price escalation clause)Flexibility through swapping cargoes: “global” exchanges of LNG cargoes accelerated, esp. from Atlantic to PacificEarly indexation clauses used crude oil

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New Trends in LNG Activities

Traditionally high take-or-pay thresholdBuyers insist on more “take” flexibility =>Emergence of new LNG suppliers outside Asia Pacific plus short reemergence of US marketFlexibility in new contracts:- disappearing of floor price- shorter term- smaller off-take- destination flexibility (FOB instead of CIF)

Important flexibility through self-contracting: upstream stakeholders purchase output + equity acquisition downstream While LTC remain, they become more flexible

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Structure



Putting a Price on

ENERGY


for Oil and Gas


Recent Developments Affecting on Gas Price Formation

1. Recent development of supply and demand- new perspectives of shale gas

2. Development of new market places - global pricing for LNG?

3. Impacts on LTCs replacement value / net back value pricing Fuel oil indexation heavy fuel oil indexation

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Issues

LTCs and replacement pricing need under supply / capacity restrictionsAre we facing a situation of oversupply? Due to shale gas

High potential but so far limited contribution to USDuration of recovery, major structural changes, e.g. due to renewables?

LNG entry point control?Q max, Q flex into existing harbours?

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Production of Unconventional Gas Production of Unconventional Gas in the United Statesin the United States (Source: WEO (Source: WEO

2009)2009)

US unconventional output has expanded nearly 4-fold since 1990 to almost 300 bcm in 2008

– equal to more than half of total US gas output and ¾ of global unconventional output

0

50

100

150

200

250

300

19901992 1996 2000 2004 2008

bcm

0%

10%

20%

30%

40%

50%

60% Shale gas

CBM

Tight gas

Unconventional gas as share of total production(right axis)

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Why LNG will not Develop a Spot Quotation

LNG not like oil:Unlike for oil: No extraterritorial storage faculties for LNG (high specific costs of storage)Bilateral deals

Relative high transparency:Follow shipsImport statistics (but also transparency by commercial actors, e.g. Spain)

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Gas Trading Hubs Gas Trading Hubs in Continental Europein Continental Europe

Source: WEO 2009

0

50

100

150

200

2003 2004 2005 2006 2007 2008

bcm

BEB (2004)

CEGH (2005)

PSV (2003)

PEGs (2004)

EGT (2006)

Zeebrugge(2000)TTF (2003)

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Recent Developments Affecting Gas Price Formation

1. Recent development of supply and demand (may last several years)- new perspectives of shale gas (too early to tell)

2. Development of new market places(difference between resource driven and contract driven market places)

- global pricing for LNG (not likely because there are no off border market places)

3. Impacts on LTCs (basic logic for cross border LTCs in Continental Europe

unchanged, but modifications to match competition downstream)

replacement value / net back value pricing (in principle based on under supply /capacity restricitons)

Fuel oil indexation (still reflecting competitive situation for small costumers, especially gas oil)

heavy fuel oil indexation (since long not based on competition with but on contestability by Heavy Fuel Oil; HFO indexed part of gas sales a multiple of HFO consumption; for large positions increasingly access to gas to gas in UK or secondary markets)

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Thank you !

Documents

Putting a Price on ENERGY International Pricing Mechanisms for Oil and Gas Energy Charter Secretariat 8 th Russian Petroleum & Gas Congress/ RPGC 2010