Gazprom’s Head of Contract Structuring and Price Formation Sergeyi Komlev, talks in an exclusive interview about gas pricing in Europe and the future of oil-indexed contracts.
Gazprom’s Head of Contract Structuring and Price Formation Sergeyi Komlev, speaking in an exclusive interview, talks about gas pricing in Europe and the future of oil-indexed contracts.
Interfax: How would you explain the gap between spot and oil-indexed gas prices in Europe?
Sergei Komlev: Long-term oil indexed contracts offer gas with flexibility in deliveries, while the spot market only offers gas in standard lots without any flexibility. These are two different market products.
A good question would be: What is the price of flexibility? One new development that explains the divergence between contract and hub prices over the global recession is the involvement of large volumes of gas under take-or-pay obligations in short-term contracts. The temporary decoupling of prices occurred as an unintended result of end-users reducing the duration of their contracts at a time of unexpected demand contraction. Many end-users and distribution companies in the European Union lost their right to make-up gas because of the short-term nature of their contracts.
For example, because BKartA [the German Federal Cartel Office] introduced limitations on contract durations as of 1 October 2007, end-users and distribution companies have only two options. They can either pay fines for gas that is not taken, or dump the gas on trading hubs, thus reducing their losses by any cash they may get from those sales. The dumped volumes sold at the hubs put pressure on spot prices and, therefore, create an additional gap in spot and contract prices. This price gap was misinterpreted by many analysts as a signal of a definitive decoupling of oil-indexed and spot gas-indexed prices. However, no major divergence of hub and contract prices would have taken place without sales of ‘take-or-pay’ gas on the hubs. End-users adjusted offtake volumes in the new short-term contracts that came in to force on 1 October 2010 and the price gap nearly closed as a result.
Interfax: The European Commission and a number of EU energy companies are making a strong case for delinking oil and gas prices and have said that liquid gas markets were better in sending short- and long-term price signals. Philip Lowe, European Director General for Energy, has stressed that a decrease in oil-indexed contracts would open the door for gas-to-gas competition and, therefore, increased market efficiency.
Do you foresee major energy producers accepting new pricing trends, for example hub-based long-term supply contracts?
SK: There is strong pressure on Gazprom to review its pricing model. We often hear suggestions that the current supply contracts could be changed by increasing the share of their spot component at the expense of oil indexation. However, a move towards supply and demand pricing is virtually impossible at the moment because hubs are not liquid enough to provide sufficient gas volumes. In February this year, many Gazprom clients turned to hubs to meet an unexpected demand spike and could not find gas there.
Hubs prices can also be easily manipulated. Relatively small additional volumes of gas dumped on the market could bring day-ahead prices down. The losses from dumping by a cartel of buyers will be fully compensated next day with a profit, when a lower day-ahead price from a previous day devalues the entire supply portfolio, which is unacceptable for the gas supplier.
Interfax: Do you see any prospects for the emergence of sustainable pricing signals in the short-term?
SK: I am pessimistic about the further virtualisation of hub trading in Continental Europe. In order to produce sustainable price signals, the churn ratio has to be at least 15. In Europe, only the UK’s NBP [National Balancing Point] meets this condition. Continental hubs have churn ratios below four.
Furthermore, financial instruments, available at the continental hubs, usually offer only six to nine months-long hedging opportunities, which reflect difficulty in forecasting prices on a balancing market over a longer period of time. It is no coincidence that the maturity of forward instruments equates to a base period in the long-term supply contract formulae, which is definitely a more predictable variable.
Interfax: Is hub-based pricing compatible with long-term contracts?
SK: Hub-based pricing is compatible with long-term contracts in a broad sense, but only when long-term contracts are oil-indexed. The move towards a larger share of gas indexation in long-term contracts is unacceptable to gas producers because it changes the balance of interests between the seller and the buyers in favour of the latter. If the oil-linked benchmark price ceases to exist, exporters selling gas under long-term contracts will be forced to accept prices irrespective of how low they are without any leverage to influence these prices.
Furthermore, the low churn ratios at Continental hubs raise doubts as to the quality of their price signals, as I have already mentioned.
Interfax: What is the future of the oil-gas linkage?
SK: There are several reasons the days of oil indexation have not passed, apart from its unique role in supporting long-term investments. Even though there is not much demand-side substitution between oil and gas in power generation in Europe, there is still more than a virtual relationship between the two fuels – both oil and gas are used in peak or semi-peak [demand periods].
The oil-gas linkage will only strengthen in the future as a result of direct competition in the transportation sector. For example, Gazprom anticipates that gas usage in transport may reach 100 billion cubic metres in 2030.
There is a new rationale for oil indexation – factoring oil products into the formula performs the function of a universal deflator better than any other man-made price index.
Last, but not least: With oil-indexation in place, consumers of gas in Europe are protected from any form of price manipulation by the dominant suppliers, as none of these suppliers are able to influence the price of oil.