Sergey Komlev: Gas modeling

March 22, 2012, the interview was taken by Sergey Pravosudov
Published in corporate Gazprom Magazine Issue 3

Sergey Komlev

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Sergey Komlev, Head of the Contract Structuring and Pricing Directorate of Gazprom Export answers the questions posed by the Gazprom Magazine.

Mr. Komlev, what pricing models are applied in the international gas markets today?

Leaving aside various non-market pricing methods, which, to our great regret, are still widely used in the world and are a major obstacle to the ‘golden age’ of natural gas, there are two market models. According to the first one, the price is determined on the basis of demand and supply. In the second case, it is set on the basis of the prices for energy products, competing with natural gas for the end user, or, in other words, on the principles of inter-fuel substitution. Oil and/or oil derivatives are the most frequently used as the ‘substitutional’ energy products.

The second pricing model in its pure form is applied in Japan, where the prices for the long-term gas supply contracts are directly indexed to the oil price. However, in Japan there is a market of nonrecurrent, or spot, transactions for the sale of liquefied natural gas (LNG), but there are no trading floors or hubs. Substantially, LNG is supplied to the EU market under the contracts similar to the Japanese ones, but this is not exactly what the Europeans want at the moment.

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Between Japan and USA

What are the results of exploration work in 2011?

The Europeans associate their hopes with the first pricing model, known as Anglo-Saxon. In its classic form, it is applied in the USA, where there is no pegging, the prices are determined at the hubs, and LNG import contracts stipulate the redirection right, if hub prices are not good enough for the exporters. After all, signing a contract, one does not know and can not know for sure the gas contract price for the next day. The right to redirect gas to other markets is now widely used by LNG suppliers in the USA, where due to the shale gas boom there are clear signs of overproduction.

Except for import, there are almost no long-term contracts in the US domestic market, that corresponds to the internal system logic of this pricing model, which assumes the maximum separation of the product price from the conditions related to its delivery obligations. But as soon as hubs are highly effective in the USA, the supplier has no reason to firmly commit itself to supplies in exchange for the sales guarantees provided by long-term contract.

But let’s come back to Europe. The reformers are not acting without a reason. Over the past 40 years, in the continental Europe market a hybrid system, combining features of the abovementioned two pricing models, has been developed and implemented. The bulk of demand in the continent is met through long-term contracts indexed to oil derivatives and nominations coming from the purchaser. Multiple hubs are used at the same time.

The reformers recognize for sure that the EU is not self-sufficient in terms of gas reserves as North America. Therefore, Europe, being dependent on import, doesn’t only want to give up long-term contracts, but strongly supports them. In this case, the focus is not on the fact that a firm commitment to long-term supplies is incompatible with the Anglo-Saxon pricing model (or such a commitment requires a special premium for the security of supply, which is extremely difficult to be determined in practice). The efforts of reformers, thus, are aimed at creating a new pricing model, the fourth one. The reengineering of a long-term contract in the context of such a model means the price gap between it and the oil price, and taking into consideration gas indices followed by bringing their share up to 100 per cent.

The suggested techniques of our contracts adjustment ‘for the new realities of the market’ shift all price risks to Gazprom while maintaining our strong commitment to supply. But it seems not to bother anybody that the so-called ‘genetically modified’ model version doesn’t suit the suppliers.

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Balancing markets

What do the hub prices in Continental Europe really show?

Carried away by liberalization, the European reformers disregard the existing hybrid two-level pricing model, considering it either obsolete and necessary to be replaced, or, in terms of trading floors, an underdeveloped version of the Anglo-Saxon model. I believe that both are not true. The present model is mature enough, it is almost 40 years old, competitive and ‘adjusted’ not only for current but also for future needs of European consumers. It is a unique pricing model in the gas market, specific only for Europe, dismantling of which would be a big mistake, under whatever slogans it took place.

There is some confusion and, possibly, cunning, when we are told that the prices of many European hubs reflect the aggregate demand and supply behavior in Europe and, therefore, they can be safely used to determine the prices for long-term contracts. It is not fair either with regard to any hub, or in terms of the average price for all European trading floors. What continental hubs really reflect is the correlation between demand and supply based on the residual, truncated principle, i.e., less the main volumes reaching Europe under long-term contracts.

In fact, hubs are local balancing markets, turning more and more into platforms for active arbitrage, which explains the high degree of price correlation between them. A subject for arbitrage is the difference between the prices for long-term contracts, continental trading floors, hubs, and the UK market. Due to the variety of prices, hubs are highly effective, and integration makes the European gas market a more convenient tool for arbitrage. This is not true for the plans to shape by any means, including administrative, a uniform gas price for the entire European Union, that will immediately deprive such a market of a large part of speculative attractiveness.

In contrast with the US hubs, where unlimited volumes of natural gas can be purchased, such a capacity of the European hubs is in doubt. Unification of gas trading and ‘classic’ purchases/sales in a single organizational structure by the European importers only complicated the obtainment of a clear answer to this question. The incapacity of hubs to replenish gas volumes, not received under long-term contracts, was particularly evident during the cold snap in Europe in early February 2012.

If we sum up the differences between the US, Japanese and European pricing models, we’ll be able to find fundamental differences. Since the gas prices in the USA depend exclusively on demand and supply, and in Japan such a dependency doesn’t exist at all, the pricing at the European continental hubs is a function of balancing and arbitrage operations. The churn ratio (a liquidity index, reflecting the relation between all transactions at a hub, including ‘paper’ trading, and the transactions resulting in physical deliveries) of the continental hubs is not high (does not exceed 4) and doesn’t have an upward trend. It means that the continental hubs cannot be deemed a secure instrument for price indication, because for this purpose the churn ratio should not be less than 15. But such a low index is not an evidence of hubs immaturity, for arbitrage and balancing operations this liquidity index is enough.

And how does the hybrid pricing model work?

In describing the existing two-level pricing model in Europe, we use intentionally the term ‘hybrid’ in order to show that the prices for long-term contracts and hubs are operating in the system integrity. Price indexes of European hubs are dependent and derivated from the prices for long-term contracts setting the price ceiling, for which hubs have to adapt later.

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Price pressure

How can you explain the fact that hub prices are usually lower than the prices for long-term contracts?

Firstly, the price difference is determined by the so called flexibility in long-term contracts that is the supplier’s commitment to fulfill the purchaser’s daily nominations, which are set by its changing day-to-day necessities. The ‘flexibility’ assurance requires that the supplier should pay for standby transport capacities, storage of seasonal and operational volumes. The ‘flexibility’ evidently has its own price. Hubs offer only fixed gas lots without any ‘flexibility’, i.e. products without delivery services.

Secondly, the unilateral balancing of volumes presses hub prices. If the amount of gas is not enough for the purchaser, it is more convenient for him to increase nomination within the framework of the current supply agreements or to conclude an additional contract. With such balancing, there is no demand for gas at the trading floor. At the same time, hubs enable to dispose of gas excess. The Finnish market can be an example of such a unilateral balancing, the gas island with a single gas supplier and a small hub with the prices lower than the contract ones.

Thirdly, the hub prices reduction is caused by the ‘flexible’ LNG that has recently been redirected to Europe from the USA because of low prices. Price arbitrage with the UK, where a zone of low prices has formed due to the oversupply, also brings the hub prices down. In the UK before its connection with the continent via an Interconnector gas pipeline, the typical Anglo-Saxon pricing model was used, but after being connected, the UK market became a subsystem of the Europe-wide hybrid model. For sure, the NBP prices are still demand and supply tools in the UK, but they take into account the continental arbitrage, which causes considerable correlation between the spot prices and the oil indexes (it is not observed in the USA).

I would also like to dispel the myth that the hybrid model does not encourage competition. At the level of export and import operations, the price competition is extremely high. The terms of existing long-term contracts allow Gazprom to sell more gas than those 150 billion cubic meters, sold by the Company last year. The fact that our European customers do not rush to take advantage of their right means that there are other suppliers willing to sell their gas cheaper. This opportunity is taken by our clients, whose freedom of action is limited only by their take-or-pay commitments to the supplier within the minimum annual volumes under the contract.

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Can the gap between hub and contract prices be cut?

Hub prices derive from the contract ones, so a simple reduction of prices for long-term contracts shall result in immediate subsidence of hub prices. Reduction of the base price stipulated by a long-term contract can give an effect in terms of increased turnover provided that there are suppliers who are not going to sell gas at a reduced price.

The second way to reduce the gap between prices of the contracts with oil pegging and the hub prices is to include a spot element in a long-term contract. But this method can be used to increase sales only within certain limits. If a spot element exceeds a critical value, it can destroy the pricing benchmark.

Why is it so important to maintain the price ceiling set by the gas with the oil product indexation?

Because otherwise the European market, maintaining long-term contracts, will lose price targets. As it was already noted, the hub prices on the continent do not reflect the ratio of the aggregate supply and demand, they only show the opportunities for arbitrage and balance. The benchmark functions under the conditions of the gas indexation domination in long-term contracts on the continent will shift to the UK market, the only solvent market in terms of pricing, with its depressed prices. And it will cause nothing but the erosion of the gas price, in the UK itself as well, since the gas will flow in the opposite direction: from the continent to the British Isles, and not vice versa, as the case is now. Today in the EU market, which almost entirely depends on import, there are no political forces objectively interested in the protection of the fair price for natural gas.

And what is the fair price for natural gas?

Among the major exchange commodities it is hard to find an analog of natural gas that would be characterized by a seven-fold price difference in various parts of the world (the USA and Japan). This difference creates populist sentiments, the echoes of which even reached Russia. It is in fashion to say that it would be a good thing to have the same price as in the USA. However, the wholesale price in the USA is untenable, because it does not support the investment cycle of gas producers in the USA, including shale gas. For this purpose the price should be at least 6–7 dollars per MBTU. As much as the American gas industry ‘architecture’ suited the model of a liberalized market, even in this model certain flaws have revealed. Gas producers do not have contracts with purchasers, but usually sign short-term contracts with financial institutions through which they hedge their price risks. As in 2008–2009 the American producers could hedge at the level of cost recovery, they were able to continue production while the contracts were valid despite the ruinous prices. However, from the middle of 2010 the hedging at the level of profitability became impossible, so the price adjustment in the US gas market should inevitably happen in the near future.

Prospects

Is the hybrid model in Europe being destroyed?

Yes, the destruction goes in two directions. Ideologists of the pricing based on supply and demand, claim that the oil indexation has lost its meaning due to the small volumes of gas replacement with petroleum products to the ultimate consumer. The point is weak, because it has not happened in Europe for at least twenty years. Gasified households in Europe, as usual, do not use simultaneously oil products for heating and do not switch from one fuel to another depending on the price changes for these two energy sources. Although, at least 30 per cent of the households in Germany, for example, still continue to use oil products for heating, and competition with natural gas remains here as relevant as ever.

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The second point of the supporters of oil indexation refusal is that between 2008 and 2009 in Europe there was a final separation of the long-term contracts and hub prices making oil indexation meaningless. This statement is not correct because the prices of long-term contracts form the benchmark to which hub prices are being adjusted. Substantial difference in prices is possible, but it does not have a systematic and long-term nature. Bridging the gap between the prices actually happened when short-term contracts bounding our gas importing customers with their purchasers ceased to exist. The legislative reduction of the terms of these contracts from 5–10 to two years, introduced in 2007 in order to promote competition in the domestic market, made it almost impossible for gas purchasers to exercise the right to carry unconsumed volumes under the contract over to future periods. The purchasers were forced to sell these volumes, unconsumed and undemanded in the crisis environment, in trading floors that ultimately brought down the hub prices. The forced sales ended with expiration of the contracts.

Mindless imposition of competition in the gas market leads to other unexpected and negative results. Distribution companies, believing that they can buy all the necessary gas volumes at a lower price at a hub, require gas at the lowest price, close to the spot one. There is an absurd situation when import wholesale prices in Europe, dependent on export, do not determine pricing at the level of ultimate consumer, but vice versa.

At the same time, prominent traditional players are barred from quotating to customers at the level below the weighted average price of the portfolio. Such artificial stimulation of competition from the anticartel service leads to the fact that importing companies cannot often win a tender for the gas purchase. They have to give the market to the so-called new suppliers that do not have their own gas and do not import it. They do not bear import related costs and occupy a privileged position according to the European cartel law. As a result, instead of the competition development, in practice conditions for unfair competition, ‘cream-skimming’ and free-riding are being created.

If in using oil product indexation neither the seller nor the purchaser can influence the price, then the creation of a new ‘reengineering’ pricing model, that we are inclined to by the European reformers, would actually mean a possibility of unilateral influence on the gas price by the purchaser in his favor

What should be done in order to save the hybrid pricing model in Europe?

In Gazprom’s opinion, a constructive solution may be presented by the active position of the importers to defend their legitimate interests before the EU cartel services, for which it is high time to work on their mistakes. If this is not done, then Europe will spontaneously switch to the American model of the gas market, which does not provide long-term firm commitments for gas supply, that is certainly not in the interests of the European consumers.

In mainland Europe, currently there are no objective prerequisites for effective operation of the American pricing model. Thus, the supply side is represented by four main suppliers, which account for two-thirds of the gas market. Such a supply structure requires protection of consumers from possible manipulations. Only oil and oil derivatives pegging provide such protection. Obviously, no one, even the largest supplier is not able to influence the price for oil and oil products, so even if a certain market totally depends on such a supplier, consumers are securely protected.

If in using oil product indexation neither the seller nor the purchaser can influence the price, then the creation of a new ‘reengineering’ pricing model, that we are inclined to by the European reformers, would actually mean a possibility of unilateral influence on the gas price by the purchaser in his favor. I would like to remind that in the present-day context gas exporters have no direct access to the trading floors and, therefore, the impact on their prices. Thus, such a change of the pricing model is unacceptable for suppliers.