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Will Oil-Indexation In Long-Term Upstream Contracts Survive Market Liberalization?
19 May 2008
Will Oil-Indexation In Long-Term Upstream Contracts Survive Market Liberalization?

A oil worker in SiberiaIntroduction from Daniel Satinsky, USRCCNE President: European dependence on Russian gas supply has been one of the most controversial and contentious areas of dispute between Europe and Russia, with the U.S. weighing in on the European side. Critics in both Europe and the U.S. have warned that Europe risks political pressure through the threat of supply cutoffs and uncontrolled price increases from its dependence on Russia. For the U.S. public, there has been very little response from the Russian side to this controversy, beyond blanket rejection of the criticism. However, there are logical arguments on the Russian side to defuse the critics based on a deeper examination of the nature of the natural gas supply business and the real nature of the pricing system. Speaking to an audience of energy industry professionals, one of Gazpromexport’s leading experts, Sergei Komlev, puts forward a cogent defense of the market integrity of current Gazprom pricing mechanisms in long term contracts in Europe. In doing so, he implicitly argues against any notion of the possibility of political pressure being exerted by Russian through the existing contract system. The presentation is a worthwhile contribution to the ongoing debate on Russia's role in energy security.


Will Oil-Indexation In Long-Term Upstream Contracts
Survive Market Liberalization?

Remarks by Sergei Komlev,
Head of Directorate for Contract Structuring and Price Formation, Gazpromexport,
at the Round Table "World Energy Demand and Price Setting Analysis,"
Padua, April 21, 2008

In my presentation I will focus on prospects for long-term contracts between producers like Gazprom and merchant gas companies like Eni or Eon Rurgas. I will not speak about midstream and retail contracts and related pricing mechanisms, not only because these contracts are less important to Gazprom, but because in my view the transformation of midstream and retail markets will follow a pattern that differs from upstream contracts.

I will speak in defense of long-term, oil-indexed contracts in Continental Europe because I believe in their relative merit in comparison to the alternative of competitive, gas-on-gas priced contracts outweighs any of their perceived disadvantages. Europe would make a great mistake if it moved away from long-term, oil-indexed contracts.

Although oil indexation still dominates in Continental Europe and is accepted by the major market players, there is a threat that these contracts will be abandoned by the European Commission. By end of 2008 the EU will adopt an unbundling procedure. Long-term, oil-indexed contracts will be the next stop on the liberalization roadmap. The European Commission will most likely initiate changes in pricing mechanisms because pricing systems are a fundamental part of market organization. On the UK gas market, spot pricing took the place of oil indexation following the start of NBP in 1996, unbundling occurred later, in 1999. In Continental Europe the sequence of events could be different, with unbundling coming first, followed by introduction of spot pricing.

The threat to current price mechanisms that I have mentioned is real because the European Commission has already shown considerable discomfort with oil indexation. The EC considers it to be outdated and a hindrance to the development of a genuinely competitive upstream market for natural gas. Once Brussels became obsessed with the idea of diversification of gas supply, it considered oil indexation as a natural risk factor in European energy security. Oil indexation, in fact, makes diversification of gas supply a mere mantra with no practical sense. If gas price is linked to the price of another commodity, it does not really matter how many suppliers are available, a dozen or a thousand, provided that Europe is amply supplied with natural gas. The indexed gas price will be nearly the same in any case. The EC believes that the best choice for Europe is pricing based on spot prices at the point where international supply reaches the European border.

I will build my defense of the long-term oil indexed contracts along several lines. First, I will try to show that the current oil-indexed gas price is not irrational or speculative, as generally perceived, and represents the fundamental value of gas, even though oil prices are over currently more that 100 US dollars. Second, I will present arguments that support the concept that the long-term correlation between oil and gas will persist or even become stronger. Although no serious researcher can deny that this correlation exists, even in the most liberalized gas markets, still many doubt that this relationship will continue to exist. To conclude, I will submit that unilaterally imposed gas-on-gas pricing will not provide the EU with lower prices because there are no signs of any lasting buyers' market for gas for years ahead.

Arguments against long-term, oil-indexed contracts

Long-term, oil-indexed contracts are under fire by critics for a number of reasons. The principle complaint against the indexation of gas contracts to oil prices is that this mechanism is inflexible in relation to supply and demand. Although gas supply to Continental Europe are sufficient, gas prices continue to rise. Critics of indexation contend that if gas prices were set on a competitive basis, they would definitely be lower. The chief economist of the International Energy Agency, Fatih Birol, has argued that high oil-indexed natural gas prices are leading to the destruction of currently existing and potential demand as producers of electricity in Continental Europe increasingly favor coal over gas as a fuel. And this, in turn, leads to higher greenhouse gas emissions. In his view, gas-on-gas pricing would be less destructive to demand in comparison to current overpriced oil-indexed "clean" gas that is gradually losing its popularity, with its place being taken by "dirty" coal.

A second group of critics claim that linkage of gas to oil is losing its rationale. They say that the original rationale for the linkage of gas prices to those of oil products in long-term contracts in Continental European has become increasingly dubious with the decline of dual firing capacity in the electrical generation market. Moreover, prices of gasoil, one of the two main oil products which comprise 90 percent of indexation in long-term Continental European gas contracts, are determined primarily by transportation costs and not by stationary end-users. Another argument for de-linkage of oil and gas prices is that oil-based power generation is disappearing from the stage. As a result, coal and gas remain as the two competing fossil fuels and this will inevitably weaken the relationship between oil and gas in the future.

Arguments for long-term, oil-indexed contracts

Let us start with the assertion by critics that oil-indexed gas prices are too high and that indexation is outdated. Gazpromexport conducted a comparative study of price growth for the major commodities starting from 2000. Even taking into account the speculative and geopolitical factors priced into oil, its performance does not "jump out" of the rate of appreciation for the entire group of basic commodities, including metals and other fossil fuels. Expressed in euros, the price of oil grew by only seventy percent (70%) over the past seven years, which corresponds to the price performance of the precious metals group. Expressed in gold, the price of oil has remained practically unchanged since the start of the decade.

Since oil prices keep growing in line with other basic commodities prices, or even at a slower pace than many these commodities, there is no reason to believe that oil indexation makes gas overpriced in long-term upstream contracts. Otherwise one has to admit that prices on many other commodities, including spot gas prices, are irrational and speculative as well.

Another important finding of our study is that the oil-indexed gas price does not differ much from gas-indexed price in the long-run. There are periods when gas-indexed prices are higher and vice versa. What is evident is that gas-indexed prices are not only more volatile that those in traditional oil-linked contracts, but they are also more volatile than oil prices and other commodities. This could be partly explained by the fact that it is much more difficult and expensive to store gas than oil. Gas indexation in long-term contracts to spot prices will not necessarily result in lower prices, but will definitely create problems of price volatility that will be difficult to resolve. The use of average spot prices is only a partial solution because it would remove the expected benefit of supplying gas at prices signaling supply and demand relationship.

There are good reasons to expect that the linkage of oil and gas will not lose its relevance in the future and may even become stronger. Producers can argue that gas production costs are linked to oil field development costs. With the growth of the relative importance of LNG as compared to pipeline gas, gas as commodity will resemble oil more than currently as it will be transported and stored is a similar fashion as oil. Competition for LNG with Asian prime markets with their traditional exposure to oil indexed contracts could become an additional rationale for strengthening linkage of gas and oil.

This deep-routed linkage exists despite the fact that natural gas and oil (the main source of motor fuel) are used for different purposes on different markets and are not in direct competition with each other. The linkage between the two does not necessarily have to meet physical substitution criteria – in our case, between the gas and oil products represented in the price formula – should their market price drastically diverge. One should not forget that in Japanese and Algerian contracts, the price of gas has historically been directly indexed to oil, which in and of itself is not a fuel for boilers.

Long-term, oil-indexed contracts remain a cornerstone of security of supply for Continental Europe, given its growing dependence on supply from only few foreign gas-producing sources. In many European gas markets there is a monopoly or oligopoly in the supply business, so gas-to-gas price competition does not provide defensible price indicators. Negotiated prices based on oil indexation maintain fair value over the long-term and remove market power from buyer and seller alike.

I think that the EU regulators aspire to recreate in Europe the North American market, in which thousands of players optimize their portfolios daily. This is really a back-door attempt to break up the big monopolies and let a thousand flowers bloom. But history matters, industry ownership, infrastructure and operations simply are not that fragmented in Europe, and trying to transform an industry through a change in operating rules simply adds costs and inefficiencies to the established structure. Changing the rules doesn't really change the facts on the ground.

Will oil-indexation in long-term upstream contracts survive market liberalization?

The answer to this question is not obvious. Gas market liberalization is generally associated with a forced transition away from the traditional pricing system towards a system in which prices will be driven by the balance between supply and demand. A recent poll at the Flame Conference in Amsterdam revealed that only twenty-seven percent (27%) of respondents agree that European gas supply contracts will never be determined by spot and forward hub prices and will remain oil or oil product indexed. But this does not mean that the remaining seventy percent (70%) consider the drive towards spot pricing to be self evident. There is simply no clear vision of future market organization in Continental Europe.

What EU regulators and believers in spot pricing do not want to acknowledge is that efficient and fair spot markets can easily be distorted by a concentration of market power in the hands of one or more buyers or sellers. Markets must not only be transparent and liquid; they must be "deep," with many interested buyers and sellers. If an individual buyer or seller has so much market share that it can temporarily move the price to its advantage and to the disadvantage of other market participants, then trust vanishes. This was the reason for adopting oil-indexed pricing, and that reason is still valid today: oil indexing eliminates the ability of any one player to influence prices. If the EU regulators are really worried about the risk of physical supply from overdependence on a few exporters, why then add price risk, when the turn of a valve could send spot prices soaring?

Despite the efforts of some governments and some market players, the majority of the UK's beach supplies (mostly older contracts) remain oil-indexed. In Continental Europe the percentage oil-indexed gas contracts is closer to ninety percent (90%). Clearly, oil indexation works in Europe, Scandinavia, and many countries around the world, including Egypt, Algeria, Tunisia, Libya, Nigeria, South Africa, Thailand, Japan, Korea, Indonesia, Malaysia, Australia, etc. Many of these countries have little desire to move away from oil-indexation.

The initiative in 2006-2007 to extend long term gas contracts to the years 2025-2030, came from Gazprom's European partners themselves. Our partners see no reason to abandon the traditional contracts, which have proven their credibility over decades. And this perception has nothing to do with wishful thinking.



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