A tip of the hat to Nick Drew over at the Cityunslicker blog for drawing our attention to the following gem of a natural gas market story.
As reported by Reuters late last week:
MOSCOW, Feb 19 (Reuters) – Russia’s Gazprom (GAZP.MM) has agreed to supply some of Europe’s gas at spot market prices in a bid to defend its shrinking market share after three decades of oil-indexed pricing, a Gazprom source said on Friday.
The source told Reuters that Gazprom, which supplies about a quarter of Europe’s gas, had agreed to allow a European spot price element in deals with most European customers in a move that will likely be cheered by its stock holders.
The background here is that Gazprom, for time immemorial, has sold its natural gas to Europe in long-term “take or pay” deals. These deals are priced in part off a floating oil-index which changes over time, despite most of the European market trading on a spot basis.
Given the amount of natural gas Gazprom exports to Europe, the index method — which links natural gas prices to a basket of oil products and crude — has kept the price of natural gas irrationally converged with oil prices in Europe, even when supply and demand fundamentals are completely different.
As Cityunslicker’s Drew helpfully explains, the implications of Gazprom turning towards a spot framework could possibly be huge for Europe. As he summarizes:
1. It will open the sluices on the long-constipated German spot market – which (as well as lowering gas prices still further, and potentially by a noticeable amount) provides the missing piece in the European gas market jigsaw, needed to provide security of supply for the UK. This should have happened 5 years ago but better late than never: it is Unqualified Good News.
2. It will have a monster impact on the internal Russian energy market. Russian policy (strongly advocated by Gazprom) is for subsidised internal prices of gas to be allowed to converge, over time, with their export prices (on a netback basis, i.e. correcting for transportation costs). Firstly, this is made much easier with lower export price levels, so it will happen sooner (and will compensate Gazprom somewhat for lost export revenues). This will quickly work to reduce Russian gas demand – which has long been wildly inefficient based on ultra-low prices (and often no metering!) – freeing up more for export: another win for Europe.
Secondly, Russian industrial electricity prices are pegged to fuel prices, also on a netback basis: these will consequently fall in the short term (giving Russian industry a much needed boost) but in the long run will be more convergent with European market prices, at a discount based on the netback. The long term ramifications could be profound.
The problem is that there’s a disparity between what Gazprom says and does.
As Barclays Capital observed on Monday, a few deals don’t necessarily mean a complete abandonment of long-term deal structuring for Gazprom:
European customers in H1 09 drew the minimum requirement under their take-or-pay agreements and utilised spot contracts whenever possible – Gazprom’s lower volumes can be seen in Figure 4. However, going into the second half of the year, volumes are once again rising as contracted volumes for the year are fulfilled. Although spot markets offer a cheaper alternative, the European market for contracts can only cater for around 15% of demand. Naturally, there have been negotiations between Gazprom and its customers due to what some see as an aggressive pricing formula, which was especially hard to accept during a period of weaker European industrial demand.
And more significant still:
Despite political rhetoric against pricing formula, Gazprom has stood firmly by its take-or-pay agreements with only minor (confidential) changes being made following negotiations with E.On, Eni, Botash and GasTerra. Keeping contracts as they are makes economic sense for the company, allowing relatively predictable core cash flows providing a solid base for profitability.
And that’s the key issue: while Europe’s spot prices remain depressed, it seems completely illogical for Gazprom to breakaway from its love of indexation. More to the point, Gazprom knows Europe’s supply is not yet diversified enough for it to be in any position to negotiate too fiercely.
This, for example, is the sort of margin Gazprom might otherwise have missed out upon in the last year (chart courtesy of BarCap):
And for more some perspective, here’s the latest from Russian Energy Minister Sergei Shmatko via Bloomberg on the matter of those alleged spot sales (our emphasis):
“Gazprom is quite innovative and should be more innovative, and swiftly react to changed market conditions,” Shmatko told reporters in Moscow late yesterday. “But by no means should the system of long-term contracts that we have created be destroyed.”
Related links:
LNG transatlantic arbitrage in action – FT Alphaville
How utilities are just like banks - FT Alphaville
LNG transatlantic arbitrage in action - FT Alphaville
Doth a global natgas glut come (already)? – FT Alphaville