Utilities Unbundled issue 13

The long goodbye

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With grumblings about gas prices on multiple fronts, Howard Rogers of the Oxford Institute for Energy Studies asks whether it is time to reevaluate the role of oil indexation in long-term gas supply contracts.

The real game changer that might break the oil/gas price link sooner rather than later is liquefied natural gas (LNG).” - Howard Rogers, Oxford Institute for Energy Studies

Friction between regional gas markets

Natural gas prices range from US$3 per million British thermal units (mmBtu) or less in the US to over US$15/mmBtu in Asia. This partly reflects the disparity between the price of gas under oil-indexed long-term contracts (more common in Asia and Europe) and wholesale hub prices.

Following the financial crisis, demand for gas dropped and a number of European utilities were locked into high gas prices on long-term contracts.

Some were able to negotiate concessions. E.ON, for example, announced in March 2012 a settlement with Gazprom that improved the Group’s half-year results by about €1b.15 Although the formulas – oil-indexed or otherwise – were not disclosed, the settlement demonstrated the willingness of (and need for) suppliers to adjust the approach to pricing gas so that their customers didn’t go bust.

So does oil indexation have a future?

The linkage between gas and oil prices dates back to the commercialization of the Groningen field in Holland in the 1960s, when gas was competing with oil products for heating and power generation. That is no longer the case.

Today, the attachment to oil indexation looks increasingly like an argument made by an industry that is reluctant to step away from a comfortable, low-risk position.

Looking ahead

The underlying rationale for a move away from oil indexation is clear. But with details of concessions granted during the financial crisis remaining confidential, the suspicion is that pricing formulas were simply tweaked rather than replaced.

Given the industry’s historical attachment to oil indexation, it seems highly unlikely that this relationship will be abandoned within the next five to ten years.

The real game changer that might break the oil/gas price link sooner rather than later is liquefied natural gas (LNG). The amount of incremental LNG production that looks likely to hit the markets from 2015 to 2020 could precipitate a real shake-up in the industry. LNG exports and arbitrage will certainly have a destabilizing impact on existing pricing structures.

Different pricing formulas are going to be needed, with flexible contract terms. Utilities will need to let go of the status quo and embrace the commercial realities of less certainty and more risk.

As gas moves to more consistent global pricing mechanisms, utilities will need to pay as much attention to gas markets elsewhere in the world as they do to their own supply, demand and pricing mechanisms.

This article was written by Howard Rogers of the Oxford Institute for Energy Studies. For more information on this topic, please contact Duncan Coneybeare

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