081120 Factsheet - Pricing Mechanism for Natural Gas in Europe
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Transcript of 081120 Factsheet - Pricing Mechanism for Natural Gas in Europe
8/3/2019 081120 Factsheet - Pricing Mechanism for Natural Gas in Europe
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Pricing Mechanisms for Natural GasFactsheet
In contrast to the global oil market, natural gas is traded on
regional markets where gas prices are set
through two different pricing mechanisms.
North America and the UK are the only mar-
kets where gas prices are determined at gas
trading hubs. The gas markets of Continental
Europe and Asia are characterized by the
dominance of long-term contracts betweengas producers and consumers. These long-
term contracts include pricing mechanisms which
Q Decoupling does not necessarily lead to lower gas prices. One can only expect floating prices to drop below oil-
indexed price levels in an oversupply situation. But amid a growing energy deficit, it would be naïve to bank on the
emergence of a buyer’s market on the continent within the foreseeable future.
Q Long-term supply contracts allow planning stability and contribute to Europe’s energy security. Decoupling would
only lead to increased price volatility - which creates opportunities for speculators, but does not serve the interest
of end consumers. At the same time, the oil-peg makes the continental gas market immune against the dominant
position of major suppliers. With decoupling, this advantage would be lost.
index the gas price to oil or a basket of oil products.
At times of rising oil prices, some policy-makers in
Europe have proposed de-coupling gas prices
from oil prices and moving towards the Anglo-
Saxon model of free floating gas prices. This sug-
gestion is based on the hope that gas-indexed
prices would be lower. This background paper
explains why gas trading is organized differently inregional markets, how long-term contracts con-
tribute to Europe’s energy security, and why de-
WOULD DECOUPLING OF GAS PRICES FROM OIL PRICES LEAD TO LOWER
universal motor fuel that will replace oil. And gas has lower
carbon emissions per thermal unit than oil or coal. In the long
term, this development will strengthen the oil-gas tandem.
In the short term, LNG is helping to make the world’s gas
markets truly global. In the absence of competition from
cheaper pipeline gas, Asian markets are attracting ever-greater
volumes of relatively expensive LNG, which, in turn, are starting
to serve as the price target for both sides of the Atlantic.
The long-term comparison of the oil-indexed German
Border Price (GBP) with the spot price of the most
important gas trading hubs in North America (Henry Hub)
and the UK (National Balancing Point) reveals that gas prices
in the US and the UK continue to correlate with oil-indexed
prices, even in the absence of any contractual peg. This
usually occurs during periods when demand and supply are
balanced.
However, the short-term volatility of gas prices issignificantly higher on spot markets. This volatility creates
arbitrage opportunities for gas traders and speculators, but
fails to lower prices for end consumers.
On a joule-for-joule basis, the price of natural gas does not
exceed 70 percent of the price of oil. This discount is
explained by the superior properties of oil as a commodity.
It is the fuel of choice in the transportation sector and can
be stored and transported much easier than gas.
However, the gas price discount to oil prices is most likely to
disappear. Liquefied natural gas (LNG) leads to a
convergence of the commodity properties of oil and gas. In
both cases, we are dealing with liquids that are shipped by
tankers and poured into special tanks for storage. Gas-to-
liquids (GTL) are potentially capable of turning into a
KEY FINDINGS
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TRADE IN NATURAL GAS: THE CURRENT SITUATION
8/3/2019 081120 Factsheet - Pricing Mechanism for Natural Gas in Europe
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Page 2
Pricing mechanisms for natural gasFactsheet
WOULD IT BE POSSIBLE TO ESTABLISH FREE FLOATING GAS PRICES IN EUROPE?
very few market players on each side. This creates a situation in
which a small number of suppliers and buyers have to hedge
investment risks and distribute rewards in order to uphold a
reasonable level of planning security.
This is typically done through long-term
contracts which include negotiated
pricing mechanisms in order to ensure
that one side cannot unilaterally dictate
price levels. In other words, for import-
dependent markets such as Europe, long-
term contracts provide the fundamental
basis of energy security.
LNG transport, which is particularly
developed in Asia, allows more flexibility
than pipeline systems, because there is
no physical reason why LNG tankers cannot be re-directed to
different destinations. However, due to the capital-intensivenature of investments in LNG facilities, together with high
production and transportation costs, most LNG is sold through
long-term contracts. It should also be noted that LNG currently
represents only a small fraction of the global gas market
WHY DO GAS PRICING MECHANISMS DIFFER ACROSS REGIONS?
For the foreseeable future, a transition to free-floating gas
prices could not be accomplished simply because there is no
European reference point for gas prices. Europe’s gasmarket remains fragmented, and the liquidity of the small
trading hubs in Continental Europe is too low for any of
them to provide a reference point.
The replacement of the existing system would be a major legal
and logistical challenge, given that 90% of the gas consumed in
Continental Europe is sold under long-term contracts with oilprice indexation, many of which have recently been extended
beyond 2030.
To overcome this constraint, gas can nowadays be
transformed into liquefied natural gas (LNG). But this
process is very energy intensive and can cost up to one
third of the original energy in the gas. This is why the
gas market is and will stay to a high degree a regional
Due to its high energy density and its liquid form,
oil can be transported and stored at lower cost
than other fossil fuels. Moreover, it can be shipped
and stored in a flexible way, which is why oil is
easily traded on a truly global market.Because of its low energy intensity and its fugitive
form, both the transportation and storage of gas is
expensive compared to oil. Traditionally, natural
gas is transported in pipelines. Pipelines can only
be built with high capital investment and over
limited distances from production sites to
consumers. Once built, pipelines offer no flexibility
to re-route supplies, and establish a long-term
business relationship between a limited number of
producers and consumers.
The regional differences between the price mechanisms can
be attributed to differences in geography and resource
endowments. Until the end of the 20th century, both the US
and the UK were self-sufficient or
even net exporters of gas. At the
same time, gas reserves in both
countries are located in small to
medium-sized gas fields which can
be exploited by a large number of
smaller undertakings. In this
situation, governments can decide
to set a general regulatory
framework for the domestic gas
value chain and then leave
production and sales decisions to
the market.
In Continental Europe, the situation is significantly different.Here, key gas consuming countries have always been
dependent on gas imports from gas fields situated in
Algeria, Norway, the Netherlands and Russia. Cross-border
supply pipelines are capital-intensive and often have only
WHY IS GAS NOT TRADED ON A GLOBAL COMMODITY MARKET LIKE OIL?
w w w . g a z p r o m . c o m
w w w . g a z p r o m . c o m
w w w . g a z p r o m . c o m
I. Further reading: Energy Charter Secretariat (2007): Putting a Price on Energy, International Pricing Mechanisms for Oil and Gas. II. The indicator for liquidity is called “churn”. Churn is the ratio between traded volumes and delivered volumes. A churn of at least 15 is usually considered to be the
threshold for a liquid market. Henry Hub, the main gas hub in North America, has a churn of 100, while the National Balancing Point in the UK oscillates between a
churn of 10 and 15. The few existing Continental European hubs all have a churn of clearly below 10, while Asia has no hubs at all. For comparison: on the oil side, the
churn of WTI and Brent is about 500. Source: Energy Charter Secretariat (2007).