How to Resolve Price

Mismatch Problem?

Third European Gas Price Structuring and

Market Liquidity Forum, Berlin

January 28, 2014

Sergei Komlev Head of Contract Structuring and Price Formation

Gazprom Export

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TTF from January 2010 to December 2013 versus: r

Brent 1st month futures 0.69

Brent 1st month futures - 3 months moving average 0.80

Brent 1st month futures - 6 months moving average 0.86

Brent 1st month futures - 9 months moving average 0.85

Source: Bloomberg, Gazprom export

Gas Hub and Oil-indexed Prices – Still Bound Together

(TTF)

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Gas Hub and Oil-indexed Prices – Still Bound Together

(NBP)

Source: Bloomberg, Gazprom export

NBP from January 2010 to December 2013 versus: r

Brent 1st month futures 0.69

Brent 1st month futures - 3 months moving average 0.79

Brent 1st month futures - 6 months moving average 0.84

Brent 1st month futures - 9 months moving average 0.83

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Gazprom Export estimate for imported gas 2012

39.5%

17.0%

14.5%

1.7%

3.2%

17,0%

4.8% 2.3%

Gazprom oil-indexed Norway oil-indexed

Algeria oil-indexed Libya oil-indexed

Qatar oil-indexed Norway hub-indexed

Qatar hub-indexed Gazprom hub-indexed

72.7%

27.3%

*Excluding Baltic and CIS countries and including Turkey

Reuters published a report in March 2013

demonstrating that only 34.8% to 37.7% of all

major European gas supplies are now priced

off trade hubs.

The American research company PIRA Energy

Group came to the same conclusion as

Reuters in its own February 2013 study, which

estimated that roughly 2/3 of European gas

consumption is still oil indexed.

ACER November 2013 Market Monitoring

Report states that “Oil prices is still the main

determinant of wholesale gas prices in

Europe…”(p.180). Higher oil prices in 2012

“put upward pressure on hub prices” (p. 179).

Three out of the four major suppliers of gas to

Europe still support oil indexation as means of

preserving intrinsic, long-term value of gas.

Gas Exported to Europe is Predominantly Oil-indexed

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Tandemic and Asymptotic Contract and Hub Price

Behavior

0

2

4

6

8

10

12

14

US

D/m

mb

tu

BAFA import price, Germany TTF (ENDEX), 1st month

Hub prices are not independent:

they are, in fact, derivatives of the

contract prices that set a baseline

trend for their behavior. Supply and

demand only mutate their changes

Hub prices will generally fall

below contract prices because

gas delivered under long-term

contracts offers greater supply

security and delivery flexibility

Sources: Bloomberg, BAFA

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Even on a tight gas market of

2013, intervals when contract

gas was cheaper than hub gas

were brief

Contract Gas is a More Valuable Product than Hub Gas

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Mismatch Between Contract Price and Hub Price

Contract price

Money

Time

Hub price Hub price is lower than

contract price

Hub price is higher than

contract price

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Country Effective

from

Obligation to Sell Gas at Hubs Obligatory Introduction of Spot

Component in Regulated Price

Way of gas index

linkage

Poland 11.09.2013

Suppliers to initially sell 30% of the

previous year’s volume through the

bourse

PGNIG has to consider

OTC and GASPOOL prices

when putting the offers

01.01.2014

Suppliers to initially sell 55% of the

previous year’s volume through the

bourse

PGNIG has to consider

OTC and GASPOOL prices

when putting the offers

Hungary 01.10.2011

Obligation to sell gas on regulated market

at 70% hub-indexed prices

TTF

01.10.2013

Obligation to sell gas on regulated market

at 100% hub-indexed prices

TTF

Italy 01.04.2013 Regulated gas prices to be 20% linked to

spot

TTF

01.10.2013 Regulated gas prices to be 100% linked to

spot

TTF

Belgium 01.01.2014

Oil-indexation of final gas prices must be

capped at 35%

Zeebrugge

01.01.2015

Oil-indexation of final gas prices is phased

out

Zeebrugge

France 01.01.2013 Government formula applied to GdF

SUEZ prices is 36% spot-linked

TTF

European

regulators are

obsessed with

perspective of

decreasing gas

prices by decree

Regulators Impose Hub Pricing as Industry Standard

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Promotion of unfair competition

(“free-riding”)

Governments and regulators enforce hub

indexation

Introduction

of spot

component

in end-user

regulated price

National regulators

Importers End-users

Obligation

to sell

gas at

hub-based

price

$/mcm

Hub Prices

Contract Prices

• Key gas importers responsible for national energy security are deprived of their legitimate margins when forced

to sell gas to end-users at hub indexes

• “Free riders” able to source small volumes of hub gas prosper. They produce no gas, have no import contracts

and do not pay full cost for seasonal storage and structuring of deliveries

Direct and Indirect Enforcement of Hub Pricing

Leads to Price Mismatch

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Euroct/kWh, excluding taxes

Germany: Positive Spreads between End-Users and

Hub Prices

-1

0

1

2

3

4

5

2008

Q1

2008

Q2

2008

Q3

2008

Q4

2009

Q1

2009

Q2

2009

Q3

2009

Q4

2010

Q1

2010

Q2

2010

Q3

2010

Q4

2011

Q1

2011

Q2

2011

Q3

2011

Q4

2012

Q1

2012

Q2

2012

Q3

2012

Q4

2013

Q1

Household consumers Small industrial consumers

Mid-size industrial consumers Large industrial consumers

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Price mismatch problem leads to margin squeeze of the mid-streamers. It forces Gazprom to make

a tough choice – to terminate contracts with the existing clients or bring profitability back to the

midstream operations at its own expense. Gazprom via ex-post rebates and contract adjustments

acts as a major sponsor of the European energy security by observing its historic obligations to

deliver gas in the environment that poses a threat to the very existence of the long term contracts.

There are different ways of resolving price mismatch problem.

Adjusting contract price to hub level while keeping oil indexation in place:

1. partial indexing to hub prices

2. introduction of the price corridors that bring price mismatch to a tolerable level

3. decreasing Po to hub level but keeping oil/oil acceleration in the formula

4. removing flexibility from the contracts

Complete oil de-indexation and introduction of hub price tracking in the long-term contracts

Ways of Resolving Price Mismatch Problem

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Price

Period 1 Period 2 Period 3 Period 4 Period Х

Intrinsic Premium for Security Supply and Flexibility

reproduces Contract/Hub Price Mismatch

Making contract and hub

prices comparable simply

by lowering contract

prices leads to a new

cycle of downward

adjustment in the spot

prices

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Contract with flexibility

MAQ

ACQ

Flat contract without flexibility

Assumptions Arbitrage opportunities between BAFA

and TTF for the period 1 July 2010 - 30 November 2012 under the

following assumptions: gas in required quantities is available on the hubs;

additional cost of delivering gas to final place of consumption is not included

Additional profits from arbitrage

enhancement (USD/mcm) % of

flexibility 15% 20% 25%

Average profit

7.99 10.66 13.39

Maximal profit

15.16 19.05 22.78

We can also assume that the amount of the fine that Gazprom must pay if it fails to meet its clients’

obligations is a suitable proxy for the supply security and delivery flexibility premium embedded in

the long-term contract price

Explanation of the Contract-Hub Price Gap:

Contracted Gas Offers Greater Supply Security

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Cost of Seasonal Flexibility

Average cost of full-cycle gas storage

(assumes that over the year the

volume of gas pumped into

underground storage equals the

volume of withdrawals)

US$21.45/mcm

Cost of Short-term

Flexibility

Additional transportation capacity

payments for flexible capacity

(7,000 hours of flexibility)

US$13.7/mcm

Explanation of the Contract-Hub Price Gap:

Contracted Gas Offers Enhanced Delivery Flexibility

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0

100

200

300

400

500

600

MC

M/d

Gazprom is a major provider of supply flexibility to Europe s seasonal swing in Russian gas daily deliveries doubled

Source: International Energy agency database

1998-2005

80-100 MCM/d

seasonal swing

2005-2013

100-220 MCM/d

seasonal swing

Removal of Flexibility Threatens Energy Security

Dumping persists until Qs = Qc

Volumes consumed

Volumes purchased

for dumping on hubs Qs

Qc

qs qs qs qs qs qs

Dumping by Buyers’ Cartel in Case of 100% Indexation

In the case of 100% gas

indexation, any take-or-pay

obligations on the buyer’s side

lose their function as a

guarantee of demand security

because buyers can dispose of

excess volumes on hubs with no

risk to their revenues

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”Oil linked pricing – in the gas market a synonym for competitive pricing – has proved to be a

very successful principle for constant market development, reasonable pricing, adequate gas

production and the timely development of the natural gas infrastructure. By and large, it is generally

understood that the long term contracts with oil linked pricing will remain the key reference for

gas prices. This should provide producers and investors in production and infrastructure with

adequate securities to develop and implement new projects. However it will have to allow for

increasing gas-to-gas competition and reflect to a greater extend seasonal variations in prices and

the greater significance of spot markets”.

Source: United Nations Economic Commission for Europe (UNECE) Gas Centre report on the Security of

National Gas Supply in the European Part of the UNECE Area. 10/09/2003. P.14.

Joaquin Almunia, EU Commissioner for Competition:”While market conditions in the past may

have justified the use of oil indexation, the competition directorate's analysis [is] that the

development of the spot gas market and the fundamental changes in the global market wrought by

the surge in shale gas production [means] that those justifications are no longer held. Oil

indexation does not respond to the fundamentals of the market, to the interplay between

supply and demand that should exist in a market and that we want to exist in our internal

market.”

Source: Answers to a written parliamentary question by MEP – 12/09/2012

Market Failure in Gas Industry

does not Justify Pricing Model Change

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European politicians, regulators, and academics claim that gas has lost its link to oil once and

forever.

This is not true. The days of oil indexation are not over.

– Oil and gas compete in the residential sector and industry. One third of houses in Germany

still use oil products for heating

– Even though there is not much demand-side substitution between oil and gas in power

generation, there remains more than a virtual relationship between the two fuels

– Merit order puts oil products and gas in the same category of fuels used in peak or semi-

peak periods of consumption

– Oil products serve as a reserve fuel for many power plants and industrial applications

should gas supplies be interrupted

– The oil-gas link will only be reinforced in the future due to direct competition in the

transportation sector from gas-fueled vehicles and the use of LNG as bunker fuel

The Rationale for Oil Indexation Prevails

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Energy Mix in EU-27 Oil/gas link is not obsolete and responds to the fundamentals of the market

Data source: Eurostat, IEA

5,0% 6,7% 5,7% 6,8% 7,2% 8,9%

24,1% 26,0% 34,0% 36,2% 34,8% 39,2% 4,7% 4,4% 13,3% 12,5% 42,2% 40,1% 14,5% 10,5%

96,7% 93,8% 18,8% 15,6%

23,6% 21,9% 31,5% 31,4% 36,4% 32,8%

2006 2011 2006 2011 2006 2011 2006 2011

Total Industry Transport Households

Energy mix in EU-27, MMtoe

Natural gas

Oil products

Coal

Electricity and heat

Nuclear

RES

Biofuels

Others

1175,6 1103,3 319,5 287,1 371,1 364,1 484,9 452,1

5,6% 7,8% 6,6% 8,4% 3,9% 8,1% 10,6% 4,3% 5,9% 5,8% 7,8% 6,3% 9,0% 6,6% 6,6% 9,3%

9,1% 9,5% 9,9% 11,5% 10,8%

23,0% 21,5% 12,5%

12,5%

43,1% 40,6% 15,8% 11,1% 96,8% 93,9% 20,0% 16,4%

28,6% 27,5% 38,5% 39,4% 43,6% 41,4%

2006 2011 2006 2011 2006 2011 2006 2011

Total Industry Transport Households

Adjusted Energy Mix in EU-27, MMtoe

Natural gas

Oil products

Coal

Nuclear

RES

Biofuels

Others

1175,6

1103,3 319,5 287,1 364,1 484,9 371,1 452,1

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Oil/gas link is not obsolete and responds to the fundamentals of the market

30.1

82.7

174.3

Total consumption, mtoe

Petroleum products

Natural gas

Others

30.1

82.7

35.9

Consumption of fossil fuels, mtoe

Petroleum products

Natural gas

Coal

Country

Share of

petroleum

products in

consumption

Share of natural

gas in

consumption

Share of

petroleum

products in

consumption of

fossil fuels

Share of

natural gas in

consumption of

fossil fuels

EU-27 10.5% 28.8% 20.2% 55.6%

Germany 4.0% 31.7% 8.0% 63.7%

Turkey 5.9% 30.6% 8.9% 46.1%

Italy 11.6% 30.9% 21.5% 57.4%

Poland 6.4% 19.7% 11.9% 36.6%

UK 15.8% 34.8% 25.8% 56.8%

France 16.5% 28.3% 28.5% 48.9%

The Czech

Republic 5.0% 24.6% 8.5% 42.4%

Hungary 3.1% 35.3% 6.1% 69.8%

Austria 8.5% 25.4% 19.0% 56.4%

Slovakia 2.5% 22.0% 4.8% 42.4%

Natural Gas & Petroleum Products

as Competing Fuels: Industry

Data source: Eurostat, EU 27 Energy Balances, 2011

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70.7

148.3

233.1

Total consumption, mln toe

Petroleum products

Natural gas

Others

70.7

148.3

12.2

Consumption of fossil fuels, mln toe

Petroleum products

Natural gas

Coal

Country

Share of

petroleum

products in

consumption

Share of natural

gas in

consumption

Share of

petroleum

products in

consumption of

fossil fuels

Share of natural

gas in

consumption of

fossil fuels

EU-27 15.6% 32.8% 30.6% 64.1%

Germany 23.1% 30.6% 41.7% 55.2%

Turkey 17.1% 25.8% 27.7% 41.9%

Italy 12.3% 50.6% 19.6% 80.4%

Poland 10.3% 16.7% 20.0% 32.3%

UK 7.3% 54.5% 11.6% 87.0%

France 20.4% 26.0% 43.7% 55.5%

The Czech

Republic 3.8% 34.9% 8.5% 78.6%

Hungary 4.9% 52.6% 8.2% 88.6%

Austria 16.7% 20.3% 44.5% 54.1%

Slovakia 2.0% 40.4% 3.8% 78.4%

Natural Gas & Petroleum Products

as Competing Fuels: Commercial & Residential Sector

Oil/gas link is not obsolete and responds to the fundamentals of the market

Data source: Eurostat, EU 27 Energy Balances, 2011

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150

200

250

300

350

400

450

500

Rig

s

Gas Shales Oil/Liquid Shales

40

540

1040

1540

2040

2540

500

700

900

1100

1300

1500

1700

Na

tura

l G

as P

rod

uctio

n (M

Mcm

/d)

Na

tura

l G

as R

igs

Natural Gas Rig Count Natural Gas Production

Sources: Pace Global, Baker Hughes and EIA. Data shown for the U.S.

In a properly functioning market costs exceeding revenues should lead to reduced investment and

declining production, particularly with shale gas wells that experience first-year production decline

rates of 50-85 percent. However, natural gas behaves differently from other commodities and

therefore displays an irregular response to underlying changes in supply and demand. Natural gas

production grows while natural gas rig counts and average spot prices have decreased substantially.

Liberalized Markets Drive Dry Gas Industry into Comatose State Making it Subject to the Largest Market Failure in the World

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Major depressing factors that affect hub-priced gas prices:

• In the USA and UK, associated gas deliveries play a secondary or auxiliary role compared to oil

deliveries. Gas as byproduct of oil and gas liquids production is not a self sufficient commodity.

• Although the volumes of natural gas global exports are only 4 times lower in US$ value than the

sales of oil, the financial markets have disregarded natural gas as an attractive hedging

instrument. As a result gas price is not supported by the financial markets like many other

commodities.

• USA financial markets – principally futures markets – enable producers to lock in profits for

years ahead. Low cash prices now do not discourage producers that sold today’s production

several years ago at much higher and profitable prices. As a result, supply to price adjustment

mechanisms do not function properly.

• Almost all gas markets outside of North America lack the level of competition and liquidity to

create market mechanisms to fairly price gas as an independent commodity.

• History of gas industry is a history of persistent fight with the market failure of various kind.

Oil Indexation is a ‘natural’ remedy to that failure that should be preserved in the interest

of gas buyers and sellers. It is the only realistic solution to price mismatch problem too.

Free Markets Fail to Support

Long-Term Investments in Gas Industry

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THANK YOU FOR YOUR ATTENTION!

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• Oil and gas continue to share many commonalities; price indexation is a natural extension of this

– Similar exploration and drilling technologies

– Similar cost structures

– Increasing convergence in end-use markets

Transport, 61.7%

Industry, 9.3%

Non-energy use, 16.5%

Other, 12.5%

World Oil Consumption

Transport, 61.7%

Industry, 9.3%

Non-energy use, 16.5%

Other, 12.5%

World Gas Consumption

Transport, 5.50%

Industry, 34.90%

Non-energy use, 10.80%

Other, 48.80%

World Gas Consumption

“Other” includes agriculture, residential, commercial and public services, and non-specified uses. Source: IEA.

Market Commonalities Argue in Favor of Similar

Pricing Structures for Oil & Gas

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• The price for a significant

portion of traded

commodities has grown 3-

4 times over the last

decade

• Oil-indexed gas has

grown in line with other

commodities, while hub-

linked gas has lost some of

its value

• Oil-indexed prices are

competitive market prices,

and are more reflective of

market equilibrium than

their hub derivatives

Average prices, ratio to 2001:

in 2010 in 2011 in 2012

Metals: 2,9 3,2 2,8

Zinc 2,4 2,4 2,2

Steel 2,4 2,6 2,4

Aluminum 1,5 1,7 1,6

Nickel 3,3 3,6 2,9

Tin 4,7 5,6 4,9

Agricultural crops 2,2 2,7 2,3

Wheat 2,2 2,6 2,7

Corn 2,0 3,0 3,0

Cotton 2,0 2,8 1,8

Cocoa 2,9 2,8 2,3

Orange juice concentrate 1,7 2,0 1,6

Chemicals 2,5 3,2 3,3

Ammonium nitrate 2,7 3,9 4,6

Potassium Chloride 2,8 3,7 3,9

Methanol 1,8 2,2 2,2

Rubber 2,6 3,2 2,5

Oil and oil products 3,1 4,3 4,5

Brent 2,9 4,0 4,1

Gas oil 3,2 4,5 4,7

Fuel oil 3,0 4,0 4,2

Diesel 3,4 4,6 4,8

Natural gas: 2,0 2,6 2,6

Henry Hub, USA 1,1 1,0 0,7

NBP, UK 2,0 2,9 3,0

LNG, import in Japan 2,6 3,5 3,9

BAFA 2,2 2,8 2,9

Coal 1,6 2,0 1,8

The Fair Price for Gas Oil-Indexed Gas is Not Overpriced Compared to a Broad Range of Commodities

Source: Bloomberg

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3,9

10,2 10,1 10,7

17,0

20,1 19,4

3,9

26,9

21,2

0

5

10

15

20

25

30

HH TTF (1st month)

NBP (1st month)

BAFA Gas import, Japan

Brent (1st month)

WTI (1st month)

Coal (CIF ARA)

Gas oil (1st month)

Electricity (ICE, Base, 1st month)

Energy Commodity Prices by Calorific Value, USD/mbte (July 2013)

Sources: Bloomberg, BAFA, World Bank

Variety of Gas Prices, no Global Benchmark