by Max Hoyt
The gas market of the European Union is in a transitional phase. Centerpiece to the changes is the 2011 Third Energy Package and its goal of creating a single natural gas market. Natural gas, however, is a huge stumbling block for EU energy liberalization due to the EU’s 65% dependence on foreign imports to meet its demand. Two state-owned companies, Gazprom (51%) and Statoil (67%), are the leading actors in the European Union’s gas market in terms of volumes exported. Both companies have anticipated the market change but have reacted with different strategies. Gazprom has chosen to stick with its predominately oil-indexed pricing while Statoil is making the transition to spot-market pricing. This article outlines the basics for both pricing strategies and provides a rationale for each. It then identifies the two competing strategies of Gazprom and Statoil and comes to short-to-mid-term conclusions.
The Dutch [indexed] gas to competing fuel sources while allowing for a marginal price differential which was just enough to incentivize a switch from the substitute fuel to natural gas.
Brief introduction to Long-Term Contracts, Oil-Indexation, and Spot-Market Pricing
Long-term natural gas exports contracts (LTNGEC) are the bread and butter instrument for Europe-destined international gas trade. LTNGEC were first established in 1962 to facilitate sales from the Netherland’s flagship gas field, Groningen. The goal was to maximize profits for the gas exporter while maintaining a marketable price. The Dutch achieved this by indexing gas to competing fuel sources while allowing for a marginal price differential which was just enough to incentivize a switch from the substitute fuel to natural gas.
In addition to this pricing formula, exporters in the Netherlands devised several other ingenious clauses for their European gas contracts, keeping mind both the security of demand and security of supply as well as the immense cost of gas transportation facilities. The chief mechanisms of the contracts are as follows:
Long-term: to allow for investors to recoup their financing of both the transport facilities and the development of the gas field.
Take-or-pay obligation: sellers provide a definite volume for purchase and buyers commit to at least a minimum volume.
Oil-indexation: explained above, though the price normally has a built in ‘lag’ of six to nine months from its indexed fuels.
Net-back pricing: export prices are based on the destination’s market value of the gas minus the cost of transporting the gas from seller to customer.
Destination clauses: gas could only be sold on its intended market to minimize price undercutting and arbitrage.
Price review clause: both parties could review the pricing formula to reflect technological changes and the linkage to the substitution fuels.
In summary, each target market was linked to its supplier until interested parties could recoup their investments, received predetermined volumes, and had a destination-specific price without the possibility of arbitraging on a neighboring market. These kinds of contracts proved to be so successful that they were adopted by both Russia and Norway.
Although developed half a century ago, much of the structure of the Groningen-type contract remains as the European standard (this includes many LNG contracts).
Although developed half a century ago, much of the structure of the Groningen-type contract remains as the European standard (this includes many LNG contracts). The destination clause, however, was deemed to be anti-competitive within the EU and in violation of the 1958 Treaty of Rome, which provides for the free movement of goods. The clause has since been stripped from European-based contracts.
Oil-Indexation and Spot-Market Pricing
In the debate between oil-indexation and spot-market pricing there are two leading benchmarks in Europe. The first is the GBP (German Border Price) and the second is the NBP (National Balancing Point) in the UK.
GBP corresponds to an average of all oil-index gas contracts and the spot priced gas contracts that are supplied to Germany. Given that the vast majority of gas supplied to Germany is indexed to oil – some 90% in 2008, though this volume has since changed – and Germany’s position as the largest continental gas market, the GBP is the price reference point for oil-indexed gas supplies to Europe. NBP is a much newer creation and is the spot-market price reference for more than 90% of UK’s natural gas supplies. The NBP gained its current notoriety in 1994 after the UK adopted the single hub concept. The single hub concept dictates that all gas within the UK’s transmission system is considered equal, regardless of distances or sources, once its entry fee has been paid.
There are three predominant market conditions based on supply-side factors which affect the consumer’s choice to favor either oil-indexed or spot-market gas.
As is illustrated in the graph below, prices for GBP and NBP are seldom the same with the prevailing trend from this time-series showing that GPB runs at a premium to NBP. As such, the two pricing strategies compete for market shares. According to the Carnegie Endowment for International Peace’s study “Natural Gas Pricing and its Future” by Anthony J. Melling, there are three predominant market conditions based on supply-side factors which affect the consumer’s choice to favor either oil-indexed or spot-market gas. The three market conditions are supply scarcity, supply-demand balance, and oversupply.
Supply scarcity: spot pricing is higher than long-term contracts because supply does not meet market demand. The added competition drives up the gas-gas pricing.
Supply-demand balance: gas is purchased mostly based on the oil-indexed price. However, consumers maximize their contract’s flexibility by purchasing as much of the long-term sold gas at the spot-market as possible (assuming oil-indexed gas price is running a premium to the spot-market price.)
Oversupply: spot market prices bottom out. The price plummets because demand does not meet supply and actors on the spot-market are forces to dump their reserves at any price necessary to make a sale. In this final situation, oil-indexation is uncompetitive because oil is rarely used as a substitute fuel for natural gas in today’s world. Thus, oil prices are less affected by the oversupply of natural gas meaning oil-indexed natural gas stays at an above-market-value price.
Of these three scenarios, natural gas oversupply holds the biggest implications for company pricing strategies. An increased supply on the spot-market causes a short-term ‘gas-glut’ which drives down prices and widens the price differential between spot and oil-indexed gas. A wide price differential in turn allows companies to activate the price review clause and renegotiate their long-term contracts’ price formulae. If successful, consumers purchasing oil-indexed gas can lock in lower gas prices for the short to mid-term. Companies are therefore theoretically incentivized to limit the amount they sell on the spot-market as to protect short-to-mid-term sales prices.
OAO Gazprom VS Statoil ASA
The Russian Federation’s flagship company; Gazprom’s name is inextricably linked to the Russian Federation itself and the activities of both reflect on each other. The company holds a legal export monopoly on pipeline sold natural gas from Russia and is the largest supplier of natural gas to the European Union (31% of the EU’s total imports).
Gazprom is the owner of the world’s largest gas transmission system and reaches its customer base directly through long-distance pipelines stretching all the way from Siberia. The primary European customers are Germany, Italy, Poland, the UK and France, though Gazprom supplies some 20 countries in Europe. In 2012, Gazprom Export, the 100% Gazprom-owned subsidiary, sold 110 bcm of its 138.8 bcm of its Europe-destined gas to members of the EU. Total volumes were down 12.2 bcm from 2011 corresponding to a 16 bcm decline in overall European gas imports in 2012. These figures, however, have bounced back in 2013 to 161.5 bcm, purportedly thanks to a change in price formulae in some of Gaz-prom’s contracts.
Gazprom asserts that the [gas pricing] formulae are adjustable given extenuating circumstances in gas market fundamentals, but that oil-indexation is an essential means of long-term business planning.
Long-term contracts are the primary method of sales for Gazprom’s gas in the EU. Contracts last up to 25 years and contain pricing formulae indexed to petroleum product, i.e. oil-indexation. Gazprom asserts that the formulae are adjustable given extenuating circumstances in gas market fundamentals, but that oil-indexation is an essential means of long-term business planning.
According to Dr. Mitrova of the Energy Research Institute of the Russian Academy of Sciences, Gazprom is mostly likely following a price maximization strategy. Gazprom is doing this by selling the majority of its gas through long-term, take-or-pay, oil-indexed contracts. However, there are two caveats.
First, they have decreased their take-or-pay amounts to 60% of the available volumes from the original 85%. Second, they have increased the amount of gas sold according to spot market prices by 15%, or more in some cases. Notably, Gazprom also sells its gas to a wide range of European customers. The gas markets of these customers vary from the highly liberalized market in the UK to the monopsonist controlled market of Bulgaria. The only country that Gazprom completely accepts spot-market pricing is in the UK where it traded 8bcm in 2012.
[Statoil’s] pricing for gas con-tracts is undergoing a “gradual transition from oil indexation towards gas hub-related pricing, as well as a reduction in some volume commitments and of the buyers’ daily and annual flexibility.”
Statoil ASA is the Norwegian national oil company, and the largest producer of natural gas on the Norwegian Continental Shelf. Statoil exports some 40 bcma of its own production and is in command of the marketing and sales of another 40 bcma on the behalf of the Norwegian State. The combined total of over 80 bcm in 2012 makes Statoil the second largest supplier on the European Union’s gas market, accounting for 14% of the market. Statoil sells its gas to Europe via pipelines to six terminals in France, Germany, Belgium, and the UK and via LNG (~4.2 bcm 2011). Most of Statoil’s gas is sold under long-term contracts lasting either 10 or 20 years, though some is sold with short-term contracts (5 or less years) or is traded directly on Europe’s gas hubs. According to Statoil’s official website, pricing for gas contracts is undergoing a “gradual transition from oil indexation towards gas hub-related pricing, as well as a reduction in some volume commitments and of the buyers’ daily and annual flexibility.” In the beginning of 2013, Reuters reported that “Statoil currently sells around 45 percent of its gas via oil-linked contracts and expects this to fall below 25 percent by 2015.” Norway’s biggest buyers are Germany, the UK, France, the Netherlands and Belgium; these are all highly developed Western European Member States which are geographically close to Europe’s main gas trading hubs.
Statoil has a notably smaller customer base than Gazprom. Their biggest customers are countries like the UK and Germany with highly developed and competitive gas markets. Given Statoil’s success in 2012 to maintain its European market shares vis-à-vis Gazprom when total European imports sank to 16 bcm, Statoil’s strategy is mostly likely to stabilize their market position by acquiescing to EU energy market imperatives i.e. the creation of a single energy market, a decrease in demand and an increase in competition. Statoil is doing this by continuing to sell most of its gas on long-term contracts while increasing the percentage of spot market pricing to their sales contracts. According to an interview by Bloomberg with Statoil’s executive vice president of marketing, processing and renewable energy, Eldar Saetre, Statoil expects that 75% of their natural gas sales contracts to be based on spot prices by 2015.
Why is There a Difference in Pricing Strategies?
As explained at the end of the section Oil-Indexation and Spot-Market Pricing, companies should be incentivized by market fundamentals to protect oil-indexed prices. Despite that, Statoil is gradually shifting its strategy in favor of complete spot-market pricing. There are three factors which, when aggregated, contribute to Statoil’s decision to shift to spot-market pricing and work against Gazprom’s desire to revolve away from oil-indexation.
1. Geography—The Location of Their Customers in Relation to Spot-market Hubs
Statoil’s biggest customers are western European countries – Germany and the UK followed by the France, the Netherlands and Belgium – which have domestic natural gas hubs. Gazprom’s customer bases, however, stretches all the way from Western Europe to Eastern Europe, far from functioning gas trading hubs. Yes, Gazprom’s biggest customers, Germany, Italy and the UK, are all countries with access to gas hubs, but a full half of Gazprom’s customers are in countries far from such European gas hubs. Albeit Italy and Austria do have gas hubs, PSV and Baumgarten, but they are the much less developed than the other continental hubs in Belgium, Netherlands, and Germany. Thus, if Gazprom wished to index more gas to spot-pricing in, say, Eastern Europe, it would be indexing the price to a hub quite removed both geographically and in terms of market fundamentals. Such a decision would obfuscate the future recalibration of pricing and affect the profitability of Gazprom’s sales. Statoil does not encounter this geographical issue when altering its pricing strategy simply by virtue of the geographical location of its markets.
If Gazprom wished to index more gas to spot-pricing in, say, Eastern Europe, it would be indexing the price to a hub quite removed both geographically and in terms of market fundamentals. Such a decision would obfuscate the future recalibration of pricing and affect the profitability of Gazprom’s sales.
2. Energy Liberalization—EU’s Gas Target Model and the Creation of Connected Wholesale Market Hubs
Each of these hubs is to be created with the capacity of at least 20 bcma. It is assumed that since only six EU countries have a demand of 20 bcma or higher, smaller regional gas markets will be created through the homogenization of national gas markets. This process will not greatly affect Statoil’s sales because their customers are predominantly those countries whose current gas demand meets the 20 bcma hub limit. On the other hand, Gazprom’s smaller Central and Eastern European customers might be homogenized into regional hubs in the near future. When the change occurs, Gazprom will likely be forced to adjust its sales strategy in these regions regardless of Gazprom’s need for a stable investment climate to ensure the further development of its Siberian and Arctic gas fields. Thus mid-term unpredictability necessitates Gazprom’s adoption of a short-term price maximizing strategy while Statoil can pursue whichever pricing strategy it desires because it can predict market conditions into the mid-term.
3. Market Fundamentals—the European Gas Market’s Short to Mid-term Forecast
As can be seen from the graph on the previous page, the European gas market is going to continue to be both tight and under lighter demand in the short-term. European demand shrank in 2012 and its economic recovery was slow in 2013. LNG suppliers from the global south have thus diverted their supplies to Asia where demand is still growing. The diversion of LNG to Asia coupled with declining domestic natural gas production rates in the EU mean that any new supplies demanded by the European market in the short-term will have to come from Russia, the only global supplier with capacity that cannot divert to Asia.
Therefore, Gazprom is in a good position to profit-maximize in the short-term by selling its gas at a high, oil-indexed price when there is little competition. Statoil, which does not have Gazprom’s export capacity, needs to retain market shares by selling at a more competitive price, i.e. sales linked to spot-market prices. However, in the mid to long-term more players will enter the European gas market creating a more liquid market. A more liquid gas market will affect prices and alter Gazprom and Statoil’s current market positions.
Gazprom has chosen to stick with LTNGEC favoring oil-indexation, but has made concessions on the take-or-pay volumes and spot-market percentages due to high price differentials between GBP and NBP. The company hopes that it can use its current strategy of price maximizing to exploit its market positions before more forces come into play.
However, in choosing this strategy of price maximization, Gazprom has found itself entangled in arbitration with European utility companies including E.ON, OMV, RWE over dubious pricing methods; the mere existence of such cases represent yet another soft-power loss for Gazprom when the company should be rebuilding its image as a reliable supplier after the reputation damaging 2009 Gazprom – Naftogaz gas war.
Norway’s national champion has also fallen into step behind Europe’s liberalization scheme hoping to reap a collaborator’s benefits—tenable market positions, steady relationships with wholesalers, and the image of a reliable supplier—when new entrants arrive on the market.
Statoil has shown itself to be flexible and has capitalized on Gazprom’s resolve by switching to the Anglo-Saxon gas-to-gas pricing model. Their flexibility has granted them quick gains against Gazprom and popularity with Germany and UK gas wholesalers. Norway’s national champion has also fallen into step behind Europe’s liberalization scheme hoping to reap a collaborator’s benefits – tenable market positions, steady relationships with wholesalers, and the image of a reliable supplier when new entrants arrive on the market.
The author predicts that both companies will maintain the status quo for the short-term. However, depending on the evolution of European regional gas hubs, Gazprom will be forced to renegotiate its pricing formulae with Europe to include more spot- market pricing before the end of the decade. Unfortunately, a change to spot-market prices which, coincidentally, might occur simultaneously with the arrival of new suppliers in the European gas market will be trouble for Gazprom. The resulting gas-glut, if even only marginal and short-term, will drive down European natural gas prices and the profita-bility of the gas market. The author agrees with the analysis of Dr. Konoplyanik, the former Russian deputy secretary general of the Energy Charter Secretariat in Brussels, Belgium, that LTNGEC are investment vehicles which ensure the development of expensive gas fields. However, it is doubtful that the initial steps will be taken to develop such fields if their profitability cannot be proven to investors in the near-term. These fields are necessary to meet the projected gas demand of the European Union up until 2030 and the perquisite conditions –possibility for returns on investment – for their development should be taken into consideration by their future consumer-base.
Max Hoyt is an MA student in the ENERPO program at European University at St. Petersburg.
Notes for the Reader and References:
The industry term for oil-indexation is replacement value pricing mechanism. However, since much of the literature refers to this as ‘oil-indexation,’ because in reality gas is index to petroleum products more than to coal, the author choose to use the term oil-indexation.
It is important for the reader to note that NBP is a traded commodity and is traded using a number of financial instruments including those associated with paper commodity trade. GBP, conversely, is only a physical commodity.
In 2013 the rare case did occur when NBP was lower than GBP. In this situation, producers sold oil-indexed natural gas to the limit of their contractual commitments. This accounts for Gazprom’s miraculous return to 161.5 bcm that year.
Data was sourced from Gazprom.com, Statoil.com, gazpromexport.ru, U.S. Energy Information Administration. The two graphs were borrowed from Tatiana Mitrova’s “Russian Gas Export Strategy” Lecture given on December 9th, 2013, at European University at Saint Petersburg
The Carnegie Endowment for International Peace.
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Energy Charter Secretariat. “Putting a Price on Energy: International Pricing Mechanisms for Oil and Gas.” Brussels, Belgium: Energy Charter Secretariat, 2011.
Konoplyanik, Andrey A. “Russian gas at European energy market: Why adaptation is inevitable.” Energy Strategy Reviews 1, no. 1 (2012): 42–56.
Yafimava, Katja. The EU Third Package for Gas and the Gas Target Model: major contentious issues inside and outside the EU. The EU Third Package for Gas and the Gas Target Model: major contentious issues inside and outside the EU. The Oxford Institute for Energy Studies, 2013. (accessed 20 Dec 2013).