One of the most remarkable events of the last decade in Europe’s energy markets has been the switch away from oil-indexed gas pricing towards the so-called Hub-model. Oil-indexed pricing for natural gas is a relic from the past, when no open markets for the trading of gas existed. Sponsored by their national governments, monopolist gas companies set up long term agreements with producers of natural gas with durations of up to thirty years. Lacking a price reference for natural gas, it was decided to peg the price to that of the most important competing fuel at that moment: oil.
Even if oil-indexation was a clever marketing strategy in the days of the fuel-switch from oil products to natural gas, when markets are liberalized, it causes some serious issues:
- The long term agreements give important competitive edge to incumbent suppliers, it’s difficult for an alternative supplier to get a contract with a gas producer. Therefore, for getting supplies, these alternative suppliers often have to buy the gas from the very incumbent suppliers that they are supposed to compete with. In the early days of gas market liberalization, we saw that alternative suppliers were often nothing more than resellers of gas that was originally purchased by a large competitor under a long-term agreement. This was obviously a poor basis for alternative suppliers to exercise the sort of competitive pressure that brings down prices,
- Moreover, such long term agreements often contained exclusive rights to the usage of capacity on key infrastructure, such as cross-border connections for the import of gas, LNG terminals or storage sites. This makes it even more difficult for alternative suppliers to develop their business,
- Oil-indexed pricing has a certain degree of mathematical complexity. End consumers often fail to grasp it, making it impossible for them to make a correct assessment of the proposals that they get on their table,
- In some markets (e.g. Germany) the market came with a huge variety of different oil-indexed formulas, making it very difficult to get a correct idea of ‘the’ price level for gas in that country,
- The market of long-term, oil-indexed contracts is not a market with a clear wholesale – retail segmentation. End consumers can only guess what their suppliers pay for the gas to their suppliers. Hence, there is no transparency at all regarding margins, putting the end consumers at a disadvantage in the contract negotiation,
- This overall lack of transparency is also clear when price management services are offered. In many countries, suppliers have a long tradition of offering oil-indexed contracts with services that allow their clients to swap floating prices for fixed, fixed for floating and even swap between different formulas. The suppliers perform the oil market hedging operations necessary to execute such swaps. However, the end client often lacks the knowledge of the formula’s mathematics and the oil market operations to give a correct judgement of whether a fix price e.g. was correct or whether his supplier was abusing the fixing operation to make some extra margin,
- From a point of view of theoretical economics, the oil-indexation is also an ugly beast. It means that the price of one product (natural gas) is determined by the supply and demand dynamics of another product (oil). Hence, the price is not giving a correct signal to producers and consumers. It could be that natural gas is short in supply, but its price is low because of a large supply of oil. At that moment, the consumer is not getting the signal to reduce its consumption and the producer is not getting the signal to increase his production, hence, the market is not restoring the supply and demand balance. I’m pretty sure that Adam Smith would have disliked the idea of oil-indexation of gas,
- Moreover, there’s more natural gas left on the planet than oil. Hence, the chances of over-valuation of natural gas are quite high when you index it to oil. That obviously explains why producers, such as Russia’s Gazprom, have been such fierce defenders of oil-indexation of natural gas. And this is not just economic theory. We have indeed seen that in every country that switched away from oil-indexation towards a hub model, the price of natural gas for the end consumers declined significantly.
The Hub model was first rolled out in the US with its Henry Hub and in the UK. With the creation of NBP, the UK did something enormously interesting, namely the creation of a virtual Hub, on which I will come back. This model was then copied in Belgium (Zeebrugge), the Netherlands (TTF), France (PEG’s), Germany (NCG and GPL), Italy (PSV) and other countries. Today, in most of the countries in Europe, gas is bought based on the pricing on a Hub. We even witnessed market integration, with pricing in those wholesale markets converging and TTF becoming thé benchmark to which prices in end consumer contracts are pegged. For most large industrial gas consumers in Europe, the disadvantages of oil-indexed gas pricing described above have become a thing of the past. They enjoy more transparent gas pricing, and it comes with a better price management service. Moreover, as mentioned above, the switch towards Hub-pricing came with lower prices and important savings. However, some countries have been left behind and haven’t made the switch towards Hub-pricing. One of them is Spain. (Portugal as well, as the Spanish and Portuguese gas markets, like the electricity markets are well linked.)
After years of neglect, the Spanish government now seems to get serious about making the adaptations necessary to reform its gas market and introduce the Hub market model that has been such a boon for gas consumers in other European countries. On the 22nd of May, the long awaited new Hydrocarbons law was published. Upon first lecture, it seems to contain some elements that could spark the development of a real Hub market on the Iberian Peninsula.
The most important element – no doubt – is the introduction of a virtual Hub. This virtualization of the gas Hub has been first tried out in the NBP with great results and then repeated in many countries, with TTF being the most spectacular example. From a contractual / legal point of view, the “Hub” is the place where the gas changes in ownership. In traditional physical Hubs such as Henry Hub or Baumgarten in Austria, this place is an actual physical location. Before that spot (often a valve on a pipeline), the gas belongs to the seller, after it, it belongs to the buyer. When a virtual Hub is created, the whole transportation grid is defined as being the Hub. Doing so, a whole geographical area, e.g. the whole of the UK or the whole of the Netherlands, becomes one big Hub or Entry-Exit Zone. This means that the seller can inject his gas at any point and it is considered to be delivered at the Hub, and the buyer can extract the gas at any point from the transportation grid, and it is considered to have been taken from the Hub.
Physical Hubs are not as beneficial to trading and retail market competition as virtual Hubs. Sellers of gas need to find access to that specific geographical location where the physical Hub is located and capacities to get there might be restricted, especially if capacity rights have historically been allocated to incumbent suppliers in the framework of long-term gas contracts. And a supplier needs to “route” his gas from that Hub to his end client. Capacity restraints can occur on that route, making it impossible for him to develop clients far away from the entry points at which he has sufficient capacity rights to get gas in. This is clear in the case of Spain, where the distances that are to be covered from injection in the Spanish system to an end client can be large. A supplier that gets his gas delivered in Huelva, on the Southern, Andalusian shore, might have difficulties routing this gas towards clients in the industrial heartland in the North and North-East of Spain. Nevertheless, we have seen the development of a market for locational swaps in Spain, where suppliers swap gas quantities that they can deliver in certain areas with quantities of other suppliers in areas where they can’t deliver. All in all, we can’t say that the Spanish market is suffering from a lack of diversity in offers. When we do gas tenders in Spain, we can easily collect up to ten different offers. What frustrates us, is that they all come with high prices (compared to other countries in Europe), oil-indexation and poor price management services.
The new Hydrocarbons Law talks about the introduction of a virtual Hub for the whole of the Spanish territory. That is a very interesting idea, as I believe that Spain or rather the Iberian Peninsula – contrary to what some suppliers say – has an almost ideal gas system for the introduction of a virtual Hub. The transportation grid is looking a bit like a giant bicycle’s wheel, with pipelines running along the coastlines and through the center (Madrid). Gas can be injected into the wheel at no less than ten places, the pipeline connections with France in the North and North-Africa in the South and eight LNG terminals. Connect all of that in one virtual Hub and you liberate suppliers from the difficulties of getting access to injection points near their clients and getting the capacity rights (or locational swaps) to go from entry to exit. You would expect that this will finally make Spanish gas suppliers and new suppliers develop the sort of competition that we’ve seen in other countries. This could bring important benefits for Spanish gas consumers, such as:
- A cost saving. Currently, we are seeing (oil-indexed) gas prices in Spain in the range of 24 – 25 euro per MWh. Prices on the North-West-European Hubs are in the 22 – 23 euro per MWh range. If due to the Hub development the prices in Spain converge with prices in the rest of Europe we could see a two euro per MWh saving opportunity. And it should be remarked that due to the drop in oil prices, the spread between prices in Spain and Hub prices elsewhere in Europe is historically low. In 2014 the spread was rather in the 10 euro per MWh range.
- Possibilities of buying energy in a different way, with spot indexation and forward products for securing future price levels.
Whether the new law will lead to a rapid development of such a more competitive Hub-based market on the Iberian Peninsula or not is unclear at this moment. The hydrocarbons Law is a general text, setting up the legal framework for developing the Spanish Hub. Whether it will function or not depends on how it will be worked out in decrees and other regulatory texts such as the code for the usage of the grid that is to determine the crucial balancing system. The Law announces the preparation of these important extra pieces of regulation. The devil will indeed be in that detail. The Spanish government has been working on the creation of a Spanish gas market Hub for a long time. As we have remarked here before, the officials seemed to be focusing too much on the financial aspects of the market, the creation of a platform to trade in spot and forward contracts for natural gas. Whereas the success of a Hub depends primarily on getting the physical aspects right, defining a large entry / exit zone and making sure that there are non-discriminatory access rights and balancing services in that zone. So we’ll have to watch carefully for the extra regulatory texts and see if they have the right elements for setting of the Hub market development in Spain.
What is a bit bizarre in the new Hydrocarbons Law is the definition of the entity that would be responsible for managing the balancing system. This is to be a company in which the transport grid company (Enagas) and the organizer of the exchange platform (OMIE/OMIP) would come together. In most other countries, the balancing system is simply run by the transport grid operator. Spain seems to aim at the introduction of some sort of independent system operator. Having the organizer of the exchange platform so tightly involved in the balancing is a reminder of Spain’s confusion of the Hub model with the organization of an exchange. And the preoccupation of the Law with getting involved in the financial aspects of the gas market is reminiscent of the dirigisme of Spanish lawmakers. Spanish energy policy, also in the electricity market, often fails to produce the best and cheapest results for the end consumers because of officials trying to arrange everything in too much detail. But we should give Spain the benefit of the doubt and hope that in the next months, a Hub market for natural gas becomes a reality for Spanish gas consumers, just as we have seen in other countries.