This week, I was invited to speak at a C5 conference in Berlin on long term gas contracts. My presentation (or speech rather) was on recent developments in gas production and the impact that they might have on developments in gas contracting in Asia. It gave me the chance of reflecting upon the transformations that we have recently seen in Europe’s gas market and their possible impact across the globe. I’d like to share those thoughts with you.
Several other speakers, among them Patrick Heather of the Oxford Institute of Energy Studies and Brian Little of Nexant, confirmed that in 2013 more than 50% of Europe’s gas will be brought to market based on Hub pricing instead of oil-indexed pricing. The word ‘tipping point’ was shortly discussed, but most speakers were rather prudent as to using it. Whether this ‘more than half the gas’-moment symbolizes the point at which an inevitable evolution towards 100% Hub-based has been started, I leave up to energy market historians to decide in a year or five. It’s not important, the important thing is that we are there already. If anyone would have said at a similar gas industry conference in 2008: “in five years, more than half of Europe’s gas will be traded at Hub conditions”, he would have been ridiculed. But it has happened, which once again shows how unexpectedly dynamic markets can be.
To assess whether this rapid evolution towards gas-to-gas pricing can be repeated in other parts of the world such as Asia, let us look more deeply at the phenomena that explain it. I am explicitly not talking about causal relationships, as I believe that it’s difficult to assign what exactly has been a cause and what has been an effect in these gas market dynamics. I see four phenomena:
- As Emir Hamad bin-Khalifa Al-Thani has ceded power to his son, it is befitting to praise his role in the development of Qatar’s gas industry and his significance for the world’s gas markets. The extra volumes of (liquefied) natural gas brought to the world’s markets by the Qatari’s have caused a supply glut that certainly in the years 2009 – 2011 contributed to low prices on Europe’s Hub markets. It caused the decoupling of Hub and oil-indexed prices that, even if Hub prices have risen in the last two years, is still a reality. I’m not sure if their contribution to the development of the Hub pricing model was a conscious choice, but the Qatari’s did even more than just bringing extra MWh’s into the market. They were also the first major supplier that signed long term contracts with Hub-indexation rather than oil-indexation.
- In the last five years, there has been a ten percent decline in the demand for natural gas in Europe. I was pleasantly surprised to see on the conference that now even a large gas supplier such as VNG stated that this decline in demand might be structural and not just linked to the economic crisis in Europe. The gas industry has long been quite delusional in thinking that the demand will come back as soon as the crisis is over. VNG was giving examples of how the broader climate policy is causing a structural decline in gas demand in Europe.
These first two phenomena have caused a temporary surplus of supply in the European market. I think this is a quite essential feature of energy markets. In energy markets, lead times for supply expansion are quite long. Therefore, supply elasticity is slower than demand elasticity. If prices of energy are high, producers start up projects to produce, pipe and/or liquefy extra volumes, projects that take five to ten years to start delivering. This is the boom phase. By the time the extra energy hits the markets, demand has often started to decline in a reaction to the high prices. The result is a supply glut. Prices crash and investment comes to a standstill, the bust phase. As demand increases again in a reaction to the higher prices, supply crunches start to occur, causing prices to rise again and the whole cycle to start up again. I know it’s a simplified scheme, but there are too many examples of it to ignore it. One of the interesting features of the shale gas development in the US, is that the lead times for supply adaptations seem to be much shorter than in conventional gas development.
In the glut phase, we have a clear example of a buyer’s market. The consumers have the bargaining power. This is clearly what we have seen in the last five years in Europe. End consumers could put pressure on traditional suppliers: mid-stream players that buy in the framework of long term contracts from producers to resell to end clients. Clients pushed the mid-stream companies to make Hub-based deals instead of the more expensive traditional oil-indexed contracts. The mid-stream companies were squeezed between the Hub conditions they had to offer their clients and the Oil-indexed prices enforced on them by the producers. This has caused a spate of contract renegotiations. Some of those came to a commercial solution. Others ended up in legal action. Last week, news broke out that RWE has won such a dispute against Gazprom. All this fighting over pricing between suppliers and producers (which is what this whole conference was about), clearly supports my vision that in the last five years the European gas market has been a buyers’ market. Of course, the lower price level has been the main reason why these buyers opted for Hub pricing. But I’m seriously convinced that in the long term the greater transparency, fairness and economic logic of Hub pricing will continue to support it. Moreover, two more phenomena have contributed to the success of Hub pricing in Europe.
- In many corners of Europe, some decisive steps have been taken to finalize the liberalization process that was started in the late nineties. Germany’s opening up of the gas market since 2007 has been crucial. In 2012 we saw a similar process in Italy, where government decisions to free up transit capacities to competitors of incumbent suppliers has caused the PSV Hub market to develop rapidly. Poland has announced a similar policy for this year, it will be interesting to observe if it succeeds. And how about Spain, which wants to launch a Hub, will that be supported by measures facilitating access to the Iberian market? It has become much easier to develop a gas supply business in many European countries. This has been the playing field of smaller (second tier) mid-stream players, that have developed supply businesses based on sourcing gas at the Hubs. They were the competitive nail in the coffin of the first tier mid-stream companies and their long-term oil-indexed contracts.
- This was made possible by the rapid development of Europe’s wholesale Hub markets themselves. Here it becomes very difficult to assign causes and effects, but the higher liquidity of many of these markets have developed and facilitated the development towards Hub-based gas retail markets. Especially TTF has played and increasingly plays a pivotal role in this.
However, in the last three years, some disturbing factors have occurred. Hub prices have started to increase. This is due to two reasons. The first one is the well-known increased demand from Asia. The second one is the delays of gas production projects that we have seen. I wouldn’t exactly say that this has caused a supply crunch, and it should be remarked that Hub prices are still well below oil-indexed prices at this moment. Still, the glut is getting thinner, causing nervousness in the markets. As a landmark of this development, we can point out the decline in LNG production witnessed in 2012. This decline was mainly caused by the reduction of production in traditional LNG production countries such as Egypt and Yemen.
Could better times be ahead? We have recently made another tour of the websites giving information on today’s projects for developing new LNG production. If all goes according to plan, we might see an increase of 30% in LNG production by the end of 2015, most of it coming from Australia, but it also contains the first cargoes of American shale gas brought to the world’s markets through the Sabine Pass terminal. Treat this information with care, as the Australian projects have been plagued massively by cost overruns and delays. But several industry experts that I spoke with at the conference confirmed our information. We are not talking here about planned LNG production, we are talking about facilities that are being built, so the chances of the projects being abolished are rather slim. Will Australia become the next Qatar in the coming two years?
That brings me to the Asian market, which is where most of this Australian gas will go (which would make more gas from places closer to us available to the European market). If these extra LNG volumes hit the market, one of the four phenomena that contributed to European Hub market development, more supply, would materialize in the next three years. But as far as the other four are concerned, it’s looking rather bleak. Gas demand in Asia is still increasing. And there are no steps taken towards liberalization of the gas markets or development of Asian gas Hubs. Therefore, the development of a full-fledged Hub market like we have seen in Europe seems improbable in Asia. What we might see though, is continuing and increasing pressure of Asian midstream gas companies to index their gas contracts to a Hub price (European or American) rather than to oil prices. This illustrates an important point about the main topic of the conference. The question is not whether long-term contracts will prevail or not. The question is which pricing model will be used in future long term contracts.