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THE TRANSITION TO HUB PRICE INDEXATION IN LONG-TERM CONTRACTS FOR IMPORT OF NATURAL GAS
Assoc. Prof. Ph.D Yuli Radev
Bulgaria, Sofia, MGU "St. Ivan Rilski", Dep. Economics and Management
ARTICLE INFO
Received 2 November 2017 Accepted 11 November 2017 Published 7 December 2017
KEYWORDS
natural gas contracts, hub prices, indexation
ABSTRACT
Over the last eight years gas price indexation to oil prices in Europe have been drastically reduced, and the linking of gas pricing to hubs has become the basis for the transactions being carried out. So far, hub prices have been accepted as a benchmark in Northwestern Europe. The southern part of Europe, including Bulgaria, also shows striving to follow hub prices, especially these ones on the NBP (United Kingdom) and the TTP (the Netherlands).
© 2017 The Author.
Long-term contracts are, as a rule, conservative. That's why attempts to change the price formula have sparked heated debates between sellers and buyers. Despite of a series of negotiations and arbitrations, tensions over the contractual structure remain in most of Europe.
The present report follows the path that has led to the current situation. It underlines the leading role of Northwest Europe, with a relative share of 58 % of total consumption and 82 % of gas production in Europe. Outlining the final results of the renegotiation and the signing of new contracts, the report describes the changes in the contract terms over the past eight years. In combination with historical trends, it is a useful tool for predicting the transition to hub indexation in Europe.
1. Transition to hub pricing. A quantitative assessment of increasing share of hubs in natural gas imports into Europe can hardly be given, having in mind, that that the data and pricing process are strictly confidential and the findings are based on observations of domestic deliveries. That is why, the balance between hub and oil price indexation of long-term gas supply contracts varies widely depending on the methodologies used. However, it can be assumed that the share of hub indexation in Europe is between 30 and 55 %.
Despite the doubts about the actual magnitude of the ongoing pricing transition, the fact that hub indexation is being made and is already paving the way for international treaties for importing natural gas into Europe is undeniable reality.
In fact, the rapid transition to hub pricing is due to a number of factors that have developed at the end of the last decade. As the US storm in development of shale deposits released large volumes of gas, a new wave of "uncommitted" LNG from Qatar began to arrive on European hubs.
As it is shown in Figure 1, the sale of Qatar's LNG to Europe for the period between 2008 and 2009 was increased by 138 %. In the same period spot and short-term (<4 years) LNG sale from Qatar has rose nearly 6 times. Until 2011 the import from Qatar continued to grow, when the trend was slowing down and even changing due to the Fukushima incident.
At about the same time, Europe was hit by a severe economic crisis, with a negative impact on gas demand. The situation was further compounded by the worsening competition of coal and renewable energy sources (RES) in power generation. As a result, gas demand in the EU has declined in 2009 (-7 %), 2011 (-11 %) and 2012 (-9 %), thereafter a relatively stable state and expectations of weak growth in 2017 (1 %) were reported. At the end of 2016, natural gas consumption was 63 billion cubic meters less than pre-crisis levels. According to the above cited estimations, these fluctuations will continue in the coming years.
IQatar ■ Algeria Nigeria ■Trinidad &Tobago BNorway ;eru Egypt Other
Fig. 1. LNG imports into the European Union (2008-2016)
Source: GIIGN.
All this processes have complicated the choice of buyers. While hub prices respond quickly to the changes in supply/demand balance, long-term contract prices, related to the oil price, are corrected only partially. For the first time hub prices and oil-related prices diverged over such a long period of time (Figure 2). In fact, during the last five years, sales of the UK's largest hub NBP have been at prices lower with $1 to $5 per million Btu than the oil-related prices.
This situation changed the initial balance of the market. On the one hand, end-users enjoy access to cheaper supplies on the hubs. In Northwest Europe, prices of the NBP and the TTF have already become a benchmark for wholesalers' transactions and their buyers.
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Fig. 2. Gas prices in the European Union (EU) Source: Eurostat COMEXT and European Commission estimates, BAFA, Platts.
On the other hand, gas companies were obliged by the long-term agreements to buy the expensive oil-related gas. Thus, gas importers in Europe fell into the trap of the losing position, embodied by the £ 2 million impressive loss per day of E.On from gas trade in 2011. The drop with 60-70 billion cubic meters in flexibility in 2009 contracts, triggered by optimistic expectations of gas demand and over-contracting before the economic crisis, was not enough to absorb the subsequent decline in demand. The response from European importers was to minimize mandatory quantities in
existing long-term oil-related price contracts in line with take-or-pay obligations, but also in search for renegotiation of prices and new supply from exchanges.
As a result of the renegotiation of the existing contracts, after 2012 the prices of long-term contracts in Northwestern Europe have gradually moved closer to hub prices (Figure 2). This gives an answer to the question why the pressure of European importers to renegotiate over the past 1 -2 years has started to weaken.
Part 2 discusses in more detail the long process of renegotiation and arbitrages that led to the current situation, while Part 3 follows the evolution of the price mechanism in the newly signed contracts. Part 4 summarizes.
2. Renegotiation of long-term contracts - conclusions and consequences. Price renegotiation in long-term contracts is a complex and lengthy process that requires sound analyzes and interpretations of the surrounding business environment. This analyzes, in turn, become important building blocks of the process of renegotiations. In many cases, both sides have a chance to avoid arbitrage and reach agreements on new pricing conditions. This result is stimulated by the obligation in the contracts for periodic review of prices as well as by the changing market conditions. It is possible that the traders have a common interest in redefining some non-price conditions. A few years ago an example in this respect was Algeria's desire to reduce its gas exports to Spain and Italy. It was dictated from one side by the shrinking demand in southern Europe and from another by the growing domestic demand and constraints on domestic extraction.
On the ground of the rapid and profound changes in the markets, the reach of agreements was a particularly difficult task. Thus, the number of arbitrations has progressively increased and the use of hub indexation has become one of the most debated issues. Arbitrators have more often recognized buyer hub indexation claims, with the exception, of course, of contracts intended for markets lacking integrative hubs. By the way, this is the case of the contract signed in 2010 between the Algerian state-owned company, Sonatrak and the Spanish distribution company, Gas Natural Fenosa.
Before discussing how hub indexation is paving the way in the long-term contracts in Europe, we will emphasize that, in addition to full hub indexation, there are variations of partial indexation as well as more creative forms of indirect hub indexation.
The information on long-term contracts has been received by several producers who have expressed a desire to share their vision of pricing. Norwegian state-owned company Staoil, for example, accepts the use of direct hub indexation in contracts with the majority of European importers like Gazterra, E.On and others. In November 2013, in a special statement, Statoil announced that half of the gas supply contracts in Europe are pricing on the basis of gas-gas competition. In addition, all contracts with Germany and almost all with Belgium and the UK contain at least partial hub indexation. Statoil has accepted a full hub indexation in the contract with Wintershall signed in 2012. According to observers, as a result of the pricing change, Norwegians have regained control over the flexibility of contracts and "started selling it as a separate product or using it as a commercial tool "(WGI, 2013).
Gasterra also announced publicly that it supports virtual trading on the TTF hub as the basis for gas trade. In its annual report in 2011, Gasterra stated that it considered TTP as an effective way to trade gas and a good opportunity to stimulate supply and demand (Gazterra, 2011). In 2013, almost the entire volume of gas traded by Gasterra in the Netherlands was offered at hub prices, and the company consistently increases hub indexation into its export contracts.
Gazprom uses stock indexation for the first time in 2010, when a 15 percent spot component became part of the formula applied to the contract with based in Essen (Germany) E.ON. Subsequently, Gazprom has been pressured by a number of arbitration boards to expand partial hub indexation for other supply contracts, including the contract with RWE1. However, no one has ever asked Gazprom for full hub indexation. It was believed that if the company agrees to such a move, it can completely change its attitude to long-term contracts. An interesting compromise was made in Gazprom's contracts with Italian Eni and the Polish oil-gas company PNGK2, where indirect spot pricing was introduced in the form of pricing corridor. The operation of this price corridor is illustrated in Fig. 3.
The fixed line represents the accepted price. When the price of oil-related gas is higher than the hub price (1 month ahead), the maximum price the buyer would pay is the price for 1 month forward plus an additional premium (1m forward + x). When the price of oil-related gas is lower than the hub price, the minimum price that the buyer would pay is the 1-month forward price with a
1 RWE, Rheinisch-Westfälisches Elektrizitätswerk.
2 PGNIG, Polskie Gornictwo Naftowe i Gazownictwo.
discount (1m forward - x). When the price of oil-related gas is within the price of 1m forward ± x, a price related to oil is admitted.
After 2013, the pressure to renegotiate Russian contracts in north-west Europe is no longer so strong. Indeed, the price levels in the Russian contracts are broadly in line with the prices of the TTF hub, although none of these contracts formally contains complete hub indexation.
In 2014 the pressure is weakening. At the same year, Eni received a new deal with Gazprom, which went beyond the 50-year old gas-indexing system to oil prices.
Source: CIEP, p.13.
Fig. 3. Functioning of the price corridor
Besides the hub indexation, renegotiation has introduced other important elements, leading to additional complications and diversification in the picture of international long-term agreement in the gas sector of Europe.
A closer look at re-negotiation processes confirms the conclusion that non-European suppliers are trying to resist structural changes in price formation mechanisms. Russia, Qatar and Algeria have maintained the traditional position that the main concept of indexing long-term contracts to oil prices should be maintained. Gazprom consistently presents price reductions based on non-structural changes as more attractive than these ones on the basis of partial hub indexation.
In some cases, as in the Gazprom-EON deal in 2012, suppliers agree to a one-off price reduction. In other cases, they receive long-term price discounts by adjusting the components of the traditional net back price formula, which, however, retains its main features, including oil-price indexation. In the traditional formula, also known as Groningen:
P n=P0+ [x% * COEFF * LFOn - LFO0 ] + [ v% * COEFF * HFOn - HFO0 ], (1)
where p is the base price, price changes of competitive fuels for the period of n years are presented in brackets, x % and y % are the relative weight of gas oil (LFO) and fuel oil (HFO), COEFF is an expression of the fact that not the entire change in the prices of petroleum products affects the price of gas. The latter take 80-90 %.
Examples of adjustments in this formula are the decrease in the base price P , a modification of the relative influence of different oil products on price formation (x % and y %) and COEFF reduction.
For observers the price cuts in the Gazprom-Eni and Sonatrak-Edison contracts are due exactly to the changes in p . Thereafter, similar cuts were made in German contracts of Gazprom.
Due to high confidentiality, it is not always possible to determine the extent to which price reductions are result of one-off reductions or to which they occupy a permanent place in the formula. As mentioned above after 2011-2012 Gazprom used both mechanisms by offering a price concession on oil-related sales to a number of Western European importers. These discounts are usually in the range of 7 to 10 %. In many cases they come into force retrospectively, thus "returning" hundreds of millions of euros to buyers. Eastern European importers, including Bulgarian Bulgargas, as well as Polish PGNIG, which traditionally pay higher prices than Western European partners, received the largest discount, 15-20 %.
Another result of the current round of talks is a reduction in gas volumes that are traded with long-term contracts related to oil prices. Because of the problems that resellers have with oil-related gas, some exporters have allowed a lowering of the required minimum. This was achieved through one-time derogations of the take-or-pay principle and a formal reduction of the minimum contracted quantity (MCQ). In 2012, for example, the mandatory take-or-pay threshold in the contract of Bulgargas with Gazprom was reduced from 90 to 80 percent and from 85 to 75 percent in the Eni-Gazprom contract. In 2014 Eni publicly stated that it had achieved a significant reduction in minimum required quantities in its contracts. In any case, Russia continues to insist that these schemes are only temporary, so the buyer is obliged to compensate for the lower requirements by buying more gas in the coming years.
Even less often, signed transactions may include a decline in the annual contracted quantity (ACQ), as is the case with Sonatrak and Eni contract in 2013. An important consequence of these measures is the increasing flexibility due to some long-term pipeline contracts. This contrasts with the lower flexibility of LNG supplies, where the take-or-pay clause typically amounts to 95 or 100 %, as well as the lower flexibility of hub-linked contracts, such as those of Statoil.
Finally, we will mention a few clauses in long-term contracts specifically accepted for the buyers. For example, Eni and Gazprom have the right to re-negotiate the price at any time, and not every three years. In today's highly volatile environment for European buyers, it is important that supply prices are kept constantly in line with price trends. Gas de France, for example, achieved this by adapting a dynamic approach to pricing. This approach requires contracts to be renegotiated every one or two years. Another result of Eny's renegotiation with Gazprom is a modification of the reverse index against oil prices from the original structure "12.0.6" to structures "6.0.3" and "3.0.3". In principle, structure "12.0.6" means that the gas price is indexed against the average price of selected petroleum products for the preceding 12 months, with an interval of 0 months between the end of the 12 month period and the introduction of the average price in the formula, and the price derived from the formula applies to the gas contract for the next 6 months.
The use of coal indexation is also part of the discussions, but there is no formal confirmation that this approach has been used to renegotiate any of the gas supply contracts.
3. New contracts for the supply of natural gas. As we have emphasized at the outset, the transition to hub prices has been achieved not only by renegotiation but also by the signing of new contracts.
With regard to new pipeline contracts in Europe, there is a clear trend towards shorter obligations and a transition to full indexation to hub price. The duration of the new contracts (usually 10-15 years) is less than the duration of the existing contracts (20-25 years). However, the signing of 25-year contracts between European buyers and Azerbaijan in 2013 showed that when guarantees are needed to finance large-scale infrastructure projects, the duration of long-term contracts is greater. The trend towards shorter-term agreements is almost entirely due to the newly signed contracts. In fact, there are no signals that the renegotiation process reduces the duration of the contracts. With except of expiring contracts that are not renewed. An example of such contract is the agreement between Turkey and Gazprom for the supply of gas through Bulgaria. Concerning the pricing mechanisms, it is important to bear in mind that (almost) all newly signed agreements contain hub indexation. Azerbaijan has confirmed that part of the production of Shah-Deniz-2 will be priced on the basis of gas-gas competition, while Statoil continues to sign new, related to hubs, contracts with European buyers.
As for the LNG, most supply contracts in Europe remain long-term oil-related, with the additional limitation that they are less flexible than pipeline contracts. The main LNG supplier on European exchanges, Qatar, firmly insists on preserving oil indexation of long-term contracts, even though it sells LNG at prices to the NBP.
Actually, long-term contracts cover 80 % of the LNG offered by Qatar. Looking ahead, the International Energy Agency (MEA) argues that 80 % of the supplies from the world's emerging LNG projects have already been agreed on a long-term basis. Moreover, the renegotiation of LNG supply contracts is not as common as pipeline gas. Even after the success of the Edison1 vs. Rasgas2 arbitration, the European LNG buyers are not particularly keen on pricing revisions. Like pipeline contracts, the average duration of long-term LNG contracts is decreasing, and a binding for period of 10-15 years is already common. Due to higher demand in Asia the relative share of LNG sales in spot markets in Europe or through short-term contracts has sharply declined in recent years. In 2010 18.7 billion cubic meters LNG (21 % of European net imports) were purchased through spot
1 Electricity and Gas Company based in Milan (Italy).
2 LNG Extraction Company in Qatar.
markets and short-term contracts. In 2013, this figure dropped to 10 billion cubic meters (or 15 % of European net imports) to reach 2 billion cubic meters in 2015
A distinctive feature of the current LNG trade is the flexibility in terms of destination. While most LNG contracts are formally long-term, point-to-point and oil-related, individual bargaining and the use of aggregators have opened new business opportunities in which LNG trade is affected by short-term changes. An example of this is Qatar's successful attempts to introduce put-option clauses in its trade with EON, Centrica and other British importers. This allows the supplier to sell when demand and/or prices in Asia are not very high. In such way, Europe is becoming a reserve destination for Qatar.
As a result of the fast-paced processes, the gap between contract prices and hub prices is gradually closing. Hub indexation breaks into long-term contracts, but the European gas market is far from balanced?
Firstly, many import contracts outside Northwest Europe remain unaffected by the positive price changes and continue to relate to oil alone. Until recently, the buyers in southern Europe were resorting to arbitration on the grounds that the contracts did not reflect actual market conditions. And although some of them have made significant progress in recent years and succeeded to renegotiate trading conditions, there is still a long way to reaching a competitive portfolio of trade agreements.
Secondly, some of the changes to the import contracts in Europe are considered as temporary. Gazprom demonstratively retains the clauses stating that the renegotiated terms are only valid in the "revision periods" (usually three years), which means that when this period is over, the previous terms will be restored. In this connection, E.ON complained that it could not make any progress in the talks with Gazprom on canceling the oil indexation.
It remains to be seen whether Gazprom is actually trying to impose the old conditions, and if so whether it will succeed in these efforts. Or, the company simply adjusts, accepting (reluctantly) the new reality.
4. Summarizing comment. Over the last 8 years, price mechanisms and other clauses in long-term gas import contracts in Europe have undergone significant changes. These changes have rocked the structure that has managed gas supplies in Europe for decades.
The leader in these changes is the Northwest Gas Market in Europe, which is constantly expanding to other regions. Trading and supply on the hub market are steadily increasing. The NBP and TFB represent the highest liquidity level and are benchmarks for the value of gas. In this part of Europe the transition has already been completed, given that prices in long-term contracts correspond to hub prices. As a result, the pressure to renegotiate contracts is significantly weakened. The structure of the Northwest market has so far developed that returning to full oil indexing is now impossible.
However, the situation remains unstable because the participation of hub prices in contracts with non-European suppliers is not yet guaranteed. Gazprom agrees to lower prices to hub levels, but officially defends the position for indexation against oil. The last round of negotiations and arbitrations complicated and diversified additionally the signed contracts. Now, when the hub and contract prices are close, new debates on volume flexibility are expected. In fact, recently Russia sells gas at the same prices as Norway, but it still offers flexibility that Statoil regained only after offering full hub indexation in its long term contracts.
Evolution in terms of the pricing mechanism changes the position of gas in the energy mix of Europe. Despite the fall in prices, gas is still not involved in market of power generation. The view that gas is too expensive for power generation provokes the question of what is the driving force of North West hub markets.
While this issue remains without answer, the report opens a discussion on supply flexibility in terms of hub prices. Due to the high concentration of gas sources in Europe, their positioning on hubs is very important. European suppliers accept NBP and TFF as natural place for trade, but the non-European supplier's motive is more complex. Russia is eager to get experience in direct sales, fearing that they will affect long-term contracts in the future. On the other hand, Qatar uses the European LNG market as a backup option.
In analyzing the dependency between flexible supplies and hub price dynamics in Northwestern Europe, it is assumed that European producers, as well as companies offering unconditional and free LNG, take prices as a given. In addition, the price of Russian gas in long-term contracts is generally higher than the hub price, which means the buyers buy Russian gas to meet the residual search. In the role of marginal source, Russian gas plays fundamental role for price formation, when residual demand is greater than the volume of Russian gas that buyers are obliged to purchase under the contracts. On the other hand, when the residual demand is less than this volume, price taking volumes determine the market price. Indeed, this is the case with Qatar gas to Europe in 2009.
Price formation ultimately depends on supply and demand. In terms of prospects for gas market in Europe, two scenarios are possible - with lower and higher prices.
The lower price scenario implies a global LNG surplus, low gas demand in Europe (especially in the electricity sector), and Russia's desire to avoid erosion on the market. As much as this scenario is possible, one can hardly imagine that prices will fall below $ 8-9/million Btu, having in mind high production cost. The higher price scenario is possible with continued high demand in Asia, growth in Europe demand and more moderate LNG production. In this scenario, Europe will look for new suppliers either through higher hub prices or by signing new long-term contracts. The question is whether external suppliers will adopt price mechanism other than indexation to the price of oil.
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