WGC ANALYSIS: Oil-linked gas pricing here to stay

Kuala Lumpur (Platts)--6Jun2012/240 am EDT/640 GMT

Gas pricing in Europe is at an irreversible tipping point, according to Zeyno Elbasi, part of UK major BP's legal framework and prices team, speaking Wednesday at the World Gas Conference in Kuala Lumpur, Malaysia. It was a view strongly contested by Sergei Komlev, pricing chief for Russia's Gazprom Export, who argues that oil indexation is here to stay as an essential part of a hybrid pricing system.

A report by industry body the International Gas Union on wholesale gas pricing presented Tuesday provided little comfort for either side. The report came to three main conclusions. First, based on 2010 survey results from over 100 countries, gas-on-gas competition -- sales where the gas price reflects supply and demand in a particular market or hub -- has grown significantly since 2007, by 30%, to represent 39% of gas traded globally. Second, the share of gas traded on an oil indexation basis, 23.5%, has not fallen significantly. And third, there is no evidence of price convergence between regions.

The rise of gas-on-gas competition is significant in northwest Europe, but the bulk of the increase has come from a decline in other types of pricing such as regulated prices or bilateral agreements, the IGU said. The level of oil indexation, however, remains stubbornly high, particularly in international trade, where it continues to dominate. The high proportion of gas-on-gas competition reflects in large the sheer size of the US gas market.

From delegate comments made at the conference, it was clear that not only monopoly suppliers favor oil indexation. For all the criticism thrown at the oil link, it does have benefits. Its widespread use is more than a historical hangover. In the absence of an effective gas-based price-setting mechanism, having recourse to a liquid market of a competing commodity as a means of agreeing a price is useful to both buyer and seller.

Both parties effectively contract out price discovery and formation to a market over which neither can exercise pricing power. This is particularly important for buyers largely or wholly-dependent on single producers, as is the case with many pipeline imports into Europe. Moreover, it means that both can use the developed financial markets around oil to hedge their gas operations.

In addition, when gas did compete more directly with oil, indexation was a means of guaranteeing demand, by effectively indexing gas at a discount to oil. This underpinned the large infrastructural investments needed to bring gas to the market and distribute it to consumers. If gas was certain to be cheaper than oil, then both producer and buyer could be confident the market for gas would develop. But this also meant that gas would drive oil out of key markets, so the competition between oil and gas was only ever likely to prove temporary, reducing the relevance of the oil link over time.

Co-existence rather than extermination, however, looks like the most likely outcome; the two pricing mechanisms do not have to be seen as locked into an evolutionary battle with a single survivor. Spot sales of LNG are an integral part of the market. Sellers cannot commit 100% of expected output to long-term contracts in case of operational difficulties, while plants can often produce a few percentage points above nameplate capacity. Buyers too need operational flexibility, provided by tolerance clauses in long-term contracts. The larger the LNG industry, the larger the spot market, at least in volumes terms, if not proportionately.

But LNG investments -- like pipelines -- cost billions of dollars. The sheer size of the investment requires guarantees that there is a market for the gas. Long-term offtake agreements need to be in place to raise finance and financiers are comfortable lending against oil-indexed contracts. Some buyers even take small equity stakes in LNG projects, which provides them with a hedge against their oil-linked exposure as parties to oil-indexed offtake agreements. Both buyer and seller want the security that the investment will go ahead and that the LNG produced will have a home.

Yet there are forces moving against oil indexation. Market liberalization has promoted gas-to-gas competition in some markets, allowing buyers to make a comparison of the prices produced by the two pricing mechanisms. This visibility has been sharply accentuated by the high price of oil, which throws into stark relief the fact that gas competes increasingly with cheaper non-oil commodities.

In times of weak demand this exposed a fundamental weakness of oil indexation. Minimizing offtake through the exercise of tolerance clauses meant an increase in gas available to the spot market, widening the gap between spot and oil-indexed prices. This is what occurred in the wake of the financial crisis of 2008-09, leading to heavy pressure from European buyers for suppliers like Russia's Gazprom to change their contractual terms.

The most deadly mix is surplus gas -- supply driven in the US and demand driven in Europe -- and high oil prices, precisely the conditions that have prevailed in non-Asia OECD since the onset of the financial crisis. With this mix prevalent, oil indexation looks increasingly exposed to the historic forces that are undermining its relevance. It, however, also follows that if the oil price falls, gas again becomes competitive in non-oil dominated markets, suggesting that the while the pressures on the oil link will remain, they could lose much of their bite.

--Ross McCracken, ross_mccracken@platts.com

--Edited by Geetha Narayanasamy, geetha_narayanasamy@platts.com

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