Breaking the chain

Most gas sold in continental Europe is still priced against oil products, even though the rationale for this link has waned. But some end-users have had enough. Oliver Holtaway reports

Gas buyers in continental Europe are putting pressure on wholesalers to move away from the traditional method of pricing gas contracts, which links the price of gas to the price of oil products such as heavy fuel oil or gas oil, in favour of gas-on-gas competition. Despite structural obstacles, they are beginning to meet with some success.

End-users argue that the historical rationale for contractually linking gas and oil prices is now redundant, and that the gas price should be set according to fundamental supply and demand, as is the case in the US. Wholesalers are starting to make some concessions to this demand. But before a paradigm shift towards gas-on-gas competition can occur in continental Europe, several obstacles must be overcome – including the reluctance of gas producers to change, the concentrated nature of the wholesale market, and the underdevelopment of Europe's gas trading hubs.

Two-tier market

The continental European gas market is two tier. In simple terms, wholesalers and merchant energy companies buy gas from producers and then sell it on to end-users. Producers have long preferred to sell gas to wholesalers on an oil-indexed basis, because it provides the stability required to make investments in infrastructure. Rising oil prices over the past decade have made that preference firmer.

Wholesalers have largely passed on those costs to end-users, meaning that customers have borne the brunt of the rising oil prices – leading some to now demand new products from wholesalers. "An increasing number of large industrial customers are putting up a fight, saying that they want prices linked to gas – or even power," says Jonathan Stern, director of gas research at the Oxford Institute of Energy Studies.

The International Federation of Industrial Energy Consumers (IFIEC) is calling for an end to the formal link between oil and gas pricing, which accounts for around 75% of gas supply contracts in Europe, according to a 2007 EC sector enquiry. "In principle, we would prefer gas contracts to be indexed to the price of gas," says David Gillett, director of co-ordination at IFIEC Europe. "We firmly believe that gas and oil are separate energy sources and should be bought and sold as such."

The practice of linking gas prices to oil product prices began in the 1970s, when fuel oil and gasoil were true substitutes for natural gas. But, as Stern has argued in a recent paper, this rationale has all but evaporated.

"The original rationale – that end-users had a real choice between burning gas and oil products, and would switch to the latter if given a price incentive to do so – was robust when oil product indexation was established," says Stern. "But since then, several factors have rendered the original rationale increasingly dubious in the majority of countries, particularly in northwest Europe." These factors include the cost and inconvenience of maintaining oil-burning equipment and substantial stocks of oil products; the emergence of modern gas-burning equipment in which the use of oil products means a substantial loss of efficiency; and tightening environmental standards in relation to emissions.

"In the context of European end-user gas prices, conventional oil indexation using heavy fuel oil makes little sense," says Colin Lyle, managing director of consultancy Gas Market Insights. "In a few remote parts of Europe, indexing gas to gasoil might make sense in some markets, such as residential or commercial heating, but even there it's tricky."

Gas buyers expect this divergence between the two commodities to increase in the future.

"Everyone knows that the oil supply situation will be much tighter than gas supply in the future," says Jim Robertson, energy director at chemical company Terra Industries and head of IFIEC's gas and oil working party. "There is no reason why a commodity like gas should be linked to oil – it's an anachronism."

But while the fundamental structure of the market has changed, the system remains convenient for some market players. "The rationale for retaining oil-linked gas pricing is that no other acceptable indexation is available, and the dominant commercial parties – producers, exporters and incumbent utilities – are comfortable with this indexation and have sufficient market power to maintain it," says Stern. "A lot of this is justified under cover of security of supply concerns," he adds.

Nevertheless a few buyers, such as chemicals company Yara, have been successful in signing gas supply contracts indexed to the price of gas at gas trading hubs, such as Holland's TTF.

"The long-term trend in the energy markets is that oil is more related to the transport sector – the market share of oil in the heat and power industry has declined over the last 30 years," says Hallgeir Storvik, senior vice president of supply and trade at chemicals company Yara. "So there is expected to be a price advantage to switching to gas-based regimes."

Yara has made a significant break from reliance on oil-linked prices. Several of its old oil-linked contracts have expired over the past two years. Noting the improved liquidity at Europe's gas hubs over the same time period, Yara chose to take more exposure to gas-linked prices; 35% of its hydrocarbon supply is now linked to various hub prices, comprising both gas bought from the hub via intermediaries on a spot market basis, and supply contracts linked to hub prices. Yara reports that these contracts have so far created significant savings to its energy buying costs.

The company had a stronger incentive to do so than many of its peers, says Storvik, because it competes globally.

"A lot of energy consumers in the EU are able to pass on energy cost increases to consumers," he says. "But we are in direct competition with other regions."

Yara's scale was also a factor in securing this outcome. As a buyer, it is always an advantage to have scale, particularly when dealing with sellers with fairly strong market power. "The bigger the customer, the more leverage they've got," says Stern.

And sellers in the European gas market – both producers and wholesalers – do enjoy significant market power, argues Robertson, making it difficult for many smaller end-users to get the pricing mechanisms they want.

"The problem is that there are not enough sellers of gas targeting different customers with different products," he says. Rather than pressure producers to change the pricing mechanism on gas supply contracts, a small number of powerful wholesalers seem content to buy on an oil-linked basis and pass the cost on to end-users. "Most of the risk has been moved from the gas companies to the end-user. More wholesale competition will lead to more gas-on-gas competition," he says.

Positive signs

Some wholesalers are expanding their portfolio of products to offer greater choice to customers, however. Dutch gas trading company GasTerra, for instance, offers gas priced on a spot market indexation, based on a 50/50 weighting of the gas prices published by price providing agencies Heren and Argus. These spot price-indexed contracts tend to be short-term contracts of one year or less. Shell, which both produces gas and sells directly to end-users via its Shell Gas Direct subsidiary, also claims to have agreed in its contracts pricing mechanisms related to gas spot prices, coal prices and other indexes, although it acknowledges that oil-linked pricing accounts for the bulk of its gas supply contracts.

"One category of clients – mostly industries that can take a certain risk – prefer actual market value prices," a GasTerra spokesperson told Energy Risk. GasTerra began to sell gas via the TTF in 2005, and says it is working to increase the number of customers trading at the hub. But while it expects further interest in gas-linked contracts, it does not believe that this will happen at an accelerating pace.

"Other customers like to avoid the more flexible or unstable development of the spot market and stay with oil-linked contracts," says the spokesperson, "also, because this type of contract still is most seen elsewhere in the EU, which means that they are more at pace with the international competition."

Many European utilities agree with this analysis. While it may seem rational for a power generator to ask for gas contracts linked to the coal price or the power price, many are happy to stick with oil-linked contracts.

"EGL is comfortable with the current situation," said gas division officials from EGL, a Swiss energy trading company that owns gas-fired generation assets. "EGL sees a coexistence of oil and gas indexed price formulas to govern the continental gas markets for some time into the future. The oil link is a reflection of fundamental factors in the hydrocarbon value chain."

German incumbent utility RWE agrees, although it sees some scope for change. "It's our view that oil-linked models will stay as an important price-building mechanism, especially in long-term contracts," says Michael Rosen, spokesman for RWE Gas Midstream, RWE's gas procurement arm. "The more liquid wholesale markets will evolve, and there is a likelihood that a range of products will be set up focusing on a broader variety of price building mechanisms."

But other commercial factors may support continued reliance on oil-linked contracts. "Oil-linked contracts are useful for large incumbent utilities because they are highly predictable," says Stern. "When energy prices go up, big utilities always do well because the pass-through on the purchase price is slower than the pass-through on the sales price."

The underdevelopment of continental Europe's gas trading hubs is a further barrier to the viability of gas-on-gas competition. Oil products are, at least, liquidly and transparently traded: while liquidity on gas trading hubs such as Holland's TTF, Belgium's Zeebrugge and France's PEG have improved over the past three years, rising from 1100Gwh/day in October 2003 (90% of which was accounted for by Zeebrugge) to 2750Gwh/day in October 2006, they are yet to match the churn levels of the UK's National Balancing Point, which traded up to 25,000Gwh/day over the same period.

Significant volumes

Depth is another issue. While liquidity on the NBP is mostly focused on the day-ahead and month-ahead contracts, there are significant volumes traded up to a year out. At present, the majority of continental hubs function almost exclusively as balancing markets, with liquidity only found in the day-ahead market; only the TTF is a significant exception.

"It is disappointing that progress has been so slow, even in northwest Europe," says Robertson. "The development of gas hubs is absolutely crucial, as it will allow consumers to see a daily transparent price, so that they can make their own minds up about how much to buy and when."

Many see the dominance of the oil-linked gas contract as a symptom of the wider problem of market concentration and illiquidity facing the European gas market. The EC, for instance, has declined to attack the issue head on. "We believe that it would be better to have an oil market and a gas market that were independent, but it is for companies to decide how to negotiate their contracts," EC energy spokesperson Ferran Tarradellas said.

Frustratingly for those who wish to buy on a gas-indexed basis, the market faces a chicken-and-egg situation: oil-linked contracts, no matter how slim their rationale, will not decrease in popularity until the gas hubs are liquid enough to provide a viable alternative; but gas hubs will not become liquid until less gas is tied up in oil-linked contracts. It will take a shock to the system – either in the form of effective EC liberalisation legislation, or a fundamental supply and demand factor, to bring about a paradigm shift in gas pricing.

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