Lower Gas Prices: Have Producers Got The Right Signals?

Gas-exporting companies and gas-importing utilities in Europe are in the process of reconvening, possibly in Norway, a conference first held last December in Algiers, to consider the impact of the current economic environment on the gas industry. Although the initiative was triggered by the prevailing oil price crisis, the Algiers conference also expressed concern about the likely effect of the forthcoming liberalisation of gas markets in Continental Europe. The producers, who took the initiative for the Algiers meeting, seem primarily troubled by the impact on investment returns of lower gas prices, whether generated by depressed oil prices or by the opening up of the gas markets. However, the two phenomena are of a different nature, create different uncertainties and challenges, and therefore signal different policy directions.

Gas price formation in a nutshell

In a managed system, as is presently the case in Continental Europe, gas is generally traded by a monopoly utility in the various market segments. As gas competes mainly with oil products, its value is derived from the end-use prices of these alternatives, weighted to reflect the share of the different segments of the market, and netted back to the export border to form the contractual base price. A price indexation formula, incorporating a pass through factor, ensures that gas maintains its competitiveness in the end-use market. In addition, to smooth out the fluctuations of oil prices, a lag mechanism is introduced typically 3 months backward-6 months forward. Therefore, when oil prices collapsed in 1998, gas prices at the borders, after having been sheltered for a while, followed suit. Indeed, when the UK-Europe Interconnector was commissioned in October 1998, contractual gas prices on the Continent were below the prices generated in the liberalised British market.

In a liberalised market, gas prices tend to be determined by the interaction of supply and demand of gas. For example, in the US market as regulations were gradually lifted in the early 1980s and market forces allowed to operate, a spot market developed, followed, since 1990, by a futures market. This facilitated price discovery for prompt deliveries and for future spot gas supplies. As a result, market-based prices replaced old indexation formulas where gas prices had been linked to those of alternative fuels. Similarly, though in a more dramatic way, the process of liberalisation in Britain has induced rapid changes in market structure and prices, leading to the development of spot and futures markets for gas. Although the structural features of the American and British markets are very different, prices have tended to reflect competitive supplies and therefore have declined substantially

Does liberalisation always generate lower supply prices?

The American and the British experiences exhibit a general pattern. In mature markets where logistics and supplies are ample, liberalisation leads to the development of commercial commodity markets. This supports the expectation that a liberalised Continental European gas market would ultimately lead to new price mechanisms. But does liberalisation always generate lower supply prices? And if yes, how low would they go?

In the short term (first stage of market opening), there is likely to be an excess of supply at the borders of North West Europe, following the commissioning of the Interconnector, and in a later phase possibly in 2000-2001, of the Belarus-Poland (Yamal) pipeline. These will be the key drivers of prices and new contractual arrangements. In particular, it is expected that gas trading through the Interconnector will greatly influence the gas business in that part of the continent. As a consequence, the development of transparent reporting of short-term transaction prices will develop into a spot market at Bacton-Zeebrugge, and, in a later phase at a trading point somewhere in Germany. As neither the Interconnector nor the Belarus-Poland pipeline capacity is fully contracted on a long-term basis, the potential floor for border prices may be set by the new Bacton-Zeebrugge spot market or the lowest offer price for Russian gas.

To a lesser extent, an opposite move in the form of upward pressure on prices and longer-term contractual arrangements, may result from a ‘dash’ for gas in the power generation sector, similar to the one caused by the first wave of gas-fired power generation in the UK in the early 1990s. However, the generators would hardly be willing to pass to the supplier some of the incremental gas value resulting from cost and efficiency gains of CCGTs as well as a premium reflecting part of the environmental cost savings.

In the longer term (second and third stages of market opening), as open access is progressively implemented, and gas-to-gas competition emerges, pressure will start to mount on long-term contract prices. In particular, determinants of gas import prices will shift from prices of competing fuels to spot prices. In this case, border prices may tend towards the marginal costs of supplies

Differing uncertainties, challenges and responses

Whether generated by depressed oil prices in a managed system or by competition in a liberalised system, lower gas prices generate lower value for the producers and therefore pose the fundamental problem not only of dwindling government revenues but also of the economic viability of investments aimed at developing new gas supplies far afield and from costly reservoirs.

However, gas producers should be aware of the fundamental difference between the uncertainty caused by low oil prices and that caused by the prospect of liberalisation. In the first case the impact is on the well head value of gas; in the second case, it is the whole structure of the value of the gas chain which is affected. In the first case, the producers-exporters alone will bear the brunt of the impact. With limited scope to raise funds for new investments, they will be compelled to reassess their upstream development and refocus their priority investments. As the main importing utilities have secured their gas supplies well until the second half of the next decade, some of them even holding supply contracts in excess of their apparent market requirements in 2010, this prospect will hardly affect the security of supply. In the second case, the impact is on all the actors, who will come under increasing pressure from competition. Existing and new players are expected to move aggressively to capture whatever new value is generated along the chain. Those who do not adapt to the new market structure will lose margins or even whole market segments.

As market developments unfold and pressure on prices increases, producers-exporters will have to find fresh ways to differentiate themselves, take advantage of new opportunities downstream and add value to their gas business. Ensuring access to the end-users, through different aggregation routes than those currently available, will be a crucial move in that direction. As one informed company leader put it candidly and bluntly: ‘It would be foolish to stay a producer only’, meaning that, in a liberalised market, the concept of a gas producer-exporter will be obsolete.

By: Robert Mabro