Streetwise Professor

Western European utilities are pressuring Russia and Qatar to eliminate long term gas supply contracts with prices tied to crude oil in favor of a spot market mechanism:

Russia and Qatar are under growing pressure from Europe’s biggest utilities to scrap a 40-year-old system that links natural-gas prices to oil after Brent crude’s 23 percent surge this year.

As delegates from countries that hold two-thirds of the world’s reserves gather in Cairo tomorrow for a one-day meeting of the Gas Exporting Countries Forum, customers from France’s GDF Suez SA to EON AG of Germany are urging producers to link prices to spot markets instead of insisting on long-term contracts that shadow the fluctuations of oil. Contract prices will rise about 15 percent in the next quarter alone, according to Wood Mackenzie Ltd., an Edinburgh-based energy consultant.

“The European contract price of gas is going up,” said Thierry Bros, a senior analyst at Societe Generale SA in Paris. “Utilities won’t sign new oil-linked contracts.”

But Gazprom says nyet, no, never!:

Spot markets don’t have enough trading to ensure adequate supply, Alexander Medvedev, deputy chief executive officer of Russia’s OAO Gazprom, the world’s biggest producer, said May 13.

“There has never been any transition to spot-priced market structure, and never will be, because spot market liquidity is insufficient,” Medvedev said in Slovakia’s capital, Bratislava. As soon as economies began to recover from the financial crisis, “it became clear that the market will work as before.”

The Other Medvedev is either an ignoramus or a liar.  Check that–he’s probably both.  Regardless of the explanation, his “analysis” is bunk.

First, there has been an extremely successful transition to a spot market structure: in the US, in the 1990s.

Second, the liquidity of the spot market is endogenous.  Believe me, the elimination or even phasing out of oil-linked contract terms would lead in very short order to the development of a robust spot pricing mechanism.  The ability to trade gas spot, and the reliance on spot prices to index contracts will initiate a virtuous cycle that will result in spiraling liquidity.  Just as occurred in the US with the elimination and phase-out of take-or-pay contracts and the elimination of gas price controls.  Just as occurred in oil in the late-1970s when OPEC abrogated oil equity contracts: there was no spot market in oil to speak of before that, but once OPEC transitioned to a different pricing mechanism, the oil spot market developed quickly.  (Note the launch of the NYMEX crude contract followed the elimination of equity contracts in oil by less than three years.)

There is no reason why, in the current environment, with current technology, that a robust spot price in gas cannot and will not develop in Europe.  The existing pricing mechanism is an anachronism rooted in a very different legal and regulatory environment, and one that is plainly unnecessary in light of the development of vibrant spot markets in myriad types of energy since the late-1970s.

Gazprom–surprise, surprise–is just talking its book.  Oil and gas prices have diverged, with oil prices rising and gas prices remaining stagnant or even falling since the end of the financial crisis.  Thus, the pricing mechanism provides a windfall to Gazprom in the existing environment.  Note TOM’s linking of “the market will work as before” to the end of the crisis.  Oil prices plummeted during the crisis, making the linking mechanism less profitable for Gazprom, but with the rise of oil prices, that mechanism works very well for the company.

But very poorly for its customers.  The linked article mentions the woes of E.ON, RWE, and GDF Suez.  Those woes will only become worse with the craven decision of the Merkel government in Germany to shutter the country’s nuclear power plants.  Merkel will soon be in a difficult position, between the Russians she habitually appeases (often at the behest of German companies, including, ironically, E.ON and RWE) and German companies, notably the just-mentioned utilities.   She has jumped from the greenie frying pan into the energy fire.

The current situation is not sustainable.   Wide divergences between prices and values like those seen between the contract price of gas and the spot price of gas cause contract disputes and market breakdowns.  Something will have to give.  Gazprom insists it won’t.  But if the divergences remain wide or even widen, it may find itself without customers and forced to give.

Here’s hoping.