Streetwise Professor

For years Russia and Gazprom have pooh-poohed the shale gas revolution.  No longer.  Putin has raised the alarm:

Russian President-elect Vladimir Putin urged energy producers from the world’s biggest natural- gas exporter to “rise to the challenge” of a changing market as the U.S. increases output of shale gas.

U.S. shale gas production may “seriously” restructure supply and demand in the global hydrocarbons market, Putin said today in an address to the Russian lower house of parliament.

The impact of shale is being felt immediately in pricing, with customers demanding concessions on Gazprom’s oil-linked pricing mechanism.  The divergence between oil and gas prices has exploded, and now tops 52 (WTI to Henry Hub) and 60 (Brent to Henry Hub): historically, the ratio has been around 10.  Although the disparity is not nearly so large in Europe, oil-linked gas prices have diverged substantially from spot prices there as well.

In defense of the oil peg, Gazprom’s Alexander Medvedev keeps blowing the same gas:

Mr Medvedev insists that the oil link is here to stay. “[Because] the liquidity of the gas market is so low, spot pricing can’t give the right price signals, to suppliers or customers,” he says. “We want predictable prices for the consumer.”

To repeat: liquidity is endogenous, and liquidity feeds to liquidity.  A move to a market-based pricing mechanism would lead to a spiral of liquidity, just as occurred in the US following deregulation in the early-1990s.

And please, oil prices that diverge radically from gas prices are giving better price signals? Really?

Finally, since when are oil prices predictable?  Yes, historically they are less volatile than gas prices, but that’s irrelevant.  Volatility per se is neither good nor bad. Prices that don’t adjust to reflect supply and demand conditions for the particular commodity are sending bad signals. If supply and demand are volatile, or there are rigidities and bottlenecks that make it difficult to adjust output in respond to shocks, then prices have to be volatile to send the right signals.  A price that is perfectly predictable is likely sending the wrong signal at all times but on a set of measure zero.

No, if prices are volatile, than customers who don’t like the risk should have the opportunity to hedge that risk via derivatives markets.  That’s exactly what happened in the US markets.  But that would involve speculators who take on that risk, and we can’t have THAT now, can we?

The pricing mechanism is really just a means to an end, from Gazprom’s perspective, the end being high prices.  You can bet the company would jettison the link in a second if the divergence was working the other way.  But the availability of low cost supplies will undermine that end, as Putin publicly recognizes.  The biggest potential obstacle to those supplies hitting the market is environmental restrictions on tracking.  Hence the widespread suspicions that Gazprom bankrolls anti-fracking campaigns and organizations, particularly in Europe.  (Good luck with that in China!)

Gazprom is one of the world’s least efficient companies. It can survive due to a relative lack of competition.  Vigorous competition from new supplies will dramatically erode its profitability-and with that comes damage to the budget of the Russian state, not to mention the personal budgets of all those myriad officials who feed at the Gazprom trough.

The day can’t come soon enough.