Streetwise Professor

Silly me, I thought the “gaz” in Gazprom was methane. But reading this article in Platts, I’m thinking it’s nitrous oxide.  I had to read it several times before I could catch a glimpse of what Sergei Komlev, head of Gazprom Export’s contract structuring and price formation department, was getting at. I now see the basic problem is that he thinks the price of gas in Europe is too low. And the culprit? Speculators! Paper traders! “Virtual gas”!

Come on Sergei, you can’t get originality points for that one. Round up the usual suspects and all that.

Anyways, FWIW, here are Sergei’s deep, N20 inspired thoughts on the subject:

“Paradoxically, gas price erosion is taking place at a time when physical supplies are tight,” Komlev said, adding that some European market analysts had acknowledged that hubs were overflowing with largely “paper” gas.

This became possible with the development of the spot gas market as hubs developed a new class of customer such as banks and commodity traders, Komlev said.

But “as no one is in a position to predict the weather, traded volumes of ‘paper’ gas significantly surpassed real world demand for gas because of the abnormally warm winter in 2014,” he said.

This artificial oversupply had put significant pressure on the market, resulting in a collapse in spot prices, he said.

“As a result, our European customers are facing negative margins as they have to supply gas to end-consumers at lower prices than they pay for physical deliveries under long-term contracts,” he said.

“When some time ago our clients sold our contract volumes on a forward curve for many months ahead they targeted this new class of customers first,” he said.

I’m doubled over in convulsions here, and I haven’t even taken a hit. Is there such a thing as second hand N20?

Let me translate what really happened. Speculators went long. Weather was unusually warm. Prices fell, and speculators took a bath. Simple story. As for “tight physical supplies”, later on Sergei lets on that gas demand in Europe fell 20 percent in the 1st half of 2014.

Sorry, but “paper gas” doesn’t heat a single home or turn a single turbine. It doesn’t oversupply. It doesn’t overdemand. It just transfers price risk. As contracts go prompt, the price of paper gas converges to the price of physical gas, which is driven by supply and demand fundamentals-most notably the weather. What frosts (or is it burns?) Sergei is that the price converged to a low price which is out of line with the oil-linked prices in Gazprom contracts. This has imposed pain on Gazprom’s customers, who are clamoring to renegotiate their contracts, which Sergei and Gazprom no likey.

Like the proverbial blind hog and the acorn, Sergei did root up a bit of the truth:

Long-term contracts were shaped at a time when spot gas markets in Europe were not developed, and the gas price — linked to oil prices — “was practically independent of supply/demand dynamics,” Komlev said.

I repeat: The oil linked price was/is “practically independent of supply/demand dynamics.”

Exactly! That’s the problem! That’s why a move to hub-based pricing, where gas prices can reflect gas values, is so necessary: it ensures that contract prices reflect supply/demand dynamics. Prices that don’t reflect values lead to distortions in output and consumption and investment, and to conflicts between buyers and sellers that inflate transactions costs.

Komlev went on to say that since price in the contracts was not flexible, and was out of line with gas values, it was necessary to permit quantity flexibility in Gazprom contracts. If the company is dragged kicking and screaming into the 21st century, and must index its contractual gas prices to-wait for it-gas prices, it will eliminate the quantity optionality.

Throw the customers into that b’rer patch, Sergei. Truth be told, fixed quantity forward supply contracts are quite the thing in the US, and have been since the dysfunctional price controls on gas were discarded in the 1980s. Companies can buy and sell base load volumes using fixed quantity long term contracts (perhaps at indexed prices); respond to near term fundamental conditions with short-term (e.g., month ahead) forward contracts entered into during something analogous to “bid week” and respond to intra-month/daily supply and demand swings with spot transactions. They can also get various customized contracts that are seasonally shaped, or have some optionality that permits efficient responses to supply and demand shocks (though the CFTC’s proposed Seven Prong-Prong, not Pirrong-test for determining whether supply contracts with quantity optionality are swaps subject to Frankendodd could wreak havoc with that).

A liberated gas market offers a variety of contract terms, including contracts that embed various sorts of quantity optionality. But the point is that heterogeneous suppliers and demanders can utilize a variety of contracts tailored to meet their idiosyncratic needs, as opposed to Gazprom contracts, which remind me of nothing so much as an ill-fitting Soviet suit.

I do have to thank Sergei. I haven’t had such a good laugh in a long time, with or without chemical assistance. But I doubt he-and Gazprom-will be laughing for long. The disconnect between oil and gas prices has become too large and too persistent for their beloved oil linkage to survive much longer.

Speaking of oil-linked prices, this is an issue in LNG markets too. I recently authored a white paper on the subject. I’ll provide a link and write a post on that subject in the next few days.