Streetwise Professor

The gas trade in Eurasia is conducted primarily under “take-or-pay” contracts, which obligate the buyer to pay for the contracted amount, regardless of whether they take the gas or not.  The Russians buy from Turkmenistan under take-or-pays, and sell to Ukraine and Eastern and Western Europe under such contracts.

Problem is, nobody is taking or paying.  Ukraine renegotiated its take-or-pays under the threat of neither taking nor paying.  Russia infamously balked on its take-or-pay obligations to Turkmenistan, and in so doing, caused an explosion in Turkmenistan’s pipeline system.  Both countries are still at loggerheads.  Now Europe is balking at paying the Russians:

Europe’s three largest purchasers of Russian gas – German E.ON, Italian ENI and Turkish Botas – have all challenged Gazprom over paying for deliveries of gas that they contracted for but did not take due to reduced demand in 2009.

These three, along with other European companies, all have long term “take or pay” contracts with Gazprom. According to  Kommersant Daily the total amount due to the Russian concern is approximately $2.8 billion.

The European’s point out that Russia made a deal with Ukraine that released the later from paying the full sum of contracted gas earlier this year and they insist on the same treatment. The companies also point out that Russia did not pay Turkmenistan any compensation whatsoever after it ceased taking delivery of Turkmen gas in April.

Once upon a time take-or-pays were common in the US too.  An excellent paper by Scott Masten and Keith Crocker in the AER in 1985 argued on classical transactions cost economics grounds that these contracts were to protect site specific investments in gas wells.  In those days, gas was purchased by pipelines that both transported the gas, and served as merchants: they bought the gas at the wellhead and sold it to industrial users and municipal utilities.  Given the natural monopoly aspects of gas transportation, this “bundling” of merchant and transport functions created a potential for holdup.  Once a well was in the ground, the (usually one) pipeline capable of shipping the gas could opportunistically demand a lower price, particularly when demand was low.  Masten and Crocker showed that take-or-pay was like a pre-packaged expectations damages clause that gave the parties an incentive to perform when the buyer would otherwise have an incentive to breach.

Seismic shifts in the gas business resulting from the perverse effect of price controls; the energy price shock of the 1970s; and the subsequent deregulation of gas prices by Reagan in the 1980s; combined to wreak havoc with these contracts in the 1980s.  Many pipelines had entered into huge take-or-pays in the 1970s when there were widespread fears of gas shortages and energy prices skyrocketed.  When prices plummeted, these contracts were extremely burdensome to the buyers, who sought any way to escape their obligations.  Moreover, the disparity between contract prices and market prices provided incentives for end users to try to buy gas directly from producers, and somehow secure the ability to transport the gas.

In the end, the entire structure of natural gas regulation collapsed.  Starting in 1986, the Federal Energy Regulatory Commission passed a series of orders that “unbundled” the merchant and transportation functions of pipelines.  Essentially, pipelines became regulated common carriers obligated to provide open access transportation to anyone who was willing to pay the tariff rate.

Soon thereafter, a vibrant gas market developed.  In place of negotiated contracts between big buyers and big sellers, there developed a whole array of markets, including daily markets, monthly markets, longer-term markets, futures markets, and swap markets.  Long term, take-or-pay contracts went the way of the dodo because every seller could contract directly with many buyers (who could get access to transportation), reducing the potential for holdup and opportunistic breach.

In brief, take-or-pay was largely an artifact of the integration of the pipeline transportation and marketing of gas.  Once pipelines became open access common carriers, these contracts became unnecessary, and buyers and sellers relied on more market-like arrangements.

Nothing like that is in prospect in contracting for pipeline-transported gas in Eurasia.   This is primarily true because the mother of all bundled gas companies–Gazprom–sits at the center of everything.  Indeed, Gazprom wants to extend its integrated activities into downstream marketing.

With an integrated Gazprom in the middle, European buyers cannot contract with Turkmenistan directly, meaning that the Turkmen need some contractual protection against expropriation.  Similarly, with all its specific investments in pipelines and producing fields, Gazprom is potentially vulnerable to holdup and opportunistic, inefficient breach, by buyers.  There is unlikely to be any prospect for the development of a vibrant gas market resembling that of the US anytime soon given the integrated, monopolistic market structure, particularly in Russia.

This also means that pricing mechanisms in contracts will have to rely on relatively inefficient proxies, like lagged oil prices.

But, as current events demonstrate, and as events in the US in the early-80s showed, take or pay contracts are also subject to breach when contract prices diverge from market values.

Things are not likely to change for the foreseeable future because Putin has announced his intention to retain the integrated, export monopoly structure of Gazprom:

Russia will maintain gas giant Gazprom’s (GAZP.MM) export monopoly in the medium term but will seek to liberalise the domestic gas market, Prime Minister Vladimir Putin said on Tuesday.

“In the near future we will try to liberalise the domestic market…, will try to liberalise access to pipelines. But the monopoly for sales on external market will be maintained…in the medium term for sure,” Putin said.

If in the long run we’re all dead, I guess in the medium run we’re all old.

It is an interesting question as to why Russia relies on an export monopoly to extract rents, rather than other mechanisms.  For instance, as in the oil market, Russia could permit open access to its pipelines and permit direct contracting between buyers and sellers, but charge a hefty export tax.  It does something analogous to this in oil.  Alternatively, it could permit direct contracting and open access common carriage, but instead of setting tariffs at levels sufficient to provide a competitive rate of return, it could set them at monopolistic levels and extract rents that way.

Both mechanisms would like be more efficient than the current system, with an integrated export monopolist.  These mechanisms would involve deadweight losses from monopoly/monopsony pricing, but would mitigate the transactions costs associated with the current structure.  Under these schemes, markets for gas could develop that would price efficiently, and which would be more flexible and less susceptible to the kinds of misalignments so evident today.  That is, transactional hazards would be mitigated under such alternatives.

So why not do it?  I have some cynical explanations.  Most importantly, the current opaque and convoluted system maximizes the potential to siphon off rents to private/siloviki pockets–or should I say the private accounts of public officials?  The tax alternative would result in monies going to the government; not that government monies are immune from theft, but it is likely easier to divert the money directly from Gazprom.  Moreover, it would give more folks a license to look into the company’s operations.  It would also expose those in Gazprom who do shady things to try to circumvent the taxes to the risk of ending up in a jail cell next to Khordovsky.

Similarly, the creation of efficient markets and fixed tariffs would make Gazprom’s finances much more transparent.  People would have a better idea of Gazprom’s real revenues, and the efficiency of its operations.  The company’s finances would be a lot simpler, and given this simplicity it would be easier to detect the diversion or tunneling of funds.   Put differently, an unbundled pipeline company with a regulated tariff provides fewer–though not zero–opportunities for theft than an immense corporate octopus engaged in all sorts of opaque deals.  The merchant function in particular permits all sorts of deals with shady intermediaries that can be–and almost certainly are–used to divert monies into silovik pockets.

Given these realities, it is likely that the Eurasian pipeline gas market will continue to be burdened by high transactions costs and inefficient contracting practices.  Contractual breaches and supply cutoffs will be chronic, especially when gas values move a lot one way or another.  In contrast, the open access US market has shown its ability to deal efficiently and rapidly with extreme shocks to supply and demand conditions.  But Gazprom ain’t going open access in the medium term, and in my view, in the long term either barring some miraculous change in the political economy of Russia.