Streetwise Professor

January 9, 2023

The Least Bad Price Control Ever?

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges — cpirrong @ 4:13 pm

At the very end of last year the European Union finally agreed on a rule capping natural gas prices. And what a strange duck it is–unlike any price cap I’ve seen before, which is probably for the best for reasons I discuss below.

Rather than a simple ceiling on the price of natural gas–which is what many EU nations were clamoring for–the rule limits trading in front month, three month, and one year TTF futures if (a) the front-month TTF derivative settlement price exceeds EUR 275 for two week(s) and (b) the TTF European Gas Spot Index as published by the European Energy Exchange (EEX) is EUR 58 higher than the reference price during the last 10 trading days before the end of the period referred to in (a).  The “reference price” is: “the daily average price of the price of the LNG assessments “Daily Spot Mediterranean Marker (MED)”, the “Daily Spot Northwest Europe Marker (NWE)”, published by S&P Global Inc., New York and of the price of the daily price assessment carried out by ACER pursuant to Article 18 to 22 of Council Regulation .”

So in other words: (a) the TTF price has to be really high for two weeks straight, and (b) the TTF price has to be really high relative to the European LNG price over that period.

In the event the cap is triggered, “Orders for front-month TTF derivatives with prices above EUR 275 may not be accepted as from the day after the publication of a market correction notice.” So basically this is a limit up mechanism applied to front month futures alone that basically caps the front month price alone. Moreover, it will not go into effect until mid-February, meaning that the last two weeks of February would have to be really cold in order to trigger it. (The chart below shows how far below prices currently are below the flat price cap trigger.)

These conditions are so unlikely to be met that one might get the idea that the cap is intended never to be triggered, and if it is, its impact is meant to be limited to front month futures. And you’d probably be right. Some nations definitely wanted a traditional cap on the price of gas inside the EU, but the Germans and Dutch especially realized this would be a potential disaster as it would cause of of the usual baleful effects of price controls, notably shortages.

The rule as passed does not constrain the physical/cash market for natural gas anywhere in the EU. This is the market that allocates actual molecules of gas, and it will continue to operate even if the front month futures market is frozen. The freezing of futures may well interfere with price discovery in the physical/cash market, but regardless, prices there can rise to whatever level necessary to match supply and demand. As a result, the cap will not achieve the objectives of those pressing for a traditional price ceiling, and won’t result in the consequences feared by the Germans and Dutch.

So the cap is unlikely ever to be triggered, and if it does, won’t interfere with the operation of the physical market or have much of an impact on the prices that clear that market. So what’s the point?

One point is political: the Euros can say they have imposed a cap, thereby appeasing the suckers who don’t understand how meaningless it is.

Another point is distributive–which is also political. The document setting out and justifying the rule spends a tremendous amount of effort discussing a very interesting fact: namely, that when prices spiked last year, basis levels got way out of line with historical precedents. Notably, TTF traded at a big premium relative to LNG prices, and to prices at other hubs in the EU. Sensibly, the document attributes these extreme basis levels to infrastructure constraints within the EU, namely constraints on gasification capacity, and pipeline constraints for moving gas within the EU. (Although I note that squeezing the TTF could have exacerbated these basis moves.)

Again, the rule won’t have any impact on the basis levels in the physical market. So again–what’s the point? Well almost in passing the document notes that many natural gas contracts throughout the EU are priced at the TTF front month futures price plus/minus a differential. What the rule does is prevent prices on these contracts from being driven by the TTF front month price when those infrastructure constraints cause TTF to trade at a big premium to LNG or to prices at other hubs. So for example, a buyer in Italy won’t pay the market clearing TTF price when that would have traded at a big premium and high flat price level: instead, the buyer in Italy will pay the capped TTF front month price.

In other words, the mechanism mitigates the impact of a very common pricing mechanism adopted in normal times against the impacts of very abnormal times. A buyer outside of NW Europe takes on basis risk by purchasing at TTF plus a differential, but usually that basis risk is sufficiently small as to be outweighed by the benefits of trading in a more liquid market (with TTF being the most liquid gas market in Europe, just as Henry Hub is in the US). However, the stresses of the past year plus have greatly increased that basis risk. The price cap limits the basis risk on legacy contracts tied to TTF, without unduly interfering with the physical market. The marginal molecules will still be priced in the (unconstrained) physical market.

So there you have it. Beneath all the political posturing and smoke and mirrors, all the rule does is limit the potential “windfall” gains of those who sold gas forward basis front month TTF, and limit the “windfall” losses of those who bought basis front month TTF. If demand spikes and the infrastructure constraints bind (or if someone exploits these constraints to squeeze TTF futures) causing the basis to blow out, the rule will constraint the impact on those who benchmarked contracts to the front month TTF.

In some respects this isn’t surprising. All regulation, in the end, is distributive.

Putting it all together, this is probably the least bad price control I’ve seen. It is unlikely to go into effect, and even if it does its impact is purely distributive rather than allocative.

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