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Should Natural Gas Prices in Europe and Asia Be De-Linked From Oil?


Those in favor argue that this would improve natural gas demand, while opponents say that producers need high prices to support expensive infrastructure costs.

While US natural gas prices are at historical lows, the same cannot be said of prices in the rest of the world.

Thanks to the rise of hydraulic fracturing, which dramatically lowered the cost of extracting shale gas, US natural gas (NYSEARCA:UNG) prices have fallen to around $2 to $4 per million British thermal units, compared to the $9 to $10 and $13 to $18 ranges seen in Europe and Asia respectively.

International natural gas prices have been rising relative to US prices because they are indexed to the price of crude oil, which has hovered around the $100 mark for over two years.

It was a historical accident that natural gas prices were linked to crude oil. Back when the resource was first uncovered in the 1960s, there wasn't a natural gas market, so European importers decided to link the price paid for gas to the value of oil, which was seen as natural competition since both were chiefly used for home heating, power generation, and industrial applications.

"So most of the natural gas contracts used an oil price (or some basket of oil prices) as the main index, and made the gas price attractive relative to that. If oil became more expensive, the gas price would rise, but still be competitive with oil. If oil became cheaper, the gas price would fall," explained Nigel Harris, co-founder of the Surrey, UK-based energy consulting firm, Kingston Energy, and a faculty member at The Oxford Princeton Programme, to Minyanville.

"This indexation also made sense to the gas producing companies and countries. For them, natural gas was, at least to some extent, a by-product of their oil production. They understood oil markets well, and if they could sell gas at a price tied to the oil market, that would suit them fine. A similar historical situation led to the adoption of oil indexation for liquefied natural gas (LNG) imports into Asian countries like Japan and Korea, and for the exporters supplying those markets," he continued.

But with crude prices staying persistently high, and with the European natural gas market in contraction thanks to eurozone economic weakness, major importers such as Germany's E.ON (ETR:EOAN) and RWE (ETR:RWE) and Italy's Eni S.p.A. (NYSE:E) are pressing for gas prices to be de-linked from oil-indexed long-term supply contracts.

"Demand for natural gas has dropped sharply across Europe, and while there are clear drivers for this that have little to do with gas prices -- economic recession, rapid expansion of renewable power generation, cheap coal supplies from the US, political support for coal burning -- it is also clear that higher gas prices couldn't have helped," said Harris.

"High oil-indexed prices can also destroy Europe's gas supply companies. Big importers like E.ON and RWE have found themselves mercilessly squeezed between long-term contracts that require them to buy large quantities of expensive Russian gas and a shrinking end-user market in which industrial customers increasingly want to pay hub prices, not oil-linked prices, for their gas supplies," Harris continued.
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