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

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

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Instead, these companies want natural gas prices to be indexed to market prices at Europe's openly-traded natural gas hubs, like the UK's National Balancing Point (NBP), the Netherlands' Title Transfer Facility (TTF), and Belgium's Zeebrugge Hub, all of which are virtual trading points, unlike Henry Hub in Erath, Louisiana, which is a physical trading location.

According to research from Reuters, only 34.8% to 37.7% of Europe's gas supplies are priced off spot markets currently. A major supplier that has responded to the demands of its customers is Norway's Statoil (NYSE:STO), which has allowed many European utilities to adjust their contracts away from oil-indexed pricing to hub pricing. Statoil's flexibility in pricing has allowed it to gain market share in the continent, compared to its chief rival, Russia's Gazprom (MCX:GAZP).

On its part, Gazprom is sticking to its guns and staying with long-term oil-index contracts, saying that stable oil-indexed gas prices were necessary to fund capital-intensive exploration and production projects.

"[Gazprom] argues that hubs are too illiquid and shortsighted to generate any kind of meaningful signal; that it is unreasonable to burden producers with both the pricing and the reservoir risk; that in Europe, only the UK's National Balancing Point is meaningfully liquid; and hub prices are anyway a function of oil indexed prices, so lowering the latter would inevitably lower the former even more; and the production costs of gas and oil are roughly similar, but gas costs about thirty times more to store and transport than oil," writes William Powell of Platts.

Additionally, Harris pointed out that "a buyer of contract gas obtains supply security and also typically gets valuable flexibility, [or] the ability to take more gas at some times of year than at others. Gazprom and others argue, very reasonably, I think, that an importer can't expect to keep all the benefits of supply security and flexibility while paying a hub price that reflects the value of the commodity alone."

Statoil, Harris said, has allowed its customers to switch to hub pricing only "at the expense of giving up flexibility and moving to a 'flat' or inflexible supply contract that obliges them to take the same amount of gas every day throughout the year."

Outside of Europe, it is also unlikely that natural gas prices will be de-linked from crude prices anytime soon. In Asia, the majority of LNG sold continues to be priced based on oil-indexed contracts running 20 years or longer, "which result in gas buyers paying roughly 15% premiums to Brent crude for their fuel," Alan Herbst, a principal at New York-based energy strategic advisory firm, Utilis Advisory Group, told Minyanville.

"While Far East LNG buyers would definitely prefer to use natural gas-indexed pricing, regional producers won't voluntarily slash their profits by altering their oil-indexed pricing, especially since there are insufficient supply alternatives available," Herbst added.

Chevron (NYSE:CVX), for example, has said that its massive and expensive Gorgon LNG project in Western Australia would require the support of oil-linked prices. On the other hand, BP (NYSE:BP) recently became the first major producer to sign a 15-year deal to supply Japanese utility Kansai Electric Power (TYO:9503) with natural gas based on Henry Hub prices.

Herbst said that he agreed with producers who assert that natural gas should continue to be priced off of oil. "I wouldn't change something that isn't broken. While the resulting lower natural gas prices would help consumers in the Far East and in Europe to a lesser extent, there would be less incentive to drill in these locations, and in the long run, natural gas supply would be constrained."

On the other hand, Harris said he was "an advocate of free markets, [even if] markets won't find the perfect solution to every issue."
"Large-scale infrastructure investment will probably always need the support of long-term contract structures. But I think where a credible natural gas market exists -- and this is certainly the case in the UK and northwest Europe -- it makes sense to use it as the basis for contract pricing," he said.

"The present two-tier approach leads to market distortions and doesn't fully allow the traded markets to do their job of setting price signals that drive investment."

Twitter: @sterlingwong
No positions in stocks mentioned.
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