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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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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.

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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