Best of 2016 | Long-term Gas Contracts: Time for a New Deal

*This article was originally published on January 23, 2016

The traditional long-term contract for natural gas may have reached the end of the road, given the new market arrangements, according to Edison's COO Pierre Vergerio. At a European gas conference in Vienna in January he spoke about a potential new deal between gas producers and marketers.

He said that sellers and buyers of gas should now strive to stabilize their respective businesses in the current modified framework and to resume the long-term relationships that have been severely challenged lately.

He said that to develop gas production and infrastructure required long-term contracts with take-or-pay clauses in order to draw in financing. “These concepts were largely accepted,” he said. “And as a reward for the commitment, the buyer was entitled to get a margin when reselling the gas in the market,” he said, “which meant they made a profit.”

A “price reopener approach,” he added, allows for price revisions. Finally, he said, long-term contracts were set at the beginning to compete with other forms of energy, such as fuel oil, so they were priced at a discount.

These characteristics, he said, had reigned from 1970-2010. However, Vergerio said dramatic changes had taken place owing to market liberalization, the financial crisis, an influx of LNG, a drop in demand, and an increase in the price of oil.

Producers no longer hold the aces

“By 2010, the situation had changed. The market price of gas had dropped, while the oil price and contract price has increased, and the seller found himself with extraordinary profit, while the buyers were incurring massive losses.”

The sellers, he recalled, were reluctant to give buyers significant discounts. While price reopener clauses were the keystones of such contracts, Vergerio said they were complex, vague and could be written in broad language. He joked that he had once seen 10 pages written on the significance of the word “significant”, and that sometimes experts might write thousands of pages on a single clause.

Still, he said disputes also focused on economics, algebra, sophisticated calculations and an understanding of the market. For the buyer, he said objectives included stopping heavy losses, in some cases to avoid bankruptcy; recovering a reasonable profit; and trying to revise the formula by moving away from oil indexation.

Negotiations and arbitrations, he said, can be quite difficult when a lot of money is at stake. At Edison, he said the approach was to prioritize the objectives of such matters. He said the company had had two cycles of price reviews since the market collapses in 2010 and 2012. The result, said Vergerio, was five arbitral awards and three commercial agreements.

Edison has been in disputes with several companies including Russian Gazprom, Italy's Eni, Qatar's Rasgas and Algeria's Sonatrach. Gazprom discloses the totals of its repayments in the relevant quarterly results without breaking them down by recipient. In its Q4 2015 report, for example, it says it repaid Rb12bn ($153mn) in retroactive gas price adjustments. 

Solutions to these disputes remain confidential but typically they will have two parts: severing the link to oil and replacing it with a link to gas; and compensation for perceived overpayments made.

Restoring the margin is key

“Our key objective in all this process, which lasted for 5 years, was to confirm the fundamental principle of these contracts and restore the margin,” he explained, adding that the arbitration had involved many players in several locations. One result was a reaffirmation that the long-term contracts had not been signed by the buyers to lose money, but being able to reimburse their marketing costs and have a net profit on top.

After several years of difficulties, he observed that sellers had made threats to sell directly at hubs – an approach that did not consider the role of the midstream company whose tasks include management of the regulatory framework; of credit and marketing issues; and of cash-flow commitments.

Vergerio noted that the positions of the buyers and sellers had now diverged as they were no tackling the constraints of a low oil price scenario. “Is there any opportunity for a new deal or attitude?” he asked.

Towards this, questions need to be addressed, like whether long-term contracts are still needed, “and if so, what are the key points for this new potential revision of existing contracts?” Long-term contracts, he explained, are still the only existing way to finance new massive and risky investments, such as US LNG, for example.

“With long-term contracts, no one can decide that they no longer need the other party,” he remarked. “They cannot be torn up and thrown away.” On the other hand there can be extreme market volatility. He presented a chart showing that oil and gas decoupling had occurred, which had cleared the need for oil-linked contracts, but oil is still affecting the price of gas.

Since last year, Vergerio pointed out, TTF and Brent had been following exactly the same track. In the east of Europe, he conceded, there is oil indexation, while in the north there is mostly hub indexation. He showed that the hubs in Europe appear to be correlated, with price differences only due to differences in logistics' costs.

Regarding the conclusions of Vergerio's new deal, he said that take-or-pay obligations should remain, but be softened; price levels should be what he termed “at market”, allowing a reasonable margin for the buyer; indexation should have a mixed balance structure of oil plus a “hubs basket” plus others (like coal); and a price reopener clause that can be modified and/or tailored in a practical way.

Drew Leifheit reporting from Vienna; edited by William Powell