Gazprom: Re-engineered Long-term Supply Contracts Not in Europe’s DNA

Is a natural gas market with long-term contracts and 100 percent hub pricing feasible for Europe? The continent’s biggest supplier says no. If Europe wants long-term natural gas contracts from a reliable supplier, better to forget the “genetic engineering” and stick with the existing hybrid pricing model. 

So said Sergei Komlev, Head of Directorate, Contract Structuring and Price Formation at Gazprom Export. He spoke to delegates at the European Gas Conference 2012 in Vienna, Austria.

Mr. Komlev noted he sees no “tectonic changes” taking place in the European natural gas market that required wholesale pricing mechanisms be completely reconsidered. 

Yet, he listed the available options: the Asian pricing model, with long term pricing contracts with 100% oil indexation, but no hubs and said this was unlikely model for Europe.

The second model, he said, was the existing hybrid, two-tier one.

“This one is represented by a combination of oil product indexed long-term contracts plus hub pricing. The term hybrid is used to indicate that these two different pricing mechanisms do not exist in parallel worlds. They are closely related and interact as one mechanism,” he explained. Continental Europe had developed a unique hybrid system based on the symbiotic co existence of oil and gas indexation. 

“Under the existing model, oil indexed prices play a leading and dominant role, while hub prices play the balancing and support role. It’s a purely market-driven and highly competitive system, though competition manifests itself in a different way compared to the Anglo-Saxon pricing model.”

He contended that the continental market was mature enough to perform the functions it was designed for and there was no cause for change.

“Those who call for changes on the continent – British consultants included – do not point to the US with its paramount, superb model based on supply and demand. They point to another, to something else. One of our clients dubbed this model ‘re engineered’ pricing model. I would personally elect to call it ‘genetically modified’ because it combines two incompatible things: hub pricing and long-term contracts with nominations coming from the buyer.”

The choice in reality, he said, was between the existing hybrid and the American gas pricing models.

“Indeed if you want pricing based on supply and demand and there are liquid hubs in place, there is no need for long-term contracts. But in this case nomination will come from the producers.

“If you prefer long-term contracts and security of supply, then you have to stick to the existing hybrid model. There’s no third way that provides the best of both worlds in the interests of the buyer, simply because it leads to unfair allocation of contract risks not acceptable to a supplier,” explained Mr. Komlev.

He continued: “Nevertheless, there is strong pressure on Gazprom to accept a re-engineered gas pricing model. There are analysts who contend that a transformation of the hybrid pricing model could be carried out in an evolutionary way, simply by increasing the share of the spot component in long-term contracts at the expense of oil indexation.” 

Komlev said although Gazprom understood the interests behind the proposal, the move towards supply and demand pricing could not be accomplished because hub prices on the European continent were not a function of total supply and demand.

“Hubs in the hybrid system do not provide a true indication of the supply-demand balance, because the continental European market comprises a complicated structure of long-term and short-term contracts.”

He said the pricing of hubs in Europe was rather a function of arbitrage of all kinds, different contract pricing structures between the contract and hub prices, between hubs, and between UK and the continent.

One example that he gave to show that hub spot prices did not correlate with supply and demand in Europe was the gas shutoff situation with Ukraine in 2009, when, despite a shortage of gas supply, hub prices did not react. “That was due to the geography of shortages. They occurred in the part of Europe where there were no hubs. Contract supplies from other exporters were sufficient enough to meet the demand in the rest of Europe.”

In accordance with Komlev’s logic, deliveries under LT contracts were not sufficient enough to meet an exponent growth of demand in early February of this year caused by a cold spill. This time consumers turned to the hubs to source gas, and hub prices overreacted.   

He added that in Q3 2010, when natural gas demand was down and additional gas volumes from Qatar came onto the market, no hub price decrease appeared.

Mr. Komlev spoke about the multiplicity of supply prices and contended that Europe’s present dual pricing model supported competition.

He concluded: “The adjustment demand of gas importers that producers should be fully responsible for price risks in long-term contracts is out of the fragile balance of interests between buyer and seller. Pushing this demand will lead to nothing else but the demolition of long-term supply contracts.”