Weekly Overview: Oil Indexation, Prices and EU Markets

French energy company Engie this week followed Uniper in getting out of a chunk, if not all, of its oil indexation clauses in its contracts with Gazprom. Long and tortuous though the negotiation process is, the battle that led to these victories must have started some time after the oil price collapse in the summer of 2014.

Now with oil around $40/barrel, the difference between spot and term prices has been squeezed, reducing the amount of potential savings, in the short term at least. Nevertheless, Engie and Uniper clearly believed the fight was worth having and narrow differences make for easier compromises.

Now the two sides, buyer and seller, will have to make do without the safety-net the contracts offered: high gas demand translates into high gas prices for the customers, while indexation to low oil prices would have deprived Gazprom of the upside of a temporary supply glitch or a prolonged cold winter. But both are Gazprom’s partners in the Nord Stream 2 pipeline project. Given the opposition to the project, that might count for something if spot prices do indeed go north.

The steady chipping away of the once-sacred principle of oil indexation now leaves very little of it left, in Europe at least; although it is still used in LNG contracts in Asia. That means that it is possible, come the day that oil bounces back, that prices in Europe will start to rise too when the arbitrage opens up.

EU Energy Market Distortions

It might though be a mistake to cheer these renegotiations as a welcome victory for the market. By linking the gas price not to oil or to electricity but to gas, the principles of a market are being followed, but given the environment in which much of it will be used, it will be competing in one of the most distorted markets Europe has: electricity.

A report by the European Commission this week pointed out the wide range of capacity mechanisms on offer and the lack of any kind of systematic approach to the problem facing governments. Most of them overpaid for the capacity and the report is part of an inquiry to help shape a more rational future – as gas now faces.

"European consumers and companies should not have to face black-outs, and capacity mechanisms can help to reduce this risk,” said EU competition commissioner Margrethe Vestager: "At the same time, consumers should not overpay for electricity and competition should not be undermined.” The results of the enquiry will feed into legislative proposals on a revised electricity market design due later in 2016.

The problem is magnified when considered from a pan-EU perspective: actions taken by one government to solve a capacity shortage can destroy investments in neighbouring countries, as Dong Netherlands learned to its cost a few years ago.

The European Union’s energy commissioner Miguel Arias Canete told the European Electricity Forum in Florence March 3 that capacity mechanisms vary from country to country with no consideration of what is happening next door. “Prices need to steer investment to the right location. For this they need to reflect physical limitations in the transmission system rather than political borders,” he said.

He said also there should be no constraints on pricing, although this dogma has so far fallen on deaf ears, particularly in central and eastern Europe, where consumers have been protected from the market and foreign investors have gone home frustrated.

Oil price uncertainty

There may be more news on oil prices after the weekend, when the dust settles on Doha. The mere prospect of the meeting has been given as a reason for the stronger oil price this week, even though commitments to act in concert on output limits are weak and enforcement of those commitments weaker still. Attending will be a host of nations, many not actually members of Opec.

In addition, oil production in North America was lower than forecast in March as shale producers continue to take a pounding. Generally there is great uncertainty about the direction of prices even in the short term.

LNG prices from the US are looking fundamentally weak, however. Working natural gas inventories ended the winter heating season at a record high, according to the US Energy Information Administration. With 2,478bn ft³ still put away, representing a major cash-flow issue, they marginally exceeded the previous end-of-March record high of 2,473bn ft³, set in 2012.

In its April 14 report, the EIA said: “Inventory withdrawals during the traditional heating season – November through March – were relatively limited this year because of winter weather that was the warmest on record and continued high levels of domestic natural gas production.” Nymex gas closed at $2.04/mn Btu on April 13, down almost half a dollar on the same day the year before.

William Powell