“Triple Whammy” in

Global Pricing for Natural Gas:

Practical Implications

Energy Dialogue IMEMO RAS

October 24, 2017, Moscow

Sergei Komlev Head of Contract Structuring and Price Formation Directorate

Gazprom Export*

*Views expressed in this presentation are the author’s sole responsibility

and do not necessarily represent that of Gazprom Export

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Statements to be Made in This Presentation

Time has come to evaluate results of the buyer-side efforts to impose pricing mechanisms based on supply and demand instead of the traditional forms of pricing in Europe and Asia, which have proven their efficiency. “Gas should be priced at a price of gas and not that of oil/oil products”, say critics of oil-indexation in the LTCs.

Despite all the attempts to change pricing paradigm, global gas prices are still a reflection of scarcity of oil rather than gas both in Europe and Asia, while in the USA a linkage to oil reinstated itself in an exotic way over a course of shale gas revolution.

Although a strategic goal of putting supply and demand instead of oil in a driver seat of the natural gas price developments was not achieved, reforms created the malfunctioning hybrid pricing mechanisms. Still dependent on oil, hubs make a situation with low oil prices even worse. Hub prices do not represent real value of natural gas and leave investment projects in the industry out of money, thus creating a risk of missing the next investment cycle.

Producers and exporters of gas should come to common assessment based on an unbiased analysis of the problem and work out practical measures to resists negative trends in pricing.

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Natural Gas Market is the Only One of its Kind:

Three Special Features

There are three main features of natural gas as a commodity which require special attention:

• Market prices of natural gas are set up by two forms of competition – gas-on-substitute (interfuel) and gas-on-gas competition. No other global commodity is characterized by this duality.

• LTCs play a leading role in the global natural gas supply and here to stay for years ahead, while a move to exchange-based pricing in other commodities is associated with elimination of the long-term contact arrangements or their radical transformation.

• Simultaneously functioning different pricing mechanisms in natural gas have direct effect on hub price, making it a hybrid product both on macro and micro level.

Assessment of these specific characters of natural gas as a commodity represents not only an academic interest but has sensible practical business-related implications.

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Competition with Other Hydrocarbons Locks Natural Gas in

Price Envelope

4 Source: Shell Source: Shell

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Interfuel Competition at Work: Oil Price Sets a Resistance Level for Natural Gas Prices

•

Source: BP, Gazprom Export

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Interfuel Competition at Work: Coal Price Sets a Support Level

for Natural Gas Prices

•

Source: BP, Gazprom Export

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Depressed NA Natural Gas Prices are Competitive with

„Expensive‟ Grades of Coal Only

* Coal and natural gas prices compared on an equivalent energy content and efficiency basis

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Special Arrangements are Required for Gas to Outcompete Coal

4

35 98 141

106 157 204

194 221 240

247 214 155

250 230 195

227 189 165

247 214 155

181 104 57

121 170 38

0

100

200

300

400

500

600

US

D /

mcm

NBP actual price Switching price

0

100

200

300

400

500

600

US

D /

mcm

NCG actual price Switching price

NBP compared to UK coal-to-gas switching price

NCG compared to German coal-to-gas switching price

Sources: Argus, Platts, IEA

*NBP day-ahead **NCG day-ahead

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Interfuel Competition at Work: Gas Price Corridor Width is Determined Mainly

by Oil Price Volatility and Stretched from Nearly Zero in 1988, 1995 and 1998 to 12

USD/MMBTU in 2013

9

Source: BP

Source: BP, Gazprom Export Source: BP, Gazprom Export

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Asian Market: Two Simultaneously Pricing Mechanisms

Represents Represent a “Toxic” Hybrid Structure There are two pricing mechanisms simultaneously functioning in Asia. Asian supply is still dominated by oil-indexed LTCs (Slide 11). Hubs in Asia are in the stage of initial formation, but there is OTC trading. The Platts’ Japan Korea Marker (JKM) index serves as proxy for the price of spot LNG trades.

Over the last five years there were upward and downward movements of the JKM depending upon supply and demand conditions in the uncontracted segment of the market. The JKM index tends to be higher than the Japan LNG price index in winter and then lower in summer but is still correlated to baseline LNG oil-indexed (Slide 13).

That kind of behavior does not make JKM a trusted price benchmark for the whole Asian market but only for its small segment represented by spot trading. As such it overreacts to minor, even “homeopathic” imbalances (Slide 14).

According to our estimates, an oversupply of 3 bcm was enough to cause a dramatic collapse of the JKM index in March 2014. Gas exporters should be extremely cautious in dealing with that excessively volatile market segment and its proxy index.

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Pricing Mechanisms in Asian and Asian Pacific Gas Consumption

Pricing Mechanisms in Asian and Asian Pacific Gas Imports

Source: IGU

Oil-indexed contracts Gas-on-Gas Other Oil-indexed contracts Gas-on-Gas Other

Asian Markets are Still Dominated by Oil Indexes which Set

Baseline Trend for Spot Trades

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Asian Demand is of Seasonal Nature

Source: PIRA

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JKM Prices are Highly Volatile: Could Drop 220 mmcm below and Surge

100 mmcm above the Baseline Trend Set up by Oil Indexed Import Prices

Source: JKM, METI

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Asian Markets: Hub/Spot Prices do not Reflect Demand-Supply

Fundamentals when the Market is in „Oversupply‟ or in „Undersupply‟

Source: Compass Lexecon

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Spot Prices in Asia Collapsed in March 2014 Due to Insignificant

Supply/Demand Mismatch in Uncontracted Segment of Market

Source: Bloomberg, Cedigaz, IHS, METI

0

5

10

15

20

25

JKM Japanese LNG Import Price

$/MMBTU

Gas Consumption in Asia

50,3 47,4

0

200

400

600

800

2013 2014

Bcm

Spot and Short-Term Trade* in Asia

* Contracts of a duration of 2 years or less

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European Gas Market: Over-Contracting and Price Degradation in Place

• There is strong evidence that hub prices in Europe are still dependent on oil indexes, meaning that even now they are driven mainly by the fundamentals of oil market. This casts doubt on the conclusion of the last IGU Price Survey which points to nearly complete OPE mechanism elimination in Europe and NWE especially (Slide 17). According to Gazprom export estimate, oil and quasi-oil indexation still maintains its prevailing role in European gas pricing (Slide 18).

• That means that hub prices of gas are the derivatives of oil prices. We expect them to be within a corridor of USD45-55 per barrel in the foreseeable future, which equals to the breakeven costs of US shale oil. Gas/oil linkage is not a problem as such, the problem is an unjustified discount of gas to oil prices.

• LNG deliveries to Europe taken full costs of liquefaction (from USD3.3 to 5 per MMBTU) are loss–making and cast doubts on expectations of gas market globalization based on flexible LNG flows.

• The origin of gas to oil price discount is an artificial oversupply of paper gas which puts downward pressure on the hub prices. This market failure could be fixed by taking nomination rights away from the buyers. It could be achieved by eliminating volumetric flexibility in the LTCs and adjusting contract volumes to baseload.

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Pricing Mechanisms in European Gas Consumption

Pricing Mechanisms in European Gas Imports

Source: IGU

Oil-indexed contracts Gas-on-Gas Other Oil-indexed contracts Gas-on-Gas Other

IGU Report Overestimates Role of Pricing based on Supply

and Demand Due to Ignoring Transitory Forms of Pricing Mechanisms

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When Quasi-Oil Indexed Contracts are Taken into Consideration, Oil

Indexes Retain Their Dominant Position in European Prices

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In Quasi Oil-indexed Contracts Oil-Linked Formula Stays on but Contract Price

is Placed in Corridor in Oder to Mitigate its Deviations from Hub price

Source: LONG-TERM GAS IMPORT CONTRACTS IN EUROPE. THE EVOLUTION IN PRICING

MECHANISMS.Luca Franza.© 2014 Clingendael International Energy Programme (CIEP). P.15.

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Hub-Based Gas Prices in Europe Move in Tandem with Oil/Quasi Oil-Indexed

Contract Prices

Even if oil-indexation elements are being substituted by hub ones, prices of LTCs exercise strong influence over hub prices and are setting up a trajectory for their movement by acting as “price anchor”. Hub prices are therefore not independent: they are derivatives of the contract prices that set a baseline trend for their behavior. Supply and demand only mutate their changes

Source: BAFA, Bloomberg, World Bank

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ACER 2016 Report: Correlation between Oil and Gas Prices is

Still High

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Correlation and Regression Analysis Indicates that TTF Price Dependence on LTC‟s

Prices is Increasing

Correlation

(TTF MA,

USD/mcm)

Time period Brent,

USD/barrel

Oil Price:

Six month

moving

average

Oil Price:

Nine month

moving

average

2008-2016 76.6% 85.5% 83.3%

2008-2013 69.9% 84.7% 81.9%

2014-2016 79.5% 87.3% 88.7%

R Squared

(TTF MA,

USD/mcm)

2008-2016 58.6% 73.1% 69.4%

2008-2013 48.9% 71.8% 67.1%

2014-2016 63.2% 76.3% 78.6%

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*Demand Includes import contracts and indigenous production

Source: Cedigaz, Eurostat, IEA, Gazprom Export LLC Database

Overcontraction as Factor of Hub Price Degradation

560

578 577 589

604 601 583 579 575

562

587

609

559 553 546 557

522

561

506 494

486

431 449

486

400

450

500

550

600

650

700

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

bcm

Contracted volume Consumption

Under-contracted

market

Balanced market Over-contracted market

1

25 31 32

82

39

77 85 89

131 138 123

0

50

100

150

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Delta,

bcm

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Illusion of Oversupply Created by Monetization of Contract

Commitments on the European Forward Market

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North America Market: Shale Gas Became By-Product of Shale Oil and

Liquids Production which Led to its Oversupply and Underpricing

• On the US gas market price distortions have acquired a systemic nature and are only

getting worse. The outcome of these distortions is the lasting inability of price

mechanisms based on supply and demand to provide sustainable price signals that

support investment in dry gas production.

• As prices for shale oil are higher than prices for shale gas, producers are flooding the

market with the associated gas volumes ignoring the negative pressure on prices that

these volumes create. As a result value of gas is jeopardized in favor of oil.

• We can observe this dependency through noting that production of natural gas in the

US leveled off and started to contract for the first time since the start of the shale gas

revolution largely because oil-associated gas production has fallen (Slide 20).

• There is nothing extraordinary in the fact that companies in liquid-rich shale plays

responded right away to the dramatic drop in oil prices that resulted in prices below the

cost of production by shutting down production ten months ahead of natural gas-

oriented shale plays.

• A shift to oil/liquids rich planes made natural gas prices “an added bonus” to prices of

the former.

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By-Product Nature of Shale Gas: Number of Gas Rigs Decreased while

Production Kept on Rising; it Stabilized when Number of Oil Rigs Dropped off

Source: Baker Hughes, IEA

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Oil-Weighted Production Tilts Shale Play Economics*

*Sunk costs excluded

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Although NA Gas Prices are Formally Disconnected from Oil, their Linkage

Reinstated itself in Negative Correlation with Tight Oil Production

Period

Correlation

Henry Hub price and American

tight oil production

2008-H12017 -53,4% 2010-H12017 -47,1% 2014-H12017 -72,8%

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Available on the publishing house site for free under reference: http://demianagency.com/OIL_INDEXATION_THE_BEST_REMEDY_FOR_MARKET_FAILURE_IN_THE_NATURAL_GAS_INDUSTRY.pdf

For Research on Different Gas Pricing Mechanisms Interaction see the Last Publication by Sergei Komlev