Eastern Europe: Import Dependence, Higher Prices

Simon Pirani, Senior Research fellow, Oxford Institute for Energy Studies showed delegates at the Ukrainian Energy Forum a long list of arbitration cases that had resulted from the changing conditions in the European natural gas market and said these were due to changes in that market. Mr. Pirani also showed a list of prices from the Russian newspaper Izvestia.

"What they show is the prices at which Russian gas is being purchased in different European countries, and this tells quite a simple story. If you're in Eastern Europe, and you are quite heavily dependent on Russian gas, you pay more than $500/TCM; if you're in the UK, where we have a pretty much complete domination of gas-to-gas market, you pay $300, or $370+ in Germany, which is somewhere in between," he explained.

Of the implications for Ukraine, he said there had been no results despite negotiations with Gazprom since mid-2010.

"There's a big question mark over the dominance of oil-linked prices in Europe - that's obviously a very big consequence for Ukraine. As a result of the high price environment, we've seen a more consistent focus from the Ukrainian government on finding alternative sources of import, on increasing Ukraine's own production, and on cutting gas consumption, " he said.

Of alternative sources of import, Mr. Pirani said the Oxford Institute's favorite was reverse flow from Europe, which he noted had already occurred from Poland.

"How could the obstructions to greater reverse flow be removed?" he asked "It could be a good short and medium term gain for Ukraine, giving it the possibility to be exposed to these lower prices in Europe."

Importing LNG, he opined, could be difficult and expensive for Ukraine.

In the longer term, changes in the Russian market could make enormous changes for Ukraine, as he contended that things were moving on in the Russian market.

"Central Asia frequently comes up in these conversations," he said. "The problem we see with respect to Central Asian gas is indeed price. We've tried to work out the net back which Turkmenistan was receiving to Ukraine versus China, and they must pay very high prices, on a net-back basis paying a $50 premium compared to what Chinese were paying." Russian prices were much lower, he noted.

As for the Russian purchase of Central Asian gas, he said it might be easier coming from Europe than negotiating a price with Turkmenistan. He said there were two other possible responses to high prices in Ukraine.

"Firstly, to increase its own production, but the question is will the new projects we've heard about make up for the natural decline in already producing fields, and if they will do more, when will they do more?" queried Mr. Pirani. "The second thing is energy saving and fuel switching."

His graph showing Ukrainian energy demand over the last six years showed that each sector had reduced its consumption since 2006, the result of economic recession, or through energy efficiency and fuel saving.

By comparing the Russian and Ukrainian economies, which generally had similar industrial structures, he said: "What we've seen in Russia between 2008 and 2012 the economy has been more or less flat, but gas consumption is more or less where it was in 2008; Ukraine, unfortunately, has not quite recovered in economic terms where it was in 2008, but gas consumption in 2012 was 20% lower, which suggests to me that there is a considerable amount of saving through energy efficiency and fuel switching, and that of course is good news."

He told delegates that natural gas had four distinctive price bands: in the US, $3-4/MMBtu; $10 in European gas exchanges; oil-linked pricing; and in Asia $15-20/MMBtu and reported that the Oxford Institute had done research into how the price had developed in these markets.

"LNG has altered the picture," said Mr. Pirani, who explained that there had been no convergence, and that in the last three years gaps between the prices had widened. Did this signal the "Globalization of Gas Pricing?"

He said that the Oxford Institute's main conclusions were that regional markets were becoming linked by LNG but there was no global market; the volume of cross border trade was increasingly influenced by international prices; Europe was moving away from oil-linked prices; there was a trend towards gas-to-gas pricing, but it wouldn't always be lower than oil-linked pricing; cartelization was a considerable way off; and the disequilibrium was to continue.

Gas prices in Europe, said Mr. Pirani, were linked to spot pricing, which was taking over from oil-linked pricing as the dominant pricing in Europe. To illustrate this, he showed the spread of German contract gas and NBP from 2006-2012.

He said that in 2013 would probably be first year when most European gas was sold at "spot" prices (in 2011 spot pricing comprised 42% of the total).

"The results of our research is, we see this as a one-way street; given the underlying economic rationale for oil-linked prices no longer exists, we do not see a road back to a European market dominated by oil-linked prices," he stated.

Mr. Pirani reported that in recent months the Oxford Institute had entered into a very lively discussion with Gazprom about the future of the European market. "Our friend Sergei Komlev of Gazprom Export has written a long article, published last month, in which he argues that there has been a systemic failure of the natural gas pricing model based on supply and demand. He argues that there are only two feasble ways of pricing gas in the European market: one is the oil-linked pricing, which is what existed historically, and the other is what we all called 'hybrid pricing' which we have at the moment - partly oil-linked, partly gas-to-gas pricing."

Mr. Komlev's rationale for the pricing link to oil being justified, he explained, was because oil and gas were often produced together and could compete in the transport sector in the future.

"My colleagues, Howard Rogers and Jonathan Stern, however have recently responded to Sergei with an article which argues that hybrid pricing will inevitably give way to gas-to-gas pricing," he said. "They say that the co existence of oil-linked prices and hub-based prices is unsustainable; they believe that oil/gas competition in the transport sector may be significant in the future, but it is not now."

There was agreement, however, that oil and gas prices would affect each other in various ways, but were less likely to be linked contractually.

Of the consequences for Gazprom of its "stubborn defense" of oil-linked pricing, he said the Russian share of imports into the European market had continued to fall, but this was not a result of recent changes in the market. "The former Soviet Union used to account for plus 40+% in the late 1990s and now it has fallen from around 30% to just above 25% in 2012. This is always interesting to show to audiences in Europe, where we hear so much concern about dependence on Russian gas - it's been going down for several years, and because of changes in the market, it has gone down even further."

Gazprom, noted Mr. Pirani, had had to renegotiate contracts with gas importers and had agreed to gas prices at spot levels temporarily, giving concessions on price levels and take-or-pay levels.

The Oxford Institute, he said, had drawn two conclusions: "Neither side wants to terminate the long-term contracts. The last year or two there's been a lot of discussion about whether long-term contracts would survive in the market, but we see that both sides want to stick with them and that negotiations last year have narrowed the gap between spot and contract price, giving the buyers protection while retaining oil indexation as the seller has wished."