IEEJ: March 2013 All Right Reserved

The Pricing of Internationally Traded
Gas: the search for new fundamentals
Jonathan Stern and Howard Rogers
IEEJTokyo, March 6, 2013

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OXFORD INSTITUTE FOR ENERGY STUDIES Natural Gas Research Programme

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The Pricing of Internationally Traded Gas,
ed. Jonathan Stern (OIES/OUP 2012)

1. The Future of Gas – what are the analytical issues
related to pricing? Christopher Allsopp and JonathanStern
2. The Pricing of Gas in International Trade – an historicalsurvey, Jonathan Stern
3. Natural Gas Pricing in North America, Michelle Foss
4. The Transition to Hub‐Based Gas Pricing in Continental
Europe, Jonathan Stern and Howard Rogers
5. Domestic Gas Prices in Russia – Towards Export
Netback ? Simon Pirani, James Henderson and Katja
Yafimava
6. The Pricing of Internationally Traded Gas in MENA and
Sub‐Saharan Africa, Hakim Darbouche
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The Pricing of Internationally Traded Gas, cont’d
7. Pricing of Pipeline Gas and LNG in Latin America,Anouk Honoré and David Ledesma
8. Pricing of Pipeline Gas and LNG in South East Asia,David Ledesma
9. Gas Pricing in India, Anupama Sen
10. Gas Pricing in China, Michael Chen
11. LNG Pricing in Asia, Andy Flower and Jane Liao
12. The Interaction of LNG and Pipeline Gas Prices: does
greater connectivity equal globalisation? Howard Rogers
13. The Gas Exporting Countries Forum: global or regional
cartelisation? Anouk Honoré and Laura El‐Katiri
14. Conclusions: globalisation, cartelisation or a continuationof regional pricing? Jonathan Stern
4Natural Gas Research Programme

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THE GAS INDUSTRY HAS BEEN
TRADITIONALLY RELUCTANTTO DISCUSS INTERNATIONALGAS PRICES: WHY IS THIS?

Lack of transparency has been very
convenient!
5Original Price Logic: fundamentals, and risk
sharing in long term gas contracts
ECONOMIC FUNDAMENTALS: Cost of development and delivery
 Financing (loan) and cash flow requirements
MARKET FUNDAMENTALS: Competing fuels in end use markets
 Ability of customers to switch to other fuels
 Degree of competition from other suppliers

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Producer took the price risk (via the base priceand indexation); buyer took the market risk
(via the take or pay clause)

6For international gas trade outside North
America “fundamentals” = oil price linkage
RATIONALE FOR EXPORTERS: Gas was developed similar to – or along with –oil
 Many gas exporters were also oil exporters
RATIONALE FOR IMPORTERS: Gas was replacing oil products and crude oil Prices were set below, and indexed to, oil toprevent customers from switching (back)Natural Gas Research Programme

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Common rationale: oil prices were setelsewhere avoiding suspicion of manipulation
by exporter or importer

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Natural Gas Research Programme

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FOR SEVERAL DECADES(CERTAINLY UP TO 1990)
THESE WERE SUCCESSFUL,
AND REASONABLY LOGICAL,ARRANGEMENTS IN MOSTCOUNTRIES: WHAT
HAPPENED NEXT?
8In OECD Gas Importing Countries
 Gas became a much larger part of energy

Natural Gas Research Programme

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IEEJ: March 2013 All Right Reservedbalances than had been expected whichmeant that instead of replacing oilproducts, gas began to develop its own
market with non-oil fundamentals
 Oil prices (especially after 2006) increasedmuch faster and to much higher levels
than anybody expected North America liberalised in the 1980s(Britain in the 1990s), creating competition
between suppliers and hub-based pricing
Serious strains began to appear in Continental
Europe post-2008; and in Asia post-20109In Europe and Asia international gas
prices have not reflected market
fundamentals for around 20 years

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No major concern about this because: what matters for the industry is price level
not price formation
 Importers could pass through purchasecosts to their (captive) customers
 All parties made lots of money – and end
users took (most of) the risk
As this highly successful business model
begins to fail, price formation becomes thecrucial issue

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NORTH AMERICAIEEJ: March 2013 All Right Reserved

US Gas Production Projection to 2040

Richard Newell, February 8, 201112

IEEJ: March 2013 All Right Reserved

AEO2011, April 20111313

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US Gas Prices to 2040: in absolute terms andrelative to coalRichard Newell, February 8, 201114

IEEJ: March 2013 All Right Reserved

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Break‐Even Henry Hub Price For
North American Gas Operators

Source: Deutsche Bank15

North America – Continued Isolation or
Key Global LNG Supply Source ?
 North American LNG export projects currently

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being pursued (but not yet approved) total 235
bcma. This is >70% of 2012 global LNG trade!
 US Federal opposition to US LNG exports
seems unlikely. Canada expected to progress
independently.
 Much depends on future HH prices
 Timing (2015+) coincides with Australia andEast Africa LNG ‘wave’.
50-100 Bcm/year of North America LNG Exports could
profoundly impact global balances.
16

Break‐even Costs for North American
LNG Exports in Europe & Asia at $5‐7HH
160.5

14$/mmbtu

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0.521210860.5
1.50.5
3

Break‐Even Price
3Re‐GasTransport24234275Liquefaction
75Henry Hub sustainable
price for dry shale gas0LowHighEuropeLowHighAsia17Natural Gas Research Programme

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EUROPE: THE MOVE TO
HUB-BASED PRICINGInability to adjust long term contract
prices to supply/demand fundamentals
Natural Gas Research Programme

OXFORD INSTITUTE FOR ENERGY STUDIES Natural Gas Research Programme

IEEJ: March 2013 All Right Reserved As fundamentals changed, contracts did not(or could not) adapt
 For a long time this “did not matter” but in
Europe the situation changed post 2008
because of recession, liberalisation andcompetition, LNG supply surplus, hub
pricing and the huge increase in oil prices..
 Oil-linked long term contract prices became
increasingly uncompetitive and..
 Led to European utilities, exposed tocompetition, losing significant amounts ofmoney for the first time
Systems change when Big Players lose Big Money!

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TTF (Hub) and Oil-Linked Contract Gas Prices,
August 2010-January 2013 (€/MWh)Natural Gas Research Programme

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Source: Platts European Gas Daily, Monthly Averages

Source: Platts European Gas Daily, Monthly Averages

2012, hub prices averaged 30% below oil-linked
20
contract prices20

Hubs and Exchanges Have Developed Rapidly
Since 2010
Especially German andDutch markets
Natural Gas Research Programme

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GTF

NORDPOOLGAS

TTF

Traded volumes havecontinued to grow

ICE

APX-ENDEX
Gaspool
ZEE

EEXGas Exchanges are
creating new business
EU and regulators
pushing plans to increase
competitiveness in thegas market

NBP

PEG
NordNCG
CEGH

POWERNEXT

PEG
Sud
PEG
TIGF

PSVMS
ATR

Hubs are still evolving
Natural gas hub

Natural gas Exchange
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OXFORD INSTITUTE FOR ENERGY STUDIES Natural Gas Research Programme

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European Gas Hub Correlations 2012: prices areconverging, no sign of manipulation

Month ahead contracts

Source: ICIS Heren22

Natural Gas Research Programme

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Potential Market Power of Gazprom
 In a globally connected system comprising

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North America, Europe, Russia & CIS and theAsian LNG – importing countries; Gazprom:is the only supplier able to supply volumes
significantly above current levels at short
notice, and this headroom is growing.
 has 700 staff engaged in M&T activities on
European hubs and LNG.
 could influence European Hub prices throughsupply ‘management’.
But LNG may complicate Gazprom’s position,
Russia may be faced with a ‘price-volume’
dilemma24

Natural Gas Research Programme

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JCC-BASED LNG IMPORTING
COUNTRIESWhy has the oil price linkage been
maintained in Asian LNG contracts?
Oil price linkage was introduced in the 1970s when
oil was the main competing fuel to natural gas inJapanese power generation
 The cost pass-through mechanism allows Japaneseutilities to adjust their gas and power tariffs to endusers by the same percentage as the country’saverage LNG procurement cost movements,
regardless of an individual buyer’s actual purchasecosts Projects “need oil linked prices” to support new LNG
supplyNatural Gas Research Programme

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But, post-Fukushima, a new mood/new fundamentals;
Japanese utilities begin to make substantial losses
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What is the main problem related to pricing:is it price level or price formation?
Natural Gas Research Programme

OXFORD INSTITUTE FOR ENERGY STUDIES Natural Gas Research ProgrammeIEEJ: March 2013 All Right Reserved Is the problem that prices are too high?

If so the problem is price level Or is the problem that prices no longer
have any market logic? If so the problem
is price formation
Reducing the price level is a short term solution,
but in the longer term only a change in priceformation will solve the current problem
27

If the problem is the price level –what could be done?
Natural Gas Research Programme

OXFORD INSTITUTE FOR ENERGY STUDIES Natural Gas Research Programme

IEEJ: March 2013 All Right Reserved Reduce the base price Reduce the slope Adjust the “kink points” of the S-curve

What does this achieve: it reduces the level ofthe price, but maintains the JCC mechanism.
But if oil prices continue to rise then constantadjustment is required28

If the problem is price formation –what could be the alternatives?
FIRST: reassess the market for gas, what fuels(energies) compete with natural gas
SECOND: decide which contractual mechanism
would best reflect market conditions:Interfuel competition: a mix of oilproducts/coal/power base price/index
A spot gas index eg JKM or similar and related
to this…
A hub price: physical, virtual, located in Asia

Natural Gas Research Programme

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The basic problem is that JCC no longer
reflects gas market conditions in Japan and has
not done so for many years (like in Europe)29

Price Formation Option 1: interfuel
competition pricing
ADVANTAGES:
Reflect current energy market conditions which
can be monitored over time
Should never get substantially out of line withcompeting fuelsSame as traditional Continental Europeanmechanism so experience is valid
DISADVANTAGES:
Competitive fuels difficult to agree with sellers
May be only a transitional stage to spot/hubprices

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Power companies and city gas utilities would havedifferent price mechanisms – each company would
have its own price mechanism

30Price Formation Option 2: Spot
Pricing (eg JKM)Natural Gas Research Programme

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Spot LNG Price Index:
Advantage: reflects current Asian LNG
supply/ demand balanceDisadvantages:
too few cargoes (at least currently) on
which to base long term contracts
 May reflect global, rather than Asian,market dynamics
31

Option 3: Henry Hub-based pricing
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ADVANTAGES:Established hub price mechanism, nosuspicion of manipulation by Asianstakeholders
Currently lower price than JCC
DISADVANTAGES:
risky if HH prices rise significantly above$6/Mmbtu (and oil price falls)
No Asian market fundamentals
Henry Hub/NBP pricing risks being a short term device
to reduce price level, not a long term solution to theprice formation problem

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Price Formation Option 4: Pricing
at an Asian Hub
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ADVANTAGES:
Provides on-going price reference which
can evolve from physical trade into ahedging/risk management reference with arange of durations
Can be a physical or virtual location
PROBLEMS: needs many (all?) market
players to agree on:location – each country wants its own hub
liquidity acceptable as price referencerules – trading/financial regulation

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Possible locations for Pacific hubs 1
 SINGAPORE: demand/storage is relatively

Natural Gas Research Programme

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IEEJ: March 2013 All Right Reservedsmall with limited potential for growth, but willplay a useful “transitional role”
 SHANGHAI:
China will become the biggest gas market in
Asia by 2020 and the biggest LNG importer
some time in the 2020s
 Good mix of domestic (conventional andunconventional) and imported (LNG andpipeline) gas BUT..
 Market dynamics are different to other countries
 Overly dominated by 3 state-owned companies?
34

Possible locations for Pacific hubs 2
 JAPAN: physical “Tokyo hub” or virtual

Natural Gas Research Programme

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IEEJ: March 2013 All Right Reserved“Hub Japan”?
logical location in Asia’s biggest LNG
market would require universal endorsement byimporters and government (regulator/s)
 Korea: a large enough market for a hub butnot enough market players (similarproblem in Taiwan)?
The future could see a number of different hubs, or thegradual emergence of a single Asian hub; but this will
depend on what market players want (or what theircommercial problems will force them to develop)35

Price Transition in New LNG Contracts
 Buyers need to think hard about which system

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best reflects market fundamentals and allow for
future price transition in Asia
 One possibility is netback market pricing but
anticipating future evolution to hub pricing
 Price review clauses have to be much more
specific than in previous contracts
Agreeing to prices in new contracts which are above
market levels because producers “need high prices”
is not a sustainable strategy and does not provide
security36

Price Transition in Existing LNG Contracts withJCC
Natural Gas Research Programme

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IEEJ: March 2013 All Right Reserved How to get sellers to agree to change Sellers have based project economics on oil-linked prices; may face losses on newprojects
 Contractual/legal problems: is renegotiationand international arbitration desirable,possible, necessary?
This is the most difficult problem facing buyers and will
become acute as new projects arrive later this decade37

The Future of LNG Pricing in JCCCountries
Natural Gas Research Programme

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IEEJ: March 2013 All Right Reserved Prices have to reflect end-user marketconditions OR…
 Market conditions via hub pricing
BUT…
 This will not happen quickly even for newcontacts
 For existing contracts changes will beespecially painful (but will eventuallyhappen)
Linking to Henry Hub and NBP is a transitional phasewhich confuses price formation with price level
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CONCLUSIONS:INTERNATIONAL GASPRICING – THE SEARCHFOR NEW FUNDAMENTALS3925

Globalisation of Gas Pricing, or increasing
regional linkage?
Brent

20Asian LNG
Spot

15$/mmbtu

Europe Oil IndexedContract estimate*.

Average Japan LNGPrice

10NBP

5Henry Hub

Source: Rogers OIESJul‐12Jan‐12

Jul‐11

Jan‐11

Jul‐10Jan‐10Jul‐09Jan‐09Jul‐08Jan‐08Jul‐07

0Jan‐07

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IEEJ: March 2013 All Right Reserved* Before bi-lateral price concessions

40OXFORD INSTITUTE FOR ENERGY STUDIES Natural Gas Research Programme

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Future Gas Price and Contract Dynamics
 A contractual link to oil prices is no longer

logical BUT…
 this does not mean that oil prices are nolonger relevant to gas price formation only thatspecific contractual linkage is no longer
appropriate Hub-based prices will not automatically andalways be lower than oil-linked prices
 Hub-prices do not mean the end of long term
contracts
The analytical challenge is to work out the componentsof, and influences on, hub price formation:national/regional/global gas supply and demand; pricesof other fuels – oil, coal, electricity, carbon
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OXFORD INSTITUTE FOR ENERGY STUDIES Natural Gas Research Programme

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Gas Pricing: the search for new
fundamentals

Only spot/hub-based pricing can react quickly
enough to rapidly changing supply and demand
fundamentals but transition to hub-based pricing
will be painful:
The 1980s and 90s were difficult in North Americaand UK
 Problems in Continental Europe withrenegotiation of long term contract prices fromoil to hub-based (and arbitrations) Problems in Asia as JCC-linked LNG with oil
prices >$100/bbl becomes untenable

Analysis needs to focus on price formation not pricelevel; the trend is towards hub-based pricing

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THANK YOUjonathan.stern@oxfordenergy.org

Contact: report@tky.ieej.or.jp

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