The Natural Gas market can still be considered as “Regional” because of the lack of a unified world market. Instead of that, the market is segmented and each region is ruled by variables related to its own situation such as supply and demand. This generates important price differences among regions but in any case, those prices are tightly linked to the prices of substitute commodities that are comparable to gas, such as crude, and with which the base for price definition is settled. This comparison with substitute fuels occurs due to the fact that these products can be used interchangeably with the gas, for example to produce electricity.
Formulation of Gas prices: The relation between Gas and Crude
To formulate the prices, there are some methodologies to do that, and traditionally all are related to the prices of Substitute Fuels. Added to that, in presence of competitive markets such as United States and England, the trading of gas present a “Price maker”, which is defined by short term prices (Spot in Henry Hub or NBP/National Balancing Point), or by the values in reference markets such as Nymex (United States) or IPE (England).
Such methodologies have the following characteristics:
- Netback: Used in regulated markets (or in presence of clear monopolies), where the price of gas is indexed to the costs of alternative commodities, subtracting transport and distribution costs:
- Netback Value = BP – TC – SC – T
- BP: Price of the cheaper substitute fuel delivered to a consumer (Base Price).
- TC: Transport Cost, from the border to the customer.
- SC: Storage cost
- T: Taxes
- Netback Value = BP – TC – SC – T
- Main characteristics:
- Price Transparency: There is total transparency in price formulation because this method, as it is used in regulated markets, tariffs and details have to be public.
- Supply conditions: Depends on the conditions negotiated with the distributors (generally signing long term contracts.
- Main characteristics:
- Long term Contracts/Natural Gas imports:
- Commonly used between producers and retailers, just like in Spain for example.
- It includes obligations to deliver and take the gas, and price formulation is fixed based on formulas indexed to the evolution of alternative commodities. The formulas have to last during the entire validity period of the contract, which can be of 20 years or even more, for example for heavy users such as thermoelectric plants.
- Every 2-4 years adjustments are made to the formulas.
- The risk is shared between the seller (price risk) and the buyer (volume/supply risk).
- No transparency in prices, only bilateral agreements.
Transparency in prices is a necessary condition to promote the development of competitive gas markets, in an international context. For this reason is highly important that regulators provide sufficient market information to consumers and in that way, guarantee not only transparency but also market efficiency.
Substantial changes: Shale Gas and LNG
It was mentioned that traditionally the formulation of prices is closely linked to the prices of crude, however new innovations and evolution in technology could break this strong link. Three important factors regarding this potential change are:
– Possibilities to switch gas with oil in some sectors has dropped dramatically
– Transportation of gas for long distances is being improved
– High scale extraction of Shale Gas worldwide
Extraction of Shale Gas with the continuous improvement of its technology, and the important advantages that are coming up thanks to LNG (Liquefied Natural Gas), show the potential changes that could produce a turn of the world gas market. Despite that producing liquefied gas for different purposes it has been done since 1920, the means to carry it between very distant points had not yet been developed, and is precisely there where the big difference is showing up, due to the fact that LNG occupies 600 times less space than traditional gas. At the same time, plants or terminals for liquefaction and regasification processes are needed and close the transportation cycle, which represents adding complexity to the value chain. However, investments are increasing to build more liquefaction and regasification terminals, and positive results are starting to appear in terms of cost/benefit relation.
With LNG, transportation costs have reduced between 35% – 50% in the last years, and this can help to break the barrier between the segmented markets and allow the beginning of the transition to a World Gas Market. Adding to that, the shale gas extraction has increased the world gas supply, causing prices to drop not only in United States, where most of the extraction is done, but in the international marketplace due to this interconnection that is beginning to happen thanks to LNG. This “market unification” can cause thedecoupling of gas and crude prices and even to threaten the existence of the massive storage centers that many countries have to guarantee internal supply, because transportation costs can still drop lower so there would not be any need to store gas in that way.
As oil prices are also going down, gas prices had also been considerably affected, however the member countries of the GasExporting Countries Forum (GECF), have expressed in the past months their commitment to continue to support the prices of gas indexed to crude to guarantee fair prices and a stable development of natural gas sources. In the other hand, consumer countries, which are mainly in Europe, would have to revise its current long term gas contracts, which of course are indexed to crude prices and were signed, most of them, with the GECF countries. Such contracts are very important in the sense that allow to finance high scale gas projects and that is why keeping fair conditions to buyers is of big importance.
If this is the beginning of a transition stage, what would come next?
These times bring uncertainties but it is at the same time exciting, having in one hand large Shale Gasreservoirs ready to be exploited, with United States leading the “revolution” but with other countries that are currently defining its own policies regarding shale gas extraction, to allow it or ban it. In the other hand we have LNG making transportation costs to considerably drop and at the same time paving the road for a unified world gas market.
For example, in 2015 GNL price in Asia have reached its lowest levels in history, which allows buyers to obtain excellent conditions in their contracts. United States and Australia are preparing to be the largest gas exporters for the next years, vanishing the doubts about a potential shortage of gas supply.
Regarding gas contracts, this new situation is favoring buyers in the sense that the long 20-year contracts are disappearing and new short term contracts, as short as 1 year and with more flexible prices, are beginning to be the “standard”. Flexibility is due to the fact of indexing the prices not only to crude in a direct way, but also to international gas hubs such as the Henry Hub or European gas prices.
The link with crude still exists but anytime gas market can be a completely independent market. The transparency concept mentioned at the beginning of the article as a necessary condition to the development of more competitive gas markets, is growing clearer every moment, according to sector experts. Is gas market, then, going to depend for a much longer time on crude prices? Which would be the most relevant impact (positive or negative?) if gas and crude are totally decoupled?
Daniel Pinilla | Energy Consultant