Nov 22, 2012 | 10:05 GMT

4 mins read

A Change in Natural Gas Pricing for Europe

A Change in Natural Gas Pricing for Europe

The 10-year natural gas deal signed Nov. 20 between Germany's Wintershall and Norway's Statoil highlights a fundamental change in the way traditional natural gas exporters to Europe price their product. The contract, which will account for 6 percent of Germany's annual consumption, is based on spot-market prices rather than on oil-indexation like previous contracts, and it has two significant implications. First, the size and duration of the deal suggests that Germany will continue to prefer long-term contracts from its two largest suppliers, Norway and Russia, the latter of which signed a similar agreement with Germany's E.On earlier in 2012. Second, the move away from oil-indexation confirms a trend of pricing less subject to the volatility of crude oil prices. 

Europe is still far from having a fully liberalized natural gas market, and European consumers will continue to prefer long-term contracts to ensure a stable supply. But changes in the European natural gas market will spur deals across the continent that, like the Statoil-Wintershall agreement, will have markedly different pricing structures. 

Continental Europe's move toward a spot-market system, in which prices are based on the offer and demand of the commodity, has been slow. Despite efforts by the European Union and the European Commission to liberalize Europe's natural gas market, there are too few reliable alternative natural gas suppliers. With the majority of the natural gas coming from large traditional suppliers, long-term contracts continue to be the safest bet for high-volumes of the commodity.

For now, the pressure on the natural gas trading system is not strong enough to bring about a change in the system's contract structure. However, the growing availability of cheaper liquefied natural gas around the world has traditional suppliers worried that they may face fiercer competition in the future. This is particularly concerning for Russia, which has frequently used natural gas as a political and strategic tool against its European clients, who are looking for less risky alternatives.

Aside from the growing potential of alternative natural gas sources in Europe — shale gas reserves remain a long-term option — the growing interconnectedness of the European natural gas networks and the strengthening of the EU energy regulatory framework is making it difficult for producers to pursue independent energy policies with its various European customers. This translates into fewer rigid, unilateral discounts for strategic consumers. While we already have seen Russia discount its natural gas contracts to relatively minor markets, such as Poland, Moscow did so only after giving discounts to larger markets.

Progress Toward Normalization

The next step in price normalization will occur in the actual structure of natural gas pricing. The traditional price model for long-term consumers of piped natural gas in Europe has relied on the indexation to oil products, where a percentage of the price is attached to that of oil products. In theory, consumption and production patterns, as well as geopolitical risk, should have undone the price correlation between natural gas and oil as they did in the North American market. However, traditional suppliers to the European market continued to be able to set pricing structures to their advantage due to their hold on market supply. They therefore maintained the oil-indexation system as crude prices rose throughout the past decade.

With alternative sources of natural gas possible for large European consumers and with a more integrated European market able to present a unified front against traditional producers, the pressure is on to change the pricing structures to remain competitive and retain market share via long-term contracts. Baseline discounts on natural gas prices are no longer sufficient to satisfy European consumers, who can see all their gains from discounts disappear if a crisis causes a spike in oil prices — and by extension, their own natural gas prices.

As for baseline discounts, the larger markets will be the first customers to benefit from a change in pricing structure. It is therefore unsurprising that Norway and Russia have offered changes to the oil-index structure to Germany. We have also seen Italy beginning to negotiate with Russia to end the take-or-pay system, one of the other mainstays of natural gas pricing structure.

We can therefore expect to see more negotiations and deals similar to the Wintershall-Statoil deal being struck across Europe, even in smaller markets, that challenge the primacy of oil-indexation for natural gas pricing. For major natural gas producers that supply the European market, this will mean a significant reduction in their ability to profit from oil price instability and in the short- to medium-term will translate into a more stable yet lower-yield market.

This is not that bad an outcome for large suppliers like Norway and Russia. The former is facing declining reserves while the latter is prioritizing the stabilization of its hydrocarbon revenue stream as the risk of domestic and financial instability due to high oil prices increases.

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