Unlike oil markets, natural gas markets have long been regionalized. Transporting natural gas over long distances requires either that the gas be liquefied, an expensive process, or a long pipeline be built, which does not have the flexibility of LNG since the buyers or sellers are always those parties on either end of the pipeline. Historically natural gas was effectively a byproduct of oil production, and most gas was burned off at the source instead of sold to the market. When it was sold, it was unclear how to price it because of the lack of competition. As a result, in many contracts natural gas was indexed to the price of oil based on its energy content, roughly a fifth of crude oil's. This system has lasted more than 50 years in Russia and many other natural gas markets, including Asia. As more pipelines were built in North America, and to a lesser extent Western Europe, companies began to compete, and the competitive price of natural gas was not always the same as oil.
Natural gas supplies have boomed over the past decade and likely will continue to grow. Oil production, however, has stagnated, and as the two markets have moved away from one another so has the disparity between gas-on-gas and gas-on-oil pricing mechanisms. Traditional natural gas exporting countries like Russia and Qatar will continue to hold out as long as possible, but will have to give in eventually to the more market-oriented price formulation. Over the last decade, the percent of natural gas traded on oil-indexed contracts has fallen from about 80 percent of Europe's gas market to now less than 50 percent, while gas-on-gas pricing has risen from less than 15 percent to now around 40 to 50 percent.
The level of price liberalization differs across the continent. The most mature market is close to the North Sea. Thanks to Norway's domestic energy supplies, many independent oil and gas companies sell to Denmark and the United Kingdom, which are well connected into the North Sea's pipeline infrastructure. Countries that are tied into the North Sea supply already buy and sell much of their natural gas using gas-on-gas pricing from some of the regional benchmarks, such as the United Kingdom's National Balancing Point, the Netherlands' Title Transfer Facility and Belgium's Zeebrugge. This region also imports quite a bit of liquefied natural gas, and the region's largest supplier, Qatar, has been forced to open up to pricing more in line with those regional benchmarks. This market is not very important to Russia because the market's needs are almost fully satisfied by the North Sea and LNG imports.
The market comprising Germany and northern France has a mixture of oil and gas pricing. Liquefied natural gas and North Sea supplies can reach these markets and are traded on spot markets such as France's Gas Exchange Point Nord and Germany's GASPOOL, but Russian supplies coming in through Nord Stream and other pipelines still represent a significant portion of the overall market. The lower connectivity to the North Sea markets also means that spot natural gas prices in Germany and northern France are anywhere from $0.25 to $0.50 per million British thermal units higher than those in their northwestern neighbors. For Moscow, the German market is indispensable for supply and political reasons and is Russia's largest export market in Europe.
Southern and Central Europe's markets have been slower to develop a larger natural gas hub-based market. There are hubs in this region, such as Italy's Virtual Exchange Point, Austria's Central European Gas Hub and France's Gas Exchange Point South, but the volume traded and the liquidity of these markets are lower than that of Northern Europe's markets. Algeria and Libya are also two major natural gas exporters to the region, who sign long-term contracts that are indexed to oil prices, like Italy's previous deal with Russia. Because of even lower connectivity to high volume and liquid gas markets in the north, the region's natural gas often trades at a premium. Natural gas prices on France's Gas Exchange Point Sud are $2.50 higher per million British thermal units than those on France's Gas Exchange Point North hub. Italy's Virtual Exchange Point is about $1 per million British thermal units higher than those in the north.
Russia's Options and Advantage
The decision to link Eni's contracts with the Virtual Exchange Point hub is probably the easiest one for Russia. Italy consumes 70-75 billion cubic meters of gas a year, and a little less than 30 billion cubic meters of that supply comes from more liquid markets or Italy's own production. The rest is piped in on long-term contracts from Russia, Algeria or Libya. This means that even with Russia liberalizing its natural gas pricing, the market will not become as liquid as other markets until contracts with North African producers are renegotiated as well. The already slightly higher price of natural gas hubs in Italy also means that the cost of allowing the price to float according to the Virtual Exchange Point spot market price is lower. It is a small tradeoff for Moscow to secure Rome's support against Brussels on the South Stream project, which could be extended to Italy, but that is far from certain. This is why just days after Russia conceded on the natural gas contract, Italian Industry Minister Federica Guidi underlined the strategic importance of South Stream and said that its construction should be adopted quickly. Additionally, Italy's construction firm Saipem has just signed on to help construct the pipeline.
The agreement will also provide leverage for other European countries in their next round of negotiations. Typically, Russia renegotiates its natural gas price every three years while the contracts' volumes remain. The most interesting of these negotiations will be between Gazprom and the large natural gas importers in Germany. E.ON, Germany's largest utility, and Gazprom had a lengthy and tense round of negotiations beginning in February 2010, in which E.ON wanted spot pricing on all gas contracts. That negotiation was headed to an arbitration tribunal before E.ON and Gazprom agreed to a deal in July 2012 that kept the pricing mechanism linked to oil prices.
E.ON is Germany's largest importer of Russian natural gas — importing 20 billion cubic meters per year, roughly two-thirds of Russia's exports to Germany — and will certainly have the upper hand in the next negotiatons. RWE, Germany's second largest utility, took Gazprom to arbitration court in 2013 and won a favorable settlement. With both major German companies negotiating their contracts in the last two years, it is unlikely that either one will immediately call to renegotiate with Gazprom, but when they do, they will have a precedent to use as leverage on price formulation. Both will likely be able to secure similar terms in future contracts.
Moscow is fine with moving away from oil-indexed contracts for countries outside its immediate influence as long as it serves a greater purpose by enhancing the Russian position in other negotiations. Market pressures have already forced Russia to move away from prices that are purely oil indexed. The Asia premium for natural gas still exists and is largely consistent with historic prices determined by the energy content of natural gas compared to that of oil.
In the last five years, Russia has already been forced to move away from oil-indexed prices in Europe. The final price has a component that is determined by oil prices, but the anchoring point has not been linked to oil prices in some time. E.ON and RWE's settlements with Gazprom showcase this. While Moscow has argued that the final price of natural gas should be determined by oil prices because gas still competes in northern Europe with heating oil during the winter, Moscow is keenly aware that Europe (outside of Russia's immediate neighbors such as Ukraine) is moving toward a more liquid natural gas market throughout the continent.
While a small amount of the final price will be shaved off Gazprom's selling price, Gazprom's European market share is under no threat. Natural gas production in the North Sea is in decline, and new production is venturing further and further offshore into deeper water. Shale gas exploration has been feeble in most of Europe, with only Poland and the United Kingdom making strides toward unconventional gas development. While Gazprom, and Russia in general, is expanding oil and natural gas exploration into more difficult areas, the lion's share of Russia's upstream fields servicing the European natural gas market have low operating costs. Russia can beat anyone outside of Europe on the price of natural gas exports to continental Europe, except perhaps Qatar and the North African countries. Russia can offer cheap natural gas prices on contracts in order to dissuade investment into the critical infrastructure needed to import supplies from elsewhere.
Still, for Europe and the European Union, the further liberalization of natural gas markets is an important process of its collective energy policy. Polish Prime Minister Donald Tusk's envisioned energy union that would allow the European Union to collectively negotiate with Russia on energy prices is politically difficult and probably impossible to achieve. Now with Moscow beginning to allow contracts based on spot pricing, the likelihood of an energy union holding together is even lower.
While Russia is diversifying its energy exports to other markets, seen in its natural gas deal with China National Petroleum Corporation, for example, Europe remains its most important market. The European recession has not missed Russia, and the Russian economy overall has struggled over the past few years. In this light, Moscow also recognizes that disruptive energy prices will only hurt its largest trading partner's potential recovery, and Russia on the whole will benefit economically from a recovery, even if Gazprom does not. These forces and new supplies from external markets have changed the natural gas market in Europe, and Moscow will be forced to adapt. Russia's leverage and importance as an energy supplier will remain, but the terms of its arrangements are changing.