German Court deals a (small?) blow to oil-indexed gas pricing

By Benedict De Meulemeester

By Benedict De Meulemeester on 25/03/2010

It was a long ride yesterday from Berlin back to Frankfurt, and my German colleague Arne and I threatened to run out of conversation topics. But then the radio news gave us a topic that kept us busy for the remaining two hours. A courthouse in Karlsruhe has decided against oil-indexed gas pricing practices by two German suppliers, Rheinergie from Cologne and Stadtwerke Dreieich from Hessen. I've heard about this court case in Karlsruhe a month ago and was watching anxiously for its results. The court ruling isn't the definitive blow to oil-indexed gas pricing that some had hoped for. The judge hasn't outright forbidden oil-price indexation for gas. That's probably for the better. Where do we go when judges decide upon micro-economic realities such as gas price indexation? The ruling, to my opinion, will not be without consequences, like some German papers imply this morning.

Before we go into the details of the ruling some background. When we started consuming natural gas in large quantities in the 1960's, two different market models developed:

1. In the United States and the United Kingdom, pricing systems were created that we call 'Hub markets' or gas-to-gas pricing today. The principle is simple and economically wise. Supply and demand of the natural gas itself determine the price. Such pricing obviously calls for a competitive gas market on the supply side to avoid misuse of market power to push up prices. It is therefore not surprising that the first liberalized gas markets developed in the US and the UK. Such a market model demands a fundamental (Anglo-Saxon?) believe in the powerful force of markets. Security of supply is guaranteed by open access to markets in this model and not by political protection of energy rights. (Although the role of the UK and the US in the Iraq war shows that they are not always such firm believers of this principle either.)

2. In continental Europe, belief in the power of open markets has always been much less. Therefore, a different model was developed, that of the long-term oil-indexed pipeline gas deals (what a mouthful). European politicians of the consuming countries, such as Germany, France, Belgium, Austria, Spain, Italy, etc., negotiated long term supply contracts with the producing countries such as Russia, Norway, the Netherlands or Algeria in the South. Large pipelines were constructed to which only the companies that had invested in them had access rights. Long term contracts were made, guaranteeing the off-take of certain minimum (take-or-pay) quantities of natural gas for up to 30 - 40 years. If you make such long term contracts, you obviously don't want to go for a fixed price. And as no liquid market with gas prices was available, the habit grew of linking the price of gas to the 'first nearby' energy product: oil. There was even some economic logic for doing this. At that time, natural gas was still fighting for its place as a substitute for heating oil. By linking the gas price to heating oil prices, the producers and resellers in the countries of consumption could ensure that the gas price was developing unfavorably compared to the competing heating oil.

In the then regulated markets, the official tariffs reflected the underlying costs of the monopolistic suppliers, i.e. of the prices going up and down with the oil prices. So we have all grown accustomed to the fact that our gas prices rise, not because of supply and demand dynamics of the gas itself, but because of what is happening in the oil markets. But if you think about it, it isn't exactly logic. It's a little bit like selling potatoes for the price of tomatoes. They are both vegetables, but if the growing season for tomatoes goes wrong, this doesn't necessarily mean that the growing season for potatoes was also a failure. So if you have linked your potato price to the tomato price, you will inevitably find yourself sooner or later in a situation where you find yourself paying a high price for a product that is in abundant supply (i.e. when the tomato and not the potato growing season went wrong).

Since the middle of 2008, we find ourselves in exactly that situation in the gas markets, which brings oil-indexed gas pricing in an increasingly difficult situation. Whereas the oil prices have doubled after hitting their lowest point in February 2008, the gas prices on the Hubs have fallen since the middle of 2009. The gaspool Hub price for German gas published by has fallen by 63% compared to June 2009. This falling gas-to-gas price reflects fundamentals, namely the increasing inflow of LNG into the UK and the increasing supply of gas to the world markets due to the shale gas developments in the US. Many observers cite decreasing demand due to the economic crisis as a main reason, although that isn't completely correct. We come out of a winter with record high demand due to the cold weather, and in that winter the spot price for gas never was much higher than 17 euro per MWh. This clearly shows that increased supply is an important gas price driver at the moment.

Now let's go back to the Karlsruhe court case. This is a clear case of consumers complaining that they get potatoes sold at the price of tomatoes. And of course, a judge cannot outright forbid the practice. But the ruling does say that oil-indexation cannot be used as a justification of price rises if the underlying costs for the suppliers haven't risen equally as much. This could have some important ramifications. Gas suppliers currently win a lot of money on oil-indexed vs Hub-indexed gas arbitrage. For example. If the Hub price is low, as it currently is, they only buy their minimum obligation (take-or-pay volume) from the gas producer. If the total sum of consumption of their clients is larger than that take-or-pay level, they buy the extra gas on the Hub and sell it against oil-indexed prices to their clients. The Karlsruhe court ruling puts such money spinning based on oil-indexed end contracts in question.

Moreover, the big German gas suppliers seem to have understood that the current decoupling of gas and oil prices could continue. They have therefore renegotiated their Gazprom contracts and the Russian gas giant is now indexing part of its gas prices to the Hub prices. However, in the retail market, the big suppliers continue to encourage clients to buy gas at oil-indexed prices. Isn't that another example of what the Karlsruhe court ruling calls a price rise based on oil-indexation that is not supported by the real cost structure of the suppliers?

It remains to be seen whether the court ruling could have any short term practical consequences for industrial consumers that are frustrated with their oil-indexed gas contracts.  But I am convinced however that it could have some longer term consequences:

1/ As large European gas resellers try to renegotiate terms with Russians and Norwegians to include Hub components in the gas price indexations, the court ruling will help them in stating their case,

2/ It draws consumers attention to the ambiguity of oil-indexed gas pricing, which many large industrial consumers, especially in Germany, take for granted. They are easily convinced by suppliers' arguments that oil-indexation is 'safer'. Many think that the Hub market is a spot market. IT IS NOT ! You can buy gas for 2013 today based on Hub pricing. That's not exactly my idea of a spot market. Still, today, in almost every German newspaper I read, I find that the Hub markets are described as spot markets and spot markets are more risky. The raw facts, however, are there. If you have chosen an oil-indexed gas contract 12 months ago, you pay a lot more than if you have chosen that 'risky' Hub price. Moreover, if you had chosen a Hub contract five years ago, you would have suffered spikes that never went much higher than oil-indexed price spikes and your average gas price over those five years would have been substantially lower. The Karlsruhe court ruling might help consumers to have a fairer assessment of hub prices. I found out at least one German client today where the articles on the court ruling were being mailed around.

3/ It will draw politicians attention to the problems of continuing with oil-indexed gas prices if Hub gas prices stay where they are. The papers cited several German politicians that pleaded for ending the oil indexation, the long term contracts along with it and go for a fully liberalized gas market. That is very remarkable in a country where a former chancellor hammered out the North Stream pipeline deal (all very long term and very oil-indexed contracts) and was rewarded with a top job at the company constructing it.

The decoupling of gas and oil prices is an extremely interesting event. We are not predicting that it will continue. However, if you look at reserves of natural gas and oil, you cannot deny the potential of it continuing. If it doesn't, it is because somebody blocked the import of extra quantities of gas into Europe. Long term oil-indexed pipeline gas deals are an excellent instrument for doing so. The Karlsruhe court ruling could be an important milestone in fighting such blocking of the markets by oligopolies. Let's hope it will turn out to be so.

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