Europe — a loosening link to oil prices

Bill White

Researcher/writer for the Office of the Federal Coordinator

As occurred in Japan, the Arab oil embargo of 1973 hit European utilities between the eyes. The six-month embargo slashed world oil production by about 4 percent. An assertive OPEC pushed a doubling of world oil prices from 1972 to 1975.

Western European demand for oil plunged 23 percent during those years. Europeans wanted new suppliers of energy, and in natural gas they had some good options.

Russia had giant gas fields looking for an export market. Norway had big new discoveries in the North Sea. And Algeria, too, was home to some giant fields.

Gas trading was relatively new in Europe at the time. Belgium, Germany and France were the first to import natural gas, from a major Netherlands field called Groningen discovered in 1959.

In trying to figure out how to price gas to provide a fair return as well as the fortune needed to develop the field and pipelines, the Dutch linked natural gas prices to the prices of substitute fuel oils and insisted on long-term contracts.

Russia, Norway and Algeria adopted that pricing structure for similar reasons, and it persists today for much of Europe’s pipeline-gas imports. Those three nations and their handful of mega-fields remain Europe’s top source of foreign gas supplies. (Russia, Norway and Algeria were the world’s No. 1, 2 and 5 gas exporters last year, joined by Qatar and Canada in the No. 3 and 4 positions, with the Netherlands at No. 6. As for gas pricing in Europe, the United Kingdom gas market is more like North America’s than continental Europe’s, as will be discussed below.)

The price link to oil in Europe wasn’t as iron-clad as in Japan, however. Exporters discounted gas prices to reflect the cost of competing fuels — heavy fuel oil for industry and distillate for power plants, the EIA said. Other notable contract features: the gas destination was locked in to prevent a buyer from diverting gas from a lower-priced market to a higher-priced market the exporter also was serving — blocking unwanted competition — and the gas price could get renegotiated periodically.

Since the pivotal economic year of 2008, this decades-long system has been under attack by gas buyers.

The oil-gas price link

The big European gas buyers are playing tough. To show Gazprom they mean business, they have boosted their spot and short-term buys of LNG, often for lower prices than the pipeline gas. They’ve got a motivated LNG exporter in Qatar, which has far more capacity to make LNG than it has buyers. Qatar will negotiate its LNG price. Last year, Qatar sent some 40 percent of its LNG to Europe.

(Qatar gas sold for $15 to $16 per million Btu in East Asia in June, while selling for $9 to $12 in Europe that month and $4.25 in Texas, according to Argus.)

European imports of LNG grew by 26 percent last year, while pipeline-gas imports from Russia fell by 2 percent, the EIA said.

Gazprom is not powerless in this fight — long-term supply contracts are a potent weapon.

But Gazprom doesn’t want to jeopardize its European market share, which underpins its export business.

In some cases Gazprom is changing the basket of oil prices it uses, often adding spot gas prices to the formula, so gas-compared-to-gas pricing is gaining a toehold over gas-linked-to-oil pricing. Usually, the new price is good for a fixed period, such as two or three years. This suits the buyers, who know that oil prices can fall as well as rise.

European buyers also are playing tough with LNG suppliers, not only by sometimes getting better prices than they pay for pipeline gas. Supply contracts are shorter — five to 10 years instead of perhaps 25-year terms from a few years ago. And new language is letting buyers divert cargos to other markets — such as the premium-priced Japan spot market in 2011.

It’s unclear how loose the oil-price link will become for continental Europe gas prices. But Norway recently “switched as much as 30 percent of their contracted volumes to spot-market pricing,” the EIA said.

The British difference

Natural gas is the top fuel source in Great Britain, while in many European countries gas is a mere sidekick to oil as an energy source — in Germany gas was No. 3 behind oil and coal last year.

Like North America, the gas market in the U.K. developed over the past several decades based on its own gas reserves, often from small to medium-sized fields, not imports. That is different from continental Europe’s high dependence on imports from giant fields, according to the Energy Charter Secretariat, a group that upholds international laws to ensure the smooth flow of energy between exporters and importers.

Further, Great Britain began liberalizing its markets in the 1980s, while continental Europe is still deregulating its energy markets.

The nation even developed a hypothetical trading hub called the National Balancing Point, through which gas in the country must “pass.” NBP is akin to the Henry Hub in the United States, an actual trading hub, and the NBP price is typically cited in lists of European gas prices. An active futures market tied to the NBP also helped Great Britain separate itself somewhat from the rest of Europe on natural gas pricing.

During the peak years of Britain’s North Sea production, some gas was dirt cheap, creating another departure from the continent’s oil-linked gas prices. This cheap gas came up wells with oil or valuable gas condensate. Because gas flaring was not allowed and gas injection sometimes wasn’t cost-effective, producers discounted the gas just to get rid of it — just as occurred in Alaska’s Cook Inlet during the 1960s and 1970s, the early years of production there.

All this let U.K. price its gas based on supply and demand within the country, not oil prices. The continent’s oil-linked prices did influence U.K. gas prices, however, because excess British production was exported.

But those exports have ended. Great Britain hasn’t been self-sufficient in natural gas since 2003. The U.K.’s gas production plunged 45 percent from 2003 through last year, while gas consumption dipped 2 percent.

As a result, British utilities and other gas consumers import some gas, mainly via pipeline from Norway’s North Sea fields, but also via pipeline from the Netherlands, especially during winter. This means the nation’s gas price is not completely divorced from the long-term, oil-linked-pricing contracts found on the continent. But the NBP price usually is a little lower than prices found on the continent.

Last year, the U.K. also was officially Europe’s No. 2 LNG importer, behind Spain. But much of the LNG gas landed in the U.K. was then piped to the continent — with Britain’s well-developed gas infrastructure and better-developed gas trading markets a catalyst for delivering the LNG there rather than elsewhere in Europe. (Russia’s Gazprom is a minority investor in one pipeline connecting Britain to the continent.)

Editor’s note: This is a reprint from the Office of the Federal Coordinator, Alaska Natural Gas Transportation Projects, online at www.arcticgas.gov/print/Europe-a-loosening-link-to-oil-prices.