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Chipping away at Gazprom’s contracts amid falling demand

With demand in its largest market declining, Gazprom is making price concessions to its big European gas customers. Will its passion for oil-indexed prices be next to succumb, asks Kwok W Wan

The continued divergence between oil and gas prices, coupled with lower gas demand, has prompted Gazprom to reduce long-term prices for five large European customers. And the move might not only signal that other customers will see similar concessions, it could also be another blow to the Russian gas monopoly’s desire to maintain oil-indexed gas contracts.

Most of Russia’s gas is sold to Europe under long-term, oil-linked price deals. But with North Sea Brent crude prices and those of European gas diverging over the past two years – oil prices have soared, while gas has registered just a small increase – European utilities, forced to buy at higher oil-indexed prices, yet selling at lower spot prices – have run up substantial losses. Europe’s gas buyers are, understandably, trying to renegotiate loss-making oil-linked deals.

And they have met with some success. On 13 January, Gazprom deputy chairman Alexander Medvedev said: “Gazprom Export [has] reached and formalised agreements with several big customers in Europe, providing for a certain price correction for Russian natural gas supplies, in view of changing gas market conditions in Europe, the state of the economy and, in particular, in the energy sector of a number of European states.”

Gazprom confirmed the customers were France’s GDF Suez, Wingas (a joint venture between Gazprom and Germany’s Wintershall), Slovakia’s SPP, Sinergie Italiane and Austria’s Econgas. This year, the five firms are expected to buy a total of 35 billion cubic metres (cm), or the equivalent of 23% of Gazprom’s 2012 export volumes, according to Russian investment bank VTB Capital.

Although Gazprom did not provide details of the price correction, it is likely to be a temporary cut in the oil-linked element of the contracts.

“If you analyse all the Gazprom statements, you see two very important issues,” said Tatiana Mitrova, head of global energy at Russian consultancy Skolkovo. “First, there was no spot-price component increase in the price formula [for contracts where it was introduced previously] and there was no introduction of this component in the other contracts.”

“Second, it was not a simple price discount – it is much more complicated: several coefficients [not the base price] in the oil-linked price formulas [which comprise many components and differ from contract to contract] were reviewed,” she added.

Europe’s gas buyers have squeezed a number of concessions out of Gazprom, notably the inclusion of a spot element of up to 15% in some contracts in 2009, but the Russian firm has insisted that an oil link is necessary to maintain its investment in exploration and production.

More spot inevitable

But, JP Morgan says, the take-or-pay structure of most gas contracts increases the spot-price element if customers buy more Russian gas. This is because minimum take-or-pay volumes are oil-linked, while anything above the minimum take-or-pay volume would be spot linked. “Based on our estimates … it means around 25% of gas volumes are effectively linked to spot prices,” said Nadia Kazakova, Russian oil and gas analyst for JP Morgan. “Unless gas spot prices sink lower and oil spikes higher, European customers might be happy with the arrangement.”

But Gazprom’s willingness to cut prices instead of directly increasing the spot element also shows its determination to keep oil-indexation alive for as long as possible, and is a way for the company to keep market share without offering more spot-pricing. “Gazprom’s decision does not mean a softening of its stance on oil-linked contracts,” Mitrova said. “Gazprom acts in its traditional paradigm of oil-linkage and has given no sign it will retreat from it. The company doesn’t seem to agree that there is unstoppable change in the way gas is priced.”

Russia has been facing increasing market competition from Qatari liquefied natural gas (LNG) exports over the last two years. Europe has been flooded by LNG, which has eaten into Russia’s market share. In 2011, the UK imported around 25 billion cm of LNG, according to data from Nats PanEurAsia, a 34% increase, year-on-year. And, late last year, the Netherlands opened its Gate LNG import terminal, adding a further 12 billion cm/y of European LNG import capacity.

Positive for E.On and RWE

Gazprom’s price cut could also be a positive sign for its other customers, with E.On and RWE saying at the end of last year that they had managed to renegotiate, or end some loss-making gas contracts. As well as talks, the two German utilities, together with Poland’s PGNiG, are also taking Gazprom to arbitration over contracts.

Declining European gas consumption could also speed the move away from oil-linked contracts, with demand in 2011 dropping by 11%, to around 473 billion cm, compared with a year earlier, according to estimates by Société Générale (SocGen). And the French bank does not see demand recovering quickly. “Our model sees gas demand reaching pre-crisis 2008 levels (of 520 billion cm) only in 2018, which is not positive,” said SocGen gas analyst Thierry Bros.

Europe is Russia’s biggest and most important gas market. Cedigaz data showed Russia exported 130.6 billion cm of gas to Europe in 2010, meeting almost a quarter of the continent’s demand. But the worsening economic outlook has reduced industrial activity, cutting gas consumption. And a recovery is unlikely to be swift, with no easy solution to the eurozone debt crisis in sight.

The argument for a break with oil-linked gas has been going for years. Gazprom has dug in its heels and is still resisting the move. But as gas demand slumps in its most important market, the Russian monopoly has been forced to give ground on price. Who knows what part of the contract may be next to go.

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