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E.On and Gazprom in gas-price deadlock

E.On Ruhrgas is taking Gazprom to arbitration over long-term gas pricing in a process that could take years – and has the potential to seriously hurt the Germany utility

E.On Ruhrgas, a subsidiary of utility E.On, buys gas from Russia’s monopoly gas exporter based on an oil-linked formula. But with oil prices rising over the last three years, while natural gas and power prices have remained flat, its profits have been crushed. The company, which wants to change the pricing formula, has been in negotiations with Gazprom over amending the deal. But the Russians favour oil-indexation.

“We can confirm that we have instituted arbitration proceedings in connection with our supply relationship with Gazprom,” E.On Ruhrgas said on 1 August. “The possibility of either party initiating arbitration is expressly envisaged in existing supply contracts with producers if no agreement is reached in price renegotiations within a certain period.”

Pricing talks started in February 2010 and lasted more than a year, said Sergei Chelpanov, deputy director-general of Gazprom Export. In January last year, Gazprom agreed to include a hub-pricing element of between 15% and 20% in the contract, and to allow some oil-linked gas volumes to be received at a later date – European gas demand slumped in 2009 as a result of the recession leaving much of the region long on supply.

But E.On wants spot pricing in all gas contracts, according to media reports. In March, it claimed 2011 full-year earnings from its gas division could be halved – to just €700 million ($965 million) – because of high, oil-linked prices. E.On is due to release its next set of financial results next week.

Lengthy process

The arbitration process between E.On and Gazprom could take a couple of years, which would be painful for the Germany utility. “The length of the arbitral process can vary greatly, depending on the subject matter and complexity of the dispute. As a rule of thumb, a typical arbitration might take between 18 months and two years,” said Nicholas Fletcher, head of international arbitration at law firm Berwin Leighton Paisner.

But, he added, arbitration is likely to put an end to the dispute. “Once an arbitration award is issued, it is most unlikely to be susceptible to appeal,” Fletcher said. Both parties say negotiations will continue, despite the arbitration.

More pricing pain

E.On joins its German rival RWE in turning to arbitration to resolve a pricing dispute. RWE is also in arbitration over long-term contracts, but has not named the supplier. E.On’s decision to take the row to arbitration is more significant, however, because it is a much larger buyer of natural gas.

German media have reported that E.On may shut down the E.On Ruhrgas arm. The company would not confirm this, saying only that it was “analysing possible adjustments to the structure of the company and its business strategy”, adding that no decisions had been made. A number of factors may have prompted the strategic review, the most pressing of which is Europe’s stagnant gas market. However, the Gazprom arbitration is not thought to be directly linked.

With oil prices continuing their surge this year, the situation is not improving for Gazprom’s gas customers. At the end of 2009, oil-linked gas prices were 50% higher than hub-priced contracts, according to consultancy Brattle Group. At the end of July, North Sea Brent crude was up by around 55% compared with the same period last year at $118 a barrel; UK NBP gas prices – the most liquid European hub – were only around 20% higher, at £0.60 a therm ($9.8/million Btu) over the same period. German power prices, meanwhile, climbed a measly 9%, to €46.80 a megawatt hour.

Germany is the largest importer of Russian gas, accounting for 18.4% of its 186.45 billion cubic metres of pipeline exports in 2010, according to Cedigaz.

Gazprom has repeatedly defended its oil-linked contracts, arguing that hubs are illiquid and do not provide long-term supply security. But Gazprom is on its own. European gas buyers believe the existing contract model is unsustainable and expect more hub pricing to creep into long-term contracts.

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