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Slump in gas demand forces oil-link rethink

With EU gas demand and prices set to fall next year, importers want to renegotiate their long-term contracts. But Gazprom is sitting tight

Slumping European gas demand, stemming from shrinking eurozone economies, could force exporters to accelerate the break from traditional oil-linked natural gas contracts.

Most of Europe’s gas is bought under long-term contracts with prices indexed to oil, but while European gas prices have remained relatively flat over the last two years, oil prices have soared, meaning gas buyers have suffered huge losses on oil-linked contracts.

Large utilities, including Germany’s RWE and E.On, and Polish state-controlled PGNiG have taken Europe’s largest gas supplier, Russian monopoly Gazprom, to arbitration over expensive gas contracts. Meanwhile, a host of other buyers, including France’s GDF Suez and Italy’s Eni, have renegotiated contracts with Gazprom and Norway’s Statoil – the EU’s second-largest supplier – with varying degrees of success.

But cracks are already appearing in oil-indexation, with RWE saying in its third-quarter financial statement that it has amended, or prematurely ended three loss-making gas contracts. E.On also claimed renegotiations had been "partially successful", although neither company commented on which suppliers the contracts were with.

But the slump in demand European could land the telling body blow to the oil-price link, repeating market events in 2009 – the last time EU gas consumption fell, in the wake of the Lehman Brothers collapse and the first financial crisis.

Demand destruction

"Fundamentally, lower European gas demand could put pressure on contract-pricing structures," said Jim Henderson, senior visiting research fellow at the Oxford Institute of Energy Studies (OIES). "Gazprom was forced to renegotiate with some European customers, accepting up to a 15% spot-price element in the short term," he added.

Statoil has also approved blanket discounts to its European customers and incorporated 25% indexation to spot prices during initial renegotiations. Between them, Russia and Norway meet nearly half of Europe’s gas needs, with the former expected to deliver 158 billion cubic metres (cm) this year, while Norway exported 100 billion cm in 2010, according to Cedigaz.

Despite a rebound in European gas demand in 2010, consumption is set to fall again this year, with lingering concerns about economic growth dashing expectations of just another brief dip. Total demand across the EU’s seven largest gas markets (the UK, Germany, Italy, France, Spain, the Netherlands and Belgium) is predicted to fall by 10.6%, to 370 billion cm this year, compared with 414.1 billion cm in 2010, according to the national-grid operators.

Banks see demand drop

Even adjusted for the weather (2010 was colder than average, while 2011 is forecast to be warmer) gas consumption for this year is expected to fall by 5.5% to 372.8 billion cm, according to Deutsche Bank. "The effect of government-subsidised energy-efficiency programmes, energy-saving efforts, a subdued economic recovery and low expectations of future business conditions have overwhelmed the weak structural demand-growth trend, previously forecast at around 1% a year," said the bank.

Société Générale also forecasts a year-on-year gas consumption fall in Europe, of 7.5% to 492 billion cm, and predicts demand will remain below 2010 levels for the next five years (see Figure 1). And it said these forecasts were made before the European debt crisis.

"2011 is looking worse than 2009 for gas demand, with consumption down by 8.8% in the January to October period, compared with a drop of only 7.5% in 2009. And this was before the deepening of the eurozone crisis … with two months to go, our forecast of a 7.5% drop has more downside than upside risk," said Société Générale European gas and LNG analyst Thierry Bros.

"We remain convinced that, barring arbitration [the RWE, E.ON and PGNiG cases], oil-linked contracts will continue to account for 69% of price formation in continental Europe. And, weak gas demand in Europe in 2012 should widen the oil-linked/spot-market spread," he added.

Reflecting the bearish outlook, Dutch TTF gas hub prices for 2012 contracts have dipped by around 10%, to €25.25 a megawatt hour (MWh) ($9.90/million British thermal units) since the beginning of October, while German baseload power prices fell by 4.5%, to €54.40/ MWh.

Outlook bleak

Driving gas demand down is the eurozone’s shrinking manufacturing sector, with output in some countries showing their largest drops since mid-2009. The Purchasing Managers’ Index (PMI) for November was again below the 50 threshold needed to show sector growth – marking the third consecutive monthly decline and deepening to a 28-month low of 46.4. Markit, which compiles the PMI, also said manufacturing-output growth in Germany – Europe’s largest gas market – experienced its sharpest decline for two and a half years.

"Both production and new orders fell at rates not seen since the height of the credit crunch in the first half of 2009. It was also the first month since mid-2009 that all countries saw output fall, highlighting the broadening-out of the downturn from the periphery to the core," said Markit chief economist Chris Williamson. "Uncertainty about the business environment has clearly grown with the escalation of the region’s debt crisis."

Chaos has descended on eurozone economies, with Greece and Italy lurching towards billion-euro debt defaults, which could lead to the break-up of the euro and bring down key financial organisations that have lent the troubled countries money.

Russian bear

But Gazprom will not give up on oil-linked gas contracts, and is likely to prolong arbitration proceedings and renegotiations for as long as possible.

Gazprom has long said that the spot market is not deep enough to provide the volumes needed to satisfy demand, and that there is no break between oil-linked and hub gas prices. Sergei Komlev, head of contracts and pricing at Gazprom Export, argues that the previous two years of low demand meant excess gas bought under long-term contracts was dumped onto the spot market, pulling European hub prices down.

"Two and a half years of abominably low spot prices in Europe have created the illusion that gas has lost its link to oil once and forever. This is not true," Komlev said this week. "Temporary decoupling of prices occurred as unintended result of market restructuring, at a time of unexpected demand contraction," he added.

Another problem is that if Gazprom concedes to one company, then surely a domino effect would occur. "Gazprom’s position is rigid: it understands that if it gives up with one partner, it will have to do so with everybody," said Tatiana Mitrova, head of global energy at Russia’s Skolkovo Energy Centre.

"Moreover, if their counterparties go to arbitrage, for Gazprom it’s more profitable to use a wait-and-see approach, as oil-linked prices and their profits are high and every month of waiting means additional profits. It’s in no hurry to change anything."

But with the rush to supply Japan with liquefied natural gas (LNG) slowing, it means European LNG prices are likely to fall, undercutting Russian pipeline gas. German government figures show border import prices in September were $10.45/million Btu, compared with European spot LNG prices of around $9-10/million Btu; and UK NBP prices of around $7/million Btu for early 2012 delivery.

But Gazprom may accept losing some customers to LNG producers to keep its oil-linked contracts intact, while supply negotiations with China for up to 68 billion cm/y remain unresolved.

"If Russia agrees a price with China that will deliver a lower netback than its sales to Europe, then Gazprom would be in an awkward position with its European customers as it would have to explain why," said the OIES’s Henderson. "Russia is trying to avoid this, but is demanding a higher price from China than the country is prepared to pay."

The China-Russia gas deal was expected to be signed this year, but the countries cannot agree a price – thought to be a disagreement over around $100/’000 cm, or $2.7/million Btu. Consequently, China agreed with Turkmenistan last week to increase gas imports to 65 billion cm. The central Asian country signed a deal to export 30 billion cm/y over 30 years with initial gas landing two years ago, and the full 30 billion cm pipeline capacity expected to be available from 2013.

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