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A new reality for Gazprom amid low gas demand

Hurting customers and low gas demand, mean Gazprom must accept changes to its contract terms

Gazprom faces a dilemma over its European gas contracts, with its best customers losing billions on oil-linked prices, demand slumping and competitors likely to offer attractive discounted deals. The Russian gas-export monopoly has relented a little on pricing and, in early January, offered discounts to five customers. But this may not be enough for utilities such as Germany’s E.On and RWE, which are desperate to escape loss-making, oil-linked deals.

Gazprom’s customers on oil-linked contracts have suffered huge financial losses as a result of the disconnect between oil and spot-gas prices in 2008. This meant European importers buying gas at expensive oil-indexed prices and selling at lower hub prices. In December, oil-indexed prices were over 50% higher than the UK NBP hub gas price, according to Platts – $8.80/million British thermal units (Btu) NBP, compared with $13.60/million Btu for oil-linked gas.

Poland’s PGNiG, E.On and RWE are already taking the Russian firm to arbitration over contracts, with other companies also in the process of renegotiating. But with European gas demand stagnant and coal making a comeback for power generation, Gazprom – long adamant that oil-linked contracts are vital to support capital-intensive upstream investment – may have to release its grip before it causes serious damage to its largest customers, and its own market share.

Utilities hurting

Last year really hurt European utilities. Profits at E.On’s Gas Midstream division for the first three quarters dropped by €780 million ($1 billion) to €45 million, compared with the same period a year earlier – it blamed expensive oil-indexed gas contracts. In the same period, RWE’s Gas/Trading Midstream arm, meanwhile, registered an operational loss of €842 million, against a profit of €67 million in the same period. The company blamed some of its trading losses on the forced closure of its domestic nuclear-power plants, following the Fukushima meltdown, as well as its oil-linked gas contracts.

And European hub prices are unlikely to rise anytime soon to meet oil-indexation levels, with the continuing eurozone debt crisis damaging economic recovery. It means gas demand will remain flat, with consumption unlikely to recover to 2008 levels, of around 520 billion cubic metres (cm) until 2018, says Société Générale.

In addition, power generators are shunning gas in favour of cheaper coal, spurred by a 60% collapse in carbon prices on the European Emissions Trading System towards the end of last year. With carbon trading at around €7 a tonne, it has become more profitable to burn dirty coal, and pay for the permits, than to burn cleaner, but more expensive gas.

And the EU carbon price is expected to remain low for the next few years, with Barclays Capital forecasting an average price of: €7.5/t this year; €12/t in 2013; and €14/t in 2014. This compares with an average €13.4/t last year, and registers a huge drop from the 2008 average of €22.6/t.

Another problem comes in the form of deferred gas volumes. During the last round of contract negotiations, a few years ago, Gazprom agreed to allow some contracted gas deliveries to be delayed. Its thinking was probably to stop customers dumping excess gas on the spot market, further dragging down hub prices. But deferred gas must be delivered sometime in the future, meaning there could be up to a 22 billion cm/y gas oversupply for the next three years, claims Deutsche Bank.

And while the demand and price picture looks bearish for European gas, oil prices are expected to remain elevated and disconnected from hub gas prices. Supporting oil prices are supply concerns driven by EU sanctions banning Iranian oil imports and rising tensions over the Strait of Hormuz. Saudi Arabia, meanwhile, has raised its accepted oil price by 20-30%, meaning $100 a barrel is likely to be the new norm.

But it is not only Gazprom that’s under pressure to amend contracts, but Statoil, too. In 2009, the Norwegian firm reduced oil-indexation to make up 75% of its contracts, compared with Gazprom’s 85% in 2011. But Statoil could cut the oil-linked element to 55% by October 2012, to boost medium-term European demand, according to Société Générale. "And, if Statoil again reduces the oil-indexation in its continental Europe contracts from 2012, Gazprom would also have to be more flexible, perhaps in 2013, especially for buyers able to access spot, hub gas," said European gas and LNG analyst Thierry Bros.

Around 50% of Statoil’s gas contracts are up for their three-year review and customers will probably push for a larger spot-pricing element, a discount, or lower volumes. Any concession would put pressure on Gazprom to do the same.

Gazprom’s and Statoil’s biggest hope for maintaining oil-linked contracts is the tightening LNG market. Japan is set to import more LNG to offset reduced nuclear power output, attracting cargoes away from Europe with higher prices.

Qatar had been dumping LNG volumes originally destined for the US in Europe. The US’ gas self sufficiency, resulting from shale development, has seen the UK, the Atlantic basin’s next highest-paying buyer, sucking in the excess volumes. But if Asian customers – including South Korea, India and China – continue to lure cargoes eastwards, European hub prices could rise, as regional LNG supply is eroded.

Northwest Europe buys LNG mainly under spot or short-term contracts, so there are no supply guarantees. And with only Australia’s 4.3 million tonnes a year (t/y) Pluto project and the 5.2 million t/y Angola LNG expected to start up in the next few years, any upsurge in demand would squeeze prices.

Something has to give

If oil-indexed natural gas and hub prices are unlikely to reconnect in the next few years, then something has to give. Shareholders at Europe’s large utilities will not accept further multi-billion euro losses and the companies’ executives know it.

The process of European gas-contract reordering from the old bilateral model to a spot-market form is happening, but is a long process and full of friction. Meanwhile, Europe remains Gazprom’s most important market – Russia supplied 130.6 billion cm of gas in 2010, says Cedigaz, around a quarter of demand.

Gazprom says it should not pay for its customers trading mistakes. But with the European gas market shrinking, the disconnection in oil and gas prices continuing, and competitors set to slash prices, Gazprom must give further concessions – probably temporary, probably further discounts, and probably not increasing the spot element.

It may not be what the European gas market wants, but it may be enough to briefly satisfy Gazprom’s beleaguered customers.

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