Foundations of Natural Gas Price Formation: Misunderstandings Jeopardizing the Future of the Industry

By Sergei Komlev

‘Foundations of Natural Gas Price Formation’ examines the fundamentals of natural gas price formation and the five principal features that make it unique in the world of commodities. It presents a model of hybrid gas pricing developed by Sergei Komlev from his detailed analysis of the interlinked impact of these features that is presented as a corrective to potential market failure.

Using mainstream economic theory, the book presents hybrid-pricing mechanisms not previously analyzed. Through a failure to understand the role of hybrid-pricing, boosters of spot pricing mechanisms through gas hubs are promoting an incorrect understanding of gas markets that will lead to market failure and to potential critical supply shortages in the near-term future. ‘Foundations of Natural Gas Price Formation’ defends the system of oil-indexed pricing as an accurate, market-based mechanism that has stood the test of time.

• Language: English
• Publisher: Anthem Press
• Release date: Sep 25, 2020
• ISBN: 9781785273407

Book preview

Foundations of Natural Gas Price Formation

Foundations of Natural Gas Price Formation

Misunderstandings Jeopardizing the Future of the Industry

Sergei Komlev

Consulting Editor: Daniel M. Satinsky

Anthem Press

An imprint of Wimbledon Publishing Company

www.anthempress.com

This edition first published in UK and USA 2020

by ANTHEM PRESS

75–76 Blackfriars Road, London SE1 8HA, UK

or PO Box 9779, London SW19 7ZG, UK

and

244 Madison Ave #116, New York, NY 10016, USA

Copyright © Sergei Komlev 2020

The author asserts the moral right to be identified as the author of this work.

All rights reserved. Without limiting the rights under copyright reserved above, no part of this publication may be reproduced, stored or introduced into a retrieval system, or transmitted, in any form or by any means (electronic, mechanical, photocopying, recording or otherwise), without the prior written permission of both the copyright owner and the above publisher of this book.

British Library Cataloguing-in-Publication Data

A catalogue record for this book is available from the British Library.

ISBN-13: 978-1-78527-338-4 (Hbk)

ISBN-10: 1-78527-338-8 (Hbk)

This title is also available as an e-book.

CONTENTS

List of Illustrations

Acknowledgments

About The Author and The Consulting Editor

Introduction

1. What Is the Mission of the Natural Gas Industry and How Can It Be Successfully Completed?

2. Long-Term Contracts: Their Role and Impact on Natural Gas Pricing

3. Price Envelopes for Natural Gas or How Interfuel Competition Makes the Price of Natural Gas Rangebound

4. Hybrid Pricing in Natural Gas: Search for an Efficient Pricing Model

5. Impact of Externalities on Natural Gas Pricing

6. Conclusion

Index

ILLUSTRATIONS

Figures

1.1 Organic Process of the Oil-to-Gas Switch

1.2 European Gas Market History Periodization

1.3 Average Deviation of TTF Forward Prices from the TTF Day-Ahead Price Index

2.1 IGU Estimates of LNG Spot and Short-Term Deliveries

2.2 Spot versus Conventional LNG Contracts in World Trade

2.3 Spot LNG Cargo Destination by Regions

2.4 Average New LNG Contract by Volume and Length of Duration

2.5 Predicted LNG Sales and Competition between Term and Spot Volumes

2.6 Equinor Contracts by Duration, 2010–21

2.7 Sonatrach Contracts by Duration, 2010–21

2.8 Interaction of UK National Balance Point (NBP) Prices and LTC Prices. Represented by German Border price (BAFA), 2001–09

2.9 Interaction of TTF Prices and LTC Prices. Represented by the German border price (BAFA), 2015–19

2.10 LTCs as Center of Gravity for Spot Hub Prices of NG in Japan

2.11 Pairing of LTC and Spot LNG Prices in the United States

2.12 LTCs as the Center of Gravity for Spot/Hub Prices in the NG Industry

2.13 Spot Price Overreaction to Market Oversupply and Undersupply

2.14 March 2014 Collapse in Asian Spot Prices

2.15 Schematic Spot Price Behavior in Europe, 2009 to 2014

2.16 Emergence of Paper and Physical Gas Disconnect in the Mature Hybrid Pricing System

2.17 Emergence of the Oversupply Illusion in the European Gas Market

2.18 Overcontracting as a Factor in Hub Price Degradation

2.19 Prices on Mature Hubs and in Immature Hybrid Pricing Systems, 2009–14

2.20 Cycle of Term Price Downward Revisions Ended up in Price Degradation

2.21 Demand growth, Decrease in Overcontracting and Contract/Hub Price Convergence

3.1 NG Prices Mirror Oil Prices with a Six-Month Lag

3.2 Interfuel Competition Sets up Corridor for NG Price Fluctuations

3.3 Commonalities in End-Use Market Argue in Favor of Competition between Gas and Oil, 2018

3.4 Competition with Other Carbon Fuels Locks Global NG in a Price Envelope

3.5 Interfuel Competition at Work: The NG Price Corridor Width Is Determined Mainly by Oil Price Volatility

3.6 Day-Ahead Prices on TTF and NBP in Abnormally Cold Weather of February–March 2018

3.7 Interfuel Competition at Work: Oil Price Sets a Resistance Level for NG Prices

3.8 Comparison of NG and Oil Prices in the Aftermath of the 2008 Economic Crisis

3.9 Comparison of Fuel Oil Prices with NBP and BAFA after Oil Price Double Dip in 2014–16

3.10 Russian Fuel Oil Prices Stayed Below NG Prices for Four Months in 2015–16

3.11 Interfuel Competition at Work: Coal Price Sets Bottom Support Level for NG Price

3.12 Depressed NG Prices Competitive with Only Expensive Grades of Coal (Compared on an Equivalent Energy Content and Efficiency Basis)

3.13 Oil Products in Power Generation Mix of Japan in 2018

3.14 Competition between NG and Oil Products in Power Generation. Final Energy Consumption in Power Generation Sector by Country in OECD Europe in 2016

3.15 Competition between NG and Oil Products in Commercial and Residential Sector. Final Energy Consumption by Country in OECD Europe in 2016

3.16 Competition between NG and Oil Products in Industry. Final Energy Consumption in Industry Sector by Country in OECD Europe in 2016

3.17 Competition between NG and Oil Products in the Transportation Sector. Final Energy Consumption in Transport Sector by Country in OECD Europe in 2016

3.18 NG and Oil Will Remain Competing Fuels in the Foreseeable Future: Commercial and Residential Sector in OECD Europe

3.19 NG and Oil will Remain Competing Fuels in the Foreseeable Future: Industry in OECD Europe

3.20 Growth of European LNG Sales Showing Increase of Three Times since Europe Became a Market for Spot LNG Cargoes

3.21 In 2019 NG Prices Received no Support from Oil and Coal Prices—Comparing 3Q 2010 to 2Q 2011

4.1 Share of the Two Major Mechanisms in Setting NG Price for Global Imports and the LNG Trade in 2019

4.2 Life Cycle of LTC and GOG Pricing

4.3 Average Oil-Inked Contract Slopes by Signing Year (2014–18)

4.4 Japan LNG Import Price and JKM in Relation to Average Brent Price, 2016–19

4.5 Japan LNG Import Price and JKM in Relation to Average Brent Price, 2009–19

4.6 Contract Price in Quasi-Oil-Indexed Contracts Moves in a Corridor to Mitigate Deviations from Hub Prices

4.7 IGU Assessment of the Interaction between OPE and GOG in Europe

4.8 Pricing Pattern for NG Imports to the EU

4.9 NG Price Navigation in Europe

4.10 Traded Products Offered on European Hubs, 2018

4.11 Major Change in European NG Market Design: From a Three- to a Four-Tier Structure

4.12 Volume of Trading in Relation to Total Sales for European Midstream Importers

4.13 Spreads between Summer and Winter Prices on TTF Are Insufficient to Cover Operation Costs of Many Storage Sites

4.14 Hypothetical Price Models

4.15 Asian Market Overcontracted

4.16 Share of New LNG Contract Volumes by Price Indexation, Share of Total Volume

5.1 Impact of Demand Enhancement Policies (Cash Subsidies) on NG Price

5.2 NG Import Prices and Average Domestic Consumer Prices in Pakistan

5.3 BOTAS’s Regulated Prices for Different Categories of End Users Compared to the Acquisition Import Prices

5.4 Impact of RSP and RBC on Pricing

5.5 Hybrid Pricing on the Turkish Gas Market in Loose and Tight Markets

5.6 Market Architecture for Pricing Reform in Russia over the Interim Period: Wholesale Replacement Value Principle + Guaranteeing Supplier Model + Free-market Pricing for Uncontracted Volumes

6.1 Paradigm Typical of the Shale Industry in the US—Pay for Two Products and Get a Third One Free

6.2 Unjustified Volatility of JKM Price Compared to Brent Price

Tables

2.1 Global and European Contract to Import Index for Pipeline Gas

3.1 Correlation Coefficients of TTF to Brent and ARA

3.2 Correlation of Exchange-Traded Commodity Prices with Oil Prices

4.1 Role of the Two Major Market Pricing Mechanisms in Global Imports in BCM by Continent in 2019

5.1 IGU Survey of Types of Regulated Wholesale Prices

5.2 Volumes of Domestically Produced NG Delivered to End Users under Regulated Prices in Selected Counties, by BCM in 2019

5.3 Below-optimal Unregulated Prices Adjusted by the Dominant Regulated Pricing Mechanisms, 2019

ACKNOWLEDGMENTS

My acknowledgments need a little explanation. As head of the Directorate for Contract Structuring and Pricing at Gazprom Export, the trading arm of the world’s largest natural gas company, my responsibilities do not include studying the foundations of natural gas (NG) pricing that I will present in this book. The job of the directorate is to provide analytical support to the operational departments of the company, which are responsible for selling gas to countries outside the former Soviet Union. As such, we have very practical business support responsibilities.

However, since I joined Gazprom Export, I have often thought about the saying that nothing is more practical than a good theory. I joined Gazprom Export during a stressful time for global, and particularly European, markets, as the gas industry was undergoing a profound transformation. It became more and more evident to me that the price behavior of NG was different from what I learned from textbooks on pricing mechanisms in the world of commodities. My background as an academic scholar specializing in the studies of the evolution of the trade sector in developed countries contributed to my interest in undertaking research to explain this phenomenon and bring perceptions closer to reality. This research work occupied much of my time on weekends and on vacation. So, my first acknowledgment goes to the members of my family who tolerated my absenteeism.

Another impetus for undertaking this study came from my participation in the Strategy Committee of the International Gas Union (IGU). In this capacity, I have spent more than ten years discussing pricing mechanisms with the members of the IGU study group on pricing within the IGU Strategy Committee. In 2018, I became the leader of this study group. The group produces a flagship Wholesale Gas Price Survey, an overview of pricing mechanisms for NG in regional and global markets starting from 2005 and up to date. The research that underlies this book relies to a large extent on the results of this price report. I owe a great deal of gratitude to the members of the IGU Strategy Committee who produce it.

This book is the culmination of a long career trajectory transitioning from an academic scholar to an energy analyst working for consultancies, banks and investment companies. In all these positions, I have been helped by mentors who opened the door to new opportunities that ultimately led to me joining Gazprom Export. I owe all of them a debt of gratitude.

Probably the most relevant to this book is Mr. Alexander Medvedev, who gave me the chance to join Gazprom Export and who trusted me to perform in this capacity. Although this book does not in any way represent the official thinking or position of Gazprom Export, the company has given me the opportunity to participate in the natural gas industry as an insider.

I am also indebted to my colleagues and coworkers at the Directorate for Contract Structuring and Price Formation of Gazprom Export and especially Victor Govorukho, who assisted me in my research and in thinking through some of the issues that are reflected in this book.

While acknowledging the importance of Gazprom Export in my professional life, I cannot stress enough that this work is my own analysis of the dynamics of NG pricing. Obviously, my thinking about an overall framework for understanding gas pricing was galvanized by challenges and questions raised in the course of my work. However, no one at Gazprom Export asked me to undertake this analysis. The assertions in the book and insights that I hope it provides are all mine.

ABOUT THE AUTHOR AND THE CONSULTING EDITOR

The author, Dr. Sergei Komlev, is head of Directorate for Contract Structuring and Pricing in Gazprom Export, the trade arm of Russia’s major gas company Gazprom. Internationally, he is well known as a conference speaker, analyst and representative of Gazprom Export.

In addition, Dr. Komlev has participated in the professional organization the International Gas Union (IGU) for the past 10 years. He is a member of the Strategy Group 2 of the IGU and was recently selected to head the working group on pricing.

Before joining Gazprom Export, Dr. Komlev held various positions in the consulting and equity research business. In those positions, he worked on a variety of energy assignments encompassing NG, electricity, oil and financing matters in the Russian market and internationally. He worked as director of the Moscow office of the international energy consultancy Pace Global Energy Services. Before that, he was an area expert with the Economist Intelligence Unit and a senior analyst with the brokerage company United Financial Group.

Dr. Komlev has a PhD from the Institute of World Economy and International Relations in Moscow.

The consulting editor, Daniel Satinsky, Esq., is a business development consultant, independent scholar and writer.

Most recently, he is a coauthor of Hammer and Silicon—The Soviet Diaspora in the U.S. Innovation Economy–Immigration, Innovation, Institutions, Imprinting and Identity. Past publications include Yaroslavl Roadmap 10-15-20, a study of worldwide innovation best practices, Buyer’s Guide to the Russian IT Outsourcing Industry and Industrial Giants, Entrepreneurs and Regional Government: The Changing Business Environment in the Yaroslavl’ Oblast 1991–98.

Mr. Satinsky is an associate of the Davis Center for Russian and Eurasian Studies of Harvard University. He holds a master’s in law and diplomacy degree from the Fletcher School of Law & Diplomacy, a juris doctor degree from Northeastern University Law School and a bachelor of arts degree from James Madison College of Michigan State University.

INTRODUCTION

The global natural gas (NG) industry has a highly important mission to accomplish in order to make our world better. As the least-polluting and least CO2-emitting carbon fuel, the mission of NG is to expedite the switch from coal to gas and from oil-to-gas as part of the global environmental and climate change mitigation agenda.

The key to understanding the critical role of NG in the transition to a low carbon economy lies in the fundamentals of NG price formation and the mystery of why gas prices do not follow the same rules as other commodities. I have spent many years of my professional life wrestling with this mystery. It is a subject of great controversy among academic researchers, government regulators, producers and consumers. I have been a longtime participant in this controversy through conference presentations, articles and interviews. As such, I have had to dig deeper and deeper into the specifics of natural gas as a commodity and how to assess its market value. This book will present the full scope of my analysis and conclusions that explain the dynamics of NG price behavior and the potential for market failure. It is my contribution to answering the mysteries of NG price formation through a theoretical framework of pricing in the gas sector.

It would be incorrect to say that the transitional mission in the fuel mix is something brand-new for NG. The NG industry already has been effectively carrying out this agenda on a purely