Countries like Spain, which have long been immune to the shift from oil- to spot market-based gas pricing, are finally waking up. With that, come fresh opportunities for alternative gas suppliers to sell more and end-customers to pay less. So the evidence suggests, writes Benedict De Meulemeester, owner and founder of the international energy and environment consultancy E&C. Taking the UK as an example, he urges Spain to use a new “Hydrocarbons Law” to create a virtual gas hub for the entire Iberian Peninsula.
One of the most remarkable events of the last decade in Europe’s energy markets has been the switch away from oil-indexed gas pricing towards the so-called hub-model (where prices are a function of spot prices at regional level). Oil-indexed pricing for natural gas is a relic from the past, when no open markets for the trading of gas existed. Sponsored by their national governments, monopolist gas companies set up long-term agreements with producers of natural gas with durations of up to thirty years. Lacking a price reference for natural gas, it was decided to peg the price to that of the most important competing fuel at the time: oil.
The end of oil-indexation
Even if oil-indexation was a clever marketing strategy in the days of the fuel-switch from oil to gas, when markets are liberalised it causes some serious issues. First, the long-term agreements give an important competitive edge to incumbent suppliers; it is difficult for an alternative supplier to get a contract with a gas producer. Therefore to get supplies, these alternative suppliers often have to buy their gas from the very incumbents they are supposed to compete with. In the early days of gas market liberalisation, we saw that alternative suppliers were often nothing more than resellers of gas originally bought by a large competitor under a long-term agreement. This was obviously a poor basis for alternative suppliers to exercise the sort of competitive pressure that brings down prices.
Long-term agreements also often contain exclusive rights to the usage of capacity on key infrastructure, such as cross-border connections for the import of gas, LNG terminals or storage sites. This makes it even more difficult for alternative suppliers to develop their business.
Second, oil-indexed pricing has a certain degree of mathematical complexity. End-consumers often fail to grasp it, making it impossible for them to correctly assess the proposals they get on their table. In some markets (e.g. Germany), there has been a huge variety of different oil-indexed formulas, making it very difficult to get a correct idea of “the” price for gas in that country. The market of long-term, oil-indexed contracts is also not a market with clear wholesale/retail segmentation. End-consumers can only guess what their suppliers pay for the gas. There is no transparency whatsoever regarding margins, putting the end-consumer at a disadvantage in the contract negotiation.
In every country that switched away from oil-indexation to a hub model, the price of natural gas for the end-consumer declined significantly.
This overall lack of transparency is also clear when price management services are offered. In many countries, suppliers have a long tradition of offering oil-indexed contracts with services that allow their clients to swap floating prices for fixed prices, fixed for floating, and even swap between different formulas. The suppliers perform the oil market hedging operations necessary to execute such swaps. However, the end-consumer often lacks understanding of the formula’s mathematics and oil market operations to judge whether the end-result is correct or whether his supplier might be abusing the fixing operation to make some extra margin for example.
Third, from a theoretical economics point of view, oil-indexation is an ugly beast. It means that the price of one product (natural gas) is determined by the supply-and-demand dynamics of another product (oil). This means the price is not giving a correct signal to producers and consumers. It could be that natural gas is in short supply, but its price is low because of a large supply of oil. At that moment, the consumer is not getting a signal to reduce consumption nor is the producer getting a signal to increase production. Hence, the market is not restoring the balance of supply and demand. I’m pretty sure that Adam Smith would have disliked the idea of the oil-indexation of gas.
Finally, there is more natural gas than oil left on the planet. So the chances of over-valuing natural gas are quite high when you index it to oil. That explains why producers such as Russia’s Gazprom, have been such fierce defenders of oil-indexation. And this is not just economic theory. We have indeed seen that in every country that switched away from oil-indexation to a hub model, the price of natural gas for the end-consumer declined significantly.
The hub model was first rolled out in the US – with its Henry Hub – and in the UK. With the creation of the National Balancing Point or NBP (a virtual trading location for UK gas), the UK did something enormously interesting: it created a virtual rather than physical hub. This model was copied by Belgium (Zeebrugge), the Netherlands (TTF), France (PEG’s), Germany (NCG and GPL), Italy (PSV) and others. Today, in most European countries, gas is bought based on hub pricing. We have even witnessed market integration, with converging prices in different wholesale markets and TTF becoming the benchmark to which prices in end-consumer contracts are pegged.
For most large industrial gas consumers in Europe, the disadvantages of oil-indexed gas pricing as described above have become a thing of the past. Today, they enjoy more transparent prices with a better price management service. Moreover, also as mentioned above, the switch to hub-pricing has delivered lower prices and important savings. Yet some countries have lagged behind. They have not made the switch. One of them is Spain (along with Portugal, since the Spanish and Portuguese gas markets – like their electricity markets – are well-linked).
The virtues of virtual hubs
After years of neglect, the Spanish government now seems to be getting serious about reforming its gas market and introducing the hub model that has been such a boon to gas consumers in other European countries. On 22 May, a long-awaited new “Hydrocarbons Law” was published. Upon first reading, it seems to contain some elements that could spark the development of a real hub market on the Iberian Peninsula.
The most important element – no doubt – is the introduction of a virtual trading hub like the NBP. From a contractual or legal point of view, the hub is the place where gas changes ownership. In traditional physical hubs such as the Henry Hub or Baumgarten in Austria, this place is an actual physical location. When a virtual hub is created, the whole transportation grid is defined as being the hub. A whole geographical area, for example the whole of the UK or the whole of the Netherlands, can become one big hub or “entry-exit zone”. This means that the seller can inject his gas at any point and it is considered to be delivered at the hub, while the buyer can extract his gas at any point and it is considered to have been taken from the hub.
I’m pretty sure that Adam Smith would have disliked the idea of the oil-indexation of gas.
Physical hubs are not as beneficial to trading and retail market competition as virtual hubs. Sellers of gas via physical hubs need to find access to that specific geographical location and capacities to get there might be restricted, especially if capacity rights have historically been allocated to incumbent suppliers in the framework of long-term gas contracts. A supplier also needs to “route” his gas from that hub to his end-client. Capacity restraints can occur en route, making it impossible for him to secure clients far away from the entry points at which he has sufficient capacity rights to get the gas in.
This is a problem in Spain, where the distances to cover from injection to end-customer can be large. A supplier that gets his gas delivered in Huelva, on the Southern Andalusian shore, might have difficulties routing this gas to clients in the industrial heartlands of the North and North-East. Nevertheless, we have seen the development of a market for locational swaps in Spain, where suppliers swap gas quantities that they can deliver in certain areas with gas quantities from other suppliers in areas where they cannot deliver. All in all, you cannot say that the Spanish market suffers from a lack of diversity in offers. A gas tender in Spain can easily collect up to ten different offers. The problem is that they all come with high prices (compared to other countries in Europe), oil-indexation and poor price management services.
Liberate suppliers, reward consumers
The new Hydrocarbons Law talks about the introduction of a virtual hub for the whole of the Spanish territory. That is a very interesting idea, as I believe that Spain or rather the Iberian Peninsula – contrary to what some suppliers say – has an almost ideal gas system for the introduction of a virtual hub. The transportation grid looks a bit like a giant bicycle’s wheel, with pipelines running along the coastlines and through the center (Madrid). Gas can be injected into the wheel at no less than ten places: through pipeline connections with France in the North and North-Africa in the South and eight LNG terminals. Connect all of that in one virtual hub and you liberate suppliers from the difficulties of accessing injection points near their clients and getting the capacity rights (or locational swaps) to go from entry to exit. This could finally make Spanish gas suppliers and new entrants develop the sort of competition that we have seen in other countries. It could bring important benefits for Spanish gas consumers, such as:
- A cost saving. Currently, we are seeing (oil-indexed) gas prices in Spain in the range of 24-25 €/MWh. Prices on the Northwest-European Hubs are in the 22-23 €/MWh range. If a hub in Spain means its prices converge with those in the rest of Europe, this should therefore deliver a 2 €/MWh saving. (Note that due to the drop in oil prices, the spread between prices in Spain and hub prices elsewhere in Europe is currently historically low. In 2014, the spread was more in the 10 €/MWh range.)
- Possibilities to buy energy in a different way, with spot indexation and forward products to secure future price levels.
A hub is not an exchange
Whether the new law will lead to the rapid development of a more competitive hub-based market on the Iberian Peninsula or not is unclear at this moment. The Hydrocarbons Law is a first step that sets up the legal framework for developing a Spanish hub. Whether it will function or not, depends on how it will be worked out in decrees and other regulatory texts such as grid use codes. The Law announces the preparation of these important extra pieces of regulation. The devil will indeed be in that detail.
The Spanish government has been working on the creation of a Spanish gas market hub for a long time. So far, officials have seemed too focused on the financial aspects, or the creation of a platform to trade in spot and forward contracts for natural gas. Whereas the success of a hub depends primarily on getting the physical aspects right, in other words defining a large entry/exit zone and making sure that there are non-discriminatory access rights and balancing services in that zone.
What is a bit bizarre in the new Hydrocarbons Law is the definition of the entity that would be responsible for managing the balancing system. This is to be a company in which the gas grid operator (Enagas) and the organiser of the exchange platform (market operators OMIE/OMIP) would come together. In most other countries, the balancing system is simply run by the gas grid operator. Spain seems to aim at the introduction of some sort of independent system operator.
Having the organiser of the exchange platform so tightly involved in balancing is a reminder of Spain’s confusion of the hub model with the organisation of an exchange. And the Law’s preoccupation with the financial aspects of the gas market is reminiscent of the dirigisme of Spanish lawmakers. Spanish energy policy, also in the electricity market, often fails to produce the best and cheapest results for the end-consumer because officials try to arrange everything in too much detail. But we should give Spain the benefit of the doubt and hope that in the next months, a hub market for natural gas becomes a reality, just as we have seen in other countries.
Benedict de Meulemeester is owner/founder of the international energy and environment consultancy E&C (@EC_Consultants).This article was reproduced with permission from his blog http://energytics.wordpress.com.