In an unprecedented move for the Russian energy giant, Gazprom has agreed to incorporate spot market prices in some of its long-term European export contracts. More significantly, the move potentially represents a structural change in gas market pricing mechanisms away from oil-linked contracts and toward a system that is more reflective of supply and demand fundamentals.
At the height of last year’s European gas row, in which Gazprom and utilities battled about the liability for billions of cubic meters of gas, Gazprom chairman Alexey Miller staunchly refused to renegotiate with the likes of E.ON, GDF Suez or Eni on long-term gas contracts. The energy giant insisted that gas prices remained linked to the prevailing oil prices. However, after a few months and a $2.5 billion loss in sales , the world’s biggest gas producer has announced that it had indeed agreed to contractual changes with several European utilities. According to Gazprom’s director general of exports, Alexander Medvedev, “[The company] took into account the trends in the European market and the crisis.”
Weak demand, rising capacity in liquefied natural gas and surging growth in US unconventional gas production have depressed wholesale prices and led to a supply glut in Europe, which is expected to last three to five years. Utilities, however, have seen little benefit from the collapse in wholesale prices. They source the vast majority of their gas through multi-year take-or-pay contracts, prices of which are substantially higher due to their indexation to the price of oil.
As such, European utilities have found themselves obligated to buy billions of cubic meters of expensive gas for which they have no customers, while being unable to take advantage of cheap wholesale gas on regional spot markets. After Europe’s largest utilities failed to fulfill contractual purchases of around 10 billion cubic meters last year (valued at $2.5 billion), Gazprom responded by instituting a three-year ‘crisis’ period in which it will allow up to 15% of its contracts to be linked to the prices of spot gas.
In doing so, Gazprom has broken with its strict long-standing tradition of indexing its contracts to the price of oil products. More importantly, such a move represents a milestone in the natural gas market and could be the start of a structural shift in its pricing system. Although a move towards gas-on-gas pricing would expose utilities to greater price risks, retail customers would ultimately benefit from a price that is more truly reflective of the market’s underlying supply and demand fundamentals.