8 th Russian Petroleum & Gas Congress/ RPGC 2010 Moscow Gas Day 24 June 2010 Ralf Dickel

1. Gas Price Formation on Spot Markets and under Long-term Contracts 8th Russian Petroleum & Gas Congress/ RPGC 2010 Moscow Gas Day 24 June 2010 Ralf Dickel Director Trade and Transit Energy Charter Secretariat Dickel@encharter.org Tel: + 32 2 775 9840

2. The 1991 Energy Charter Declaration: Title I Objectives: “Within the framework of State sovereignty and sovereign rights over energy resources and in a spirit of political and economic co-operation, (the signatories) undertake to promote the development of an efficient energy market throughout Europe and a better functioning global market, in both cases based on the principle of non-discrimination and on market-oriented price formation, taking due account of environmental concerns.”

3. Publications by the ECS Free download atwww.encharter.org

4. Structure Elements / explanations of gas price formation Regional differences Recent developments

5. What are we talking about? Avoiding misunderstandings What do we mean by a market? A system where transactions along the chain are determined by the commercial decisions of the partners in the chain? or in a more narrow sense: A market place where supply physically meets demand (inclusive of facilities for storage, unimpeded transport to and from the market place) and a transparent price discovery mechanism Primary supply and demand or including secondary supply/demand What kind of transaction? On a market place? A bilateral transaction (single or longer term)? An internal transaction (crossing a border), price for taxation purposes What transaction point / reference point for the price? Where in the chain?

6. Supply curve(cost of supply) Demand curve Standard Textbook Price Formation Price Volume PC1 (Capacity limit)

7. Non-standard Theoretical Aspects Resource (and energy) economics are often different from standard economics of manufacturing ,e.g.: Risk and High Specificity of Oil and Gas Investment: Transaction Cost Theory The Character of a Natural Resource: Ricardian Rent Finiteness of Resources: Hotelling’s Theorem Producing Companies and Resource Owners: Principal-Agent Theory Inelastic Demand Combined with Supply Restrictions: Cournot-Nash-Formula Market Imperfections/Externalities: Pigou Taxes and Coase Theorem

8. Supply curve(cost of supply) Replacement value-oriented price Hotelling rent Demand curve Ricardian rent Pricing of Non-Renewable Energy Resources: RICARDIAN VS. HOTELLING RENT Price Cost-oriented price PC2 Volume PC1 (Capacity limit)

9. Futures Market Derivatives markets have existed for a long time. In the US, Chicago Board of Trade was created in 1848, trading agricultural derivatives. Developed as an instrument to hedge price risk. Modern energy futures trading starting in the late 1970s. A futures contract is an agreement between two parties to buy, or, sell an asset at a certain future time for a certain price.

10. Comparison of Spot/Forward/Futures/Options/Swaps

11. Speculation: The Influence of “Perception” Range of Capacity Perception Price ($/bbl) Perception of high demand, low capacity “real” case Range of Demand Perception Perception of low demand, high capacity Capacity (million bbl/d)

12. Structure Elements / explanations of gas price formation Regional differences Recent developments

13. Domestic Supply or Gas Import Matter for Price Formation

14. Regional Differences from the Customer’s Point of View Different sector models: US: gas on gas competition (dto UK) Henry Hub passed on to Residential/Commercial (customers with inelastic demand) Supply by individual players into the market place LNG: under self contracting and flexibility with claw back clauses Even captive customers can rely on reaction by production side on price signals (security of supply and demand reaction) Continental market West Demand aggregation for imports, via LTCs Working of LTCs based on sales to residential/ commercial, small industry with gas oil and fuel oil as alternatives (if only contestability) Continental market East - Increase to EU netted back level - Subsidies on gas and oil Japan, Korea Chain passing on the import price, complete import dependence

15. Structure Elements / explanations of gas price formation Regional differences US / UK Continental EU (West / East) LNG 3. Recent developments

16. North America / UK US, UK: market places / spot prices: - The market place: Henry hub / UK NBP Spot, forward, futures, derivatives Churn of about 100 / 15 Speculative influence Coinciding with US, UK as banking places!! Link with (crude / fuel) oil price? Impact on import price Implications for customers Large industry / power: benefits of playing the market Res + com: suffer from inelastic demand/ no benefit from oversupply

17. Structure Elements / explanations of gas price formation Regional differences US / UK Continental EU (West / East) LNG 3. Recent developments

18. LTCs: The Groningen Concept Developed by Nota de Pous (Note to Parliament in1962) For exports: Pricing: Replacement value principle (no cost-related approach) Net-back value, netted back from replacement value Regular price review, if no joint solution => arbitration Price risk and reward for seller, marketing risk for buyer Protection against arbitrage by buyer Volumes and risks: Long term supply vs. off take obligation based on minimum pay: dedication of certain volumes of reserves vs. commitment to market defined volumes Secure supply at marketable prices against reliable sales volumes at maximum highest marketable price

19. Pricing After Groningen Pricing developed by new contracts and by price reviews based on Groningen concept: NL as “trendsetter”, later also Troll Heavy fuel oil share decreased, the share of light fuel oil increased (now about 60-65%) Algerian exports partly pegged to crude oil (Algerian crude oil parity campaign early 80s) More recent: a small share of coal or electricity indicators, gas-to-gas price indicators (at the expense of HFO). Arbitration was seldom invoked => comparable price levels and similar pegging

20. LTC: Indexation by Producer

21. Gas pricing in Ukraine 2005-2010 • Until 2005 the bulk of Russian gas supplied to Ukraine was delivered as barter payment for transit services for Russian gas. In 2005, Ukraine paid a notional $50/1000m3 for Russian natural gas, Russia paid 1.09$/1000m3/100km. • 2006 – “First gas crisis”; transportation and supply deal split: agreement between Naftogaz, Gazprom and RosUkrEnergo; price set at $95/1000m3 for 2006 and $130/1000m3 for 2007; • 2009 – After “Second gas crisis”;10-years agreement between Gazprom and Naftogaz, gas imports priced at “European netback level” , special reduction by 20% for 2009; • April 2010 – “Gas for Fleet” agreement between Presidents Medvedev and Yanukovych; Ukraine received $100/1000m3 discount (by cancelling custom duties in Russia) if the price according to the formula is above $333/1000m3 or 30% if the price is lower in return for an extension of the stay of the Russian Black Sea Fleet.

22. Structure Elements / explanations of gas price formation Regional differences US / UK Continental EU (West / East) LNG 3. Recent developments

23. Long-term Contracts in LNG Trade Sale and Purchase Agreement (SPA) Long term contracts – traditional pattern - 20 years or longer Risk sharing – buyers take volume risk (take-or-pay), sellers – price risk (price escalation clause) Flexibility through swapping cargoes: “global” exchanges of LNG cargoes accelerated, esp. from Atlantic to Pacific Early indexation clauses used crude oil

24. New Trends in LNG Activities Traditionally high take-or-pay threshold Buyers insist on more “take” flexibility => Emergence of new LNG suppliers outside Asia Pacific plus short reemergence of US market Flexibility in new contracts: - disappearing of floor price - shorter term - smaller off-take - destination flexibility (FOB instead of CIF) Important flexibility through self-contracting: upstream stakeholders purchase output + equity acquisition downstream While LTC remain, they become more flexible

25. Structure Elements / explanations of gas price formation Regional differences Recent developments

26. Recent Developments Affecting on Gas Price Formation Recent development of supply and demand new perspectives of shale gas Development of new market places - global pricing for LNG? 3. Impacts on LTCs replacement value / net back value pricing Fuel oil indexation heavy fuel oil indexation

27. Issues LTCs and replacement pricing need under supply / capacity restrictions Are we facing a situation of oversupply? Due to shale gas High potential but so far limited contribution to US Duration of recovery, major structural changes, e.g. due to renewables? LNG entry point control? Q max, Q flex into existing harbours?

28. Production of Unconventional Gas in the United States(Source: WEO 2009) Shale gas 300 60% bcm CBM 250 50% Tight gas 200 40% Unconventional gas as share of total production (right axis) 150 30% 100 20% 50 10% 0 0% 1990 1992 1996 2000 2004 2008 US unconventional output has expanded nearly 4-fold since 1990 to almost 300 bcm in 2008 – equal to more than half of total US gas output and ¾ of global unconventional output

29. Why LNG will not Develop a Spot Quotation LNG not like oil: Unlike for oil: No extraterritorial storage faculties for LNG (high specific costs of storage) Bilateral deals Relative high transparency: Follow ships Import statistics (but also transparency by commercial actors, e.g. Spain)

30. BEB (2004) 200 bcm CEGH (2005) 150 PSV (2003) PEGs (2004) 100 EGT (2006) 50 Zeebrugge (2000) 0 TTF (2003) 2003 2004 2005 2006 2007 2008 Gas Trading Hubs in Continental Europe Source: WEO 2009

31. Recent Developments Affecting Gas Price Formation Recent development of supply and demand(may last several years) new perspectives of shale gas (too early to tell) Development of new market places (difference between resource driven and contract driven market places) - global pricing for LNG (not likely because there are no off border market places) 3. Impacts on LTCs (basic logic for cross border LTCs in Continental Europe unchanged, but modifications to match competition downstream) replacement value / net back value pricing (in principle based on under supply /capacity restricitons) Fuel oil indexation (still reflecting competitive situation for small costumers, especially gas oil) heavy fuel oil indexation (since long not based on competition with but on contestability by Heavy Fuel Oil; HFO indexed part of gas sales a multiple of HFO consumption; for large positions increasingly access to gas to gas in UK or secondary markets)

32. Thank you !