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IBP1288_12 NATURAL GAS PRICING: CONCEPTS AND INTERNATIONAL OVERVIEW Daniel M. Gorodicht¹, Luciano G. Veloso², Marco Antonio B.

Fidelis², Melissa Cristina P. P. Mathias² ³

Copyright 2012, Instituto Brasileiro de Petróleo, Gás e Biocombustíveis - IBP Este Trabalho Técnico foi preparado para apresentação na Rio Oil & Gas Expo and Conference 2012, realizado no período de 17 a 20 de setembro de 2012, no Rio de Janeiro. Este Trabalho Técnico foi selecionado para apresentação pelo Comitê Técnico do evento, seguindo as informações contidas no trabalho completo submetido pelo(s) autor(es). Os organizadores não irão traduzir ou corrigir os textos recebidos. O material conforme, apresentado, não necessariamente reflete as opiniões do Instituto Brasileiro de Petróleo, Gás e Biocombustíveis, Sócios e Representantes. É de conhecimento e aprovação do(s) autor(es) que este Trabalho Técnico seja publicado nos Anais da Rio Oil & Gas Expo and Conference 2012.

The core of this article is a critical analysis of different forms of pricing of natural gas existing in the world today. This paper is to describe the various scenarios of natural gas price formation models. Along the paper, the context is emphasized by considering their cases of applications and their results. Today, basically, there are three main groups of models for natural gas pricing: i) competition gas-on-gas, i.e., a liberalized natural gas market, ii) gas indexed to oil prices or its products and iii) bilateral monopolies and regulated prices. All the three groups of models have relevant application worldwide. Moreover, those are under dynamic influence of economic, technological and sociopolitical factors which bring complexity to the many existing scenarios. However, at first this paper builds a critical analysis of the international current situation of natural gas today and its economic relevance.


International Overview and Trends

The evolution of production, consumption and commercialization of natural gas around the world gained a new importance in the beginning of the 21th century. The natural gas has been on the spot in the energy markets. It is estimated that in 2035 that natural gas will be the world’s second most important energetic source by surpassing coal. This means a growth rate of 50% regarding the year 2000 which reaches the 25% of all energetic consumption on Earth by 2035 (IEA, 2011). During this period, the demand for natural gas will grow by 1,8 tcm, reaching 5,1 tcm (IEA, 2011). These promising estimations are due to intrinsic characteristics of natural gas and the evolution of its industry worldwide. First, natural gas is a “cleaner” alternative in relation to other sources, i.e., less pollutant when burned in regard to all others fossil fuels. The countries which compromised themselves to reduce GHG 1 emissions are choosing natural gas instead of coal in their thermoelectric plants (IEA, 2011). Second, natural gas is distributed in a pulverized fashion around the world - which is not the case of oil. In fact, oil is very concentrated in regions endowed with a complex geopolitical conjuncture which implies in volatility and supply constraints. As a matter of fact, both these characteristics contribute to justify the reason that natural gas thermoelectric plants (together with wind power) are responsible for the major new installed capacity of the last decade in European Union (GWEC, 2009). This optimistic tendency is affecting the LNG international trade. It has been intensified and getting cheaper given the strong demand coming from Southeast Asia and China. Moreover, the trend of liberalization of gas markets (via hub trade) aims to achieve efficiency gains to markets and, ceteris paribus, to reduce gas prices. At the supply side, the recent findings about “non conventional gases” bring a strong expectations of the expansion of supply which is rapidly reflected in the liberalized markets. Even though the technical and economic viability of non conventional gases exploration is still questionable in many countries, the immediate result is an warming-up of gas markets which in turn generates optimistic expectations. It is estimated that non conventional gases will mean 11% of total gas production in the world in 2035. In 2007, the three majors natural gas producer regions in the world were countries from former Soviet Union (specially, Russia), the North America (specially, the USA) and the Middle East. They all together respond respectively for 28%,

Green House Gases: mainly CO2 and CH4.


Economist, Analyst at Gas Energy Economist, National Agency for Petroleum, Natural Gas and Biofuels (ANP) ³ Opinions or points of view here expressed are those of the authors and do not necessarily reflect the position of Gas Energy or ANP.

Rio Oil & Gas Expo and Conference 2012 26% and 12% of the total gas production in the world (IGU, 2011). Still, the proportion of gas consumption is different. The North America consumes 28% of all natural gas in the world, followed by countries from the Former Soviet Union (18%) and then by Europe (18%). Even though Europe has an important share in the consumption of natural gas, it produces only 10% of all natural gas in the world. This implies that a significant part of its consumption is given by imports: about 52% of all natural gas imported via pipelines in the world goes to Europe as well as 23% of all LNG. Therefore, in 2007, Europe imported 422,785 bcm of natural gas – mainly from countries from the former Soviet Union (IGU, 2011). Additionally, China has playing a growing important role in gas consumption. It is estimated that China will consume 330 bcm in 2035 instead of 20bcm consumed in 2010 (IEA, 2011). It means a growth of sixteen times in 25 years. Regarding price formation, there are many types of pricing system for internal markets. It is not observed a predominant system. Regulation below cost responds for 38% of the gas produced and consumed in a single country. Competitive markets – competition gas-on-gas – represent 36% of domestic markets. The socio-politic regulation has 14% of domestic markets. The imports via pipeline (about 75% of the whole imports) are mostly indexed to oil (47%). The bilateral monopoly and the gas-on-gas competition are the other alternatives in price formation for imports, representing respectively 27% and 26%. In the case of imports via LNG, the prices indexed to oil represent 70% of total volume. The spot prices and the bilateral monopoly represent respectively 27% and 3% (IGU, 2011). Finally, in aggregate terms, the total consumption presents a variety of models for price formation. Thanks to the robust of North American market, the spot pricing is the most applied in 2007, corresponding to 32% of world’s total volume. Next, the regulation below cost - broadly applied in the Middle East – responds for 26% of total consumption. Meanwhile, the prices indexed to oil – predominant in Continental Europe – are the 20% of total volume consumed (IGU, 2011). All those pricing systems as well as the main markets are deeply disclosed in the third section of this paper. Definitely, the natural gas is following an independent path which brings to it higher level of importance than before as an energetic source (EGL, 2011; OIES, 2011). The Figure 1 shows the paths of gas prices in many markets (which are endowed with different mechanisms of price formation) comparing them with the oil price evolution. It is clear that exists a disparity regarding the evolution of both oil and gas prices since 2009. Specially, this disparity becomes stronger in the case of the liberalized American and British markets.
Figura 1

Source: OIES, 2011 Indeed, the natural gas markets are presented in different manners around the world. In this context, it emerges the discussion about the price formation and its applicability. There is no consensus about an unique model to price the gas, however there are several options at authorities’ disposal. In this sense, a pricing model which fits a specific natural gas market is a sine qua non factor in order to safeguard the efficiency and the development of the local gas industry (SCM, 2010). A system of price formation which is not coherent with the market structure may jeopardize the future of the energetic and economic situation at the respective region. 2. Economic Relevance

The growing use of natural gas as an energetic input in many industrial activities and in the thermoelectric plants points out the growing importance of its industry. Given the warmed-up markets, the trade is the crucial focus of analysis. However, in order to understand the interaction in the gas markets, it is important to understand some specific economic features regarding the natural gas industry. 2

Rio Oil & Gas Expo and Conference 2012 First, as in the electricity market, there is (almost) instantaneous equilibrium between supply and demand. The storability of natural gas means a small share of total production which are used either to marginal adjusts in the equilibria, as an marketing strategy given the prices variations and/or as strategic reserve in order to guarantee the effective supply. Theoretically, the mechanisms of pricing has to reflect the interaction between supply and demand in a way that agents feel confident that the process of buying and selling are effective. For instance, in the spot market, the invisible hand should be the main (and unique) safeguard for agents that equilibrium actually happens. In the case of contracts indexed to oil or its products, the take or pay and ship or pay clauses2 are an effort to assure the transactions. Second, the natural gas industry is notably a network industry which then presents a network economy. Due to its energetic density3, the natural gas is transported mainly through pipelines. Predominantly, these pipelines create a network. Hence, it emerges important concepts related to access and flow. In order to trade or movement natural gas, one has to have access to the network, i.e., in order to participate in the gas industry is fundamental to have access to pipelines4. At the moment that the access is granted, the natural gas becomes a flow inside the network. Thus, it is possible to deliver it at any exit point in the network. The crucial concept to characterize a network is the complementarities of nodes (exit/entry points) and links (in this case, pipelines) (Economides, 2006). Indeed, a service delivered over a network requires the use of two or more network components. Thus, network components are complementary to each other (Economides, 2006). From this complementarities, it arises the network effects 5 then. Additionally, the pipelines are a natural monopoly. They imply in very high fix costs (capital) and low marginal costs (operation). The price of natural gas – and, specially, the expectation of future prices – are a crucial parameter to define the investments in future transmission infrastructure, since that very high/low gas prices added by a transmission tariff could result in demand distortion. In fact, prices which does not reflect the market and production conditions could result in underdimensioned or overdimensioned of the transmission infrastructure (IAE, 2011). Third, the transmission infrastructure enjoys also economy of scale. The optimization of gas pipelines is a decisive factor in order to bring efficiency to the transmission activity. A pipeline network which is efficient results in a lower cost for consumer (considering gas price + transport tariff). This fact could facilitate the basis of economic prosperity in a given region. However, considering that this planning is not only a result of technical assessments, but it also includes political variables, the analysis of the development of the gas industry becomes much more complex. 3. Price Formation for Natural Gas

Nowadays, there is a liberal trend in the main gas markets around the world (IGU, 2011). Markets based on the gas-ongas competition are being diffused. Nonetheless, there are still important obstacles to greater diffusion. In European Union, for instance, most of the contracts of importation are indexed to oil and its products and provided by few giant state companies (Rogers, 2011). The European efforts of diversifying supply could be seen as pre-requisite of liberalization. As a matter of fact, the Southern Corridor6 project which aim to bring gas from the Caspian Sea to Europe is a huge move in order to diminish the bargain power of the main exporters, as the Russian giant Gazprom (OIES, 2011). Even though the efforts towards liberalization are strong, it is premature to state that gas-on-gas competition will be the predominant price formation model in the future. Geopolitical factors could be used as anti-liberalization argument. In other cases, the existence of strong state companies could undermine the liberalizing and unbundling process or even not permit it due to law constraints. The demand elasticity also plays an important role in the process of pricing natural gas. In countries where gas is used mainly for industrial fuel or thermoelectric generation tend to present a higher elasticity since the fuel substitution possibilities are higher than in the residential use (Whitman LLC, M.J Bradley & Associates, 2011). Although, in countries where the use of gas is mainly residential, the price sensitiveness is lower. A crucial aspect is the difference in price formation between the international trade and the domestic markets. In 2005, about 70% of gas consume was from domestic production. Only 22% of gas consume was from international trade

The take or pay clauses stipulates the minimum amount of natural gas which the purchase should take and pay: this minimum quantity may be paid even if it is not taken (EGL, 2011). There is a reciprocal clause to obligate shippers to deliver a minimum volume of gas: it is called ship or pay clause. 3 The energy density is a measure which aims to describe the amount of energy stored in a certain system regarding the unit volume. In the case of natural gas, its energy density is considerably low and then it becomes worth to transport through pipelines. However, when it is converted in Liquefied Natural Gas (LNG), it is energy density becomes higher and other forms of transmission emerges. 4 Each market defines the access rules according to its structure. This definition could come from governments or from private parties on a contractual basis. 5 The main network effect or externality is the increasing returns on scale in consumption. Consumers enjoy more benefits when networks are larger. For a deep explanation on network economy and its network effects, see ECONOMIDES (2006). 6 The Southern Corridor is a 10 billion Euros Project which is composed by four pipelines (ITGI, Nabucco, White Stream and the Trans Adriatic) which were proposed by the European Commission at the Second Strategic Energy Review – An EU Energy Security and Solidarity Action Plan.


Rio Oil & Gas Expo and Conference 2012 through pipelines and 6% from international trade through LNG (IGU, 2011). These different gas origins present different pricing mechanisms. Below, it is provided an analysis of the main models of price formation for natural gas. Those are the main models applied today around the world which here are seen from an economic look. In each case, it is taken into consideration the structural and conjectural conditions which justify (or not) the application of each mechanisms. 3.1 Regulated Prices and Bilateral Monopolies When analyzing regulated prices it is naïve to build a generalist analysis. There are many different models of regulated prices for natural gas. However, it is possible to group them in three main categories: cost of the service regulation, sociopolitical regulation and regulation below cost. The regulation based on the cost of service aims to cover all the expenditures to provide natural gas. This includes fix costs and the return on investments. As in other cases of regulation, the goal is to set a price which is satisfactory for both suppliers and consumers. In the case of regulation based on social & political interests, the authorities decide prices in order to satisfy its allocation objective of natural gas. Finally, it is also observed regulation below cost, i.e., completely subsided. Both in the former and the latter case, the role of state companies is crucial in order to coordinate the policies and operational process inside the industry. Generally, in those cases there are bilateral monopolies involving state companies. The main critic about the regulation prices is that there is no incentive to efficiency. According to this point of view, the usual presence of monopolist or oligopolistic giants in the industry diminishes a lot the interest of agents for efficiency since that in most of cases they are state companies facing no competition threat. This theoretical low sensitiveness for costs, imposes the necessity of price regulation which is not an option anymore. Still, that could be a significant risk of underdevelopment of the transmission and distribution networks. The lack of efficiency in such market structure could mean a disincentive of investment in infrastructure. The bilateral monopoly model is the standard of countries of the former Soviet Union. However, even in those case, it is observed moves towards liberalization. Russia starts to withdraw the subsides for the internal market and by 2014 they will be completely withdrew (IEA, 2011). 3.2 Prices indexed to oil and its products The long term contracts indexed to oil and its products is a very diffused manner to price natural gas. Those contracts are endowed with clauses which link directly the evolution of gas prices to the oil or its products – also known as oil price escalation. In 2007, this model was responsible for 26% of all gas volume consumed in the world (IGU, 2011). This mechanism of price formation is the most applied in the gas international trade. In the case of imports through pipelines, it responds for 47% in 2007. For LNG, it is even higher responding for 70% for the same year (IGU, 2011). Therefore, both Continental Europe and Asia (which are very dependable to gas imports) has this type of price formation as the general case. There are many ways to index the gas contracts. For instance, in Japan, the imported LNG is indexed an oil basket which is denominated Japanese Crude Cocktail. In the case of Europe, generally, the contracts are indexed to oil products and a substitute fuels, but not directly to oil prices (IGU, 2011). However, in both European and Asian markets, there are a visible trend towards a spot price formation. (OIES, 2011). The Southern Corridor project is indeed an massive effort of European Union towards the creation of the proper conditions to a greater liberalization. Additionally, there has been a hub concentration process in order to create the necessary liquidity for spot trade (OIES, 2011). However, without a greater diversity of suppliers, the European liberalization process is jeopardized. In the Asian case, the LNG trade has a crucial importance. Thanks to the competitive gains of LNG trade during the last decade, there is a greater diversity of suppliers and demanders which trade flexible volumes (IEA, 2011). Thus, the dynamism of LNG markets provides room for innovation in pricing. Even though that 70% of all LNG imports were indexed to oil and its products, the introduction of spot pricing has been stronger: from 13% in 2005 to 27% in 2007 (IGU, 2011). Finally, some argue that this price formation model for natural gas avoids prices volatilities. This argument is that spot pricing as an alternative would increase volatility and then destabilize the markets. 3.3 Gas-on-gas Competition The trend of liberalization in the natural gas industry has pushed many markets to adopt the gas-on-gas competition. This model set a mechanism which allows high price flexibility which ideally tend to reflect the effective scarcity of natural gas. This model is fully applied in the American and British markets. Therefore, in those markets exist two national hubs where natural gas is traded: the Henry Hub (USA) and the National Balacing Point (UK). 4

Rio Oil & Gas Expo and Conference 2012 The USA established the basis for the liberalization of its market through the Natural Gas Welhead Decontrol Act of 19897. After this Act, the purchase of natural gas is only permitted in a competitive fashion, which fostered the pulverization of the industry and then gave less market power to all players (Vazquez, Hallack, Glachant, 2012). Today, the American domestic market is considered the most liquid and dynamic, but also volatile (Anne-Sophie Corbeau, 2012). The British case is different. The process of deregulation initiated in the 80s did not achieved the same level of liberalization regarding the American case. This is explained due to a reduced share of production onshore (Whitman LLC, M.J Bradley & Associates, 2011) which may have created technologic barriers to entry. With barriers to entry blocking further competition, the robustness of the liberalization process of the market had been hold back. However, the progress towards liberalization was important 8. In economic terms, the price formation is given at P1 on the Figure 2. It represents the equilibrium of demand and supply. The supply curve here is equal to the marginal cost curve since that is based on the latter that suppliers define their selling prices. The demand curve is elastic in its middle segment. At this segment, there are sensitiveness to supply shocks.
Figura 2

Source: IGU, 2011

However, in order to safeguard a proper functioning of spot market, the gas-on-gas price formation model has some preconditions. The application of a spot pricing in a specific market should be coherent with the market structure. The main pre-conditions are the following:


To reduce market power of players by pulverizing the market instead of concentrating it; To set the rules of unbundling operations. Vertical integrated firms are very dangerous to liberalized market due to the risk of anticompetitive practices. To guarantee that market has a significant number of buyers and sellers in order to bring liquidity to it; To create a hub – physical or virtual – where is going to be based the transactions; To set clear and stable rules about access to gas infrastructure (mainly, transmission) and to create a strict regulation frame to natural monopolies.

The American case is mostly successful because it could accomplish those pre-conditions. American markets became dynamic and robust then. The British market found more difficulties to deal with its pulverization and then liquidity

According to the US ENERGY INFORMATION ADMINISTRATIO: “The Natural Gas Wellhead Decontrol Act of 1989 (NGWDA) required the removal of all price ceilings dictated by the Natural Gas Policy Act of 1978 (NGPA) by January 1, 1993, rather than by the end of the century as called for in the NGPA. One of the immediate objectives of the NGWDA was to help mitigate the gas market imbalances that had developed during the 1980s as the pricing provisions of the NGPA brought about an increase in gas production while allowing only a slow (monthly) incremental price increase for many categories (vintages) of old gas. But the immediate impact of the legislation was expected to be minimal, as gas wellhead market prices at the time generally were below most remaining price ceilings. Under the influence of the NGWDA, however, it was expected that wellhead prices would better reflect market 1 conditions. New and renegotiated contracts would eliminate restrictive pricing as well as take-or-pay clauses that became even more prevalent after passage of the NGPA and hampered industry adjustments to changing market conditions.” 8 Besides, the United Kingdom has a growing dependence of importation given its diminishing offshore production.


Rio Oil & Gas Expo and Conference 2012 constraints which resulted in a market less dynamic and robust than the American one. Actually, the establishment of those conditions are the greatest challenge of liberalization. Now, many markets are seeking for a more liberal status, but many of them are finding deep difficulties in accomplishing the pre-conditions. The results is an anomalous situation which usually results in an inefficient gas market. Moreover, another important characteristic is the relation of price volatility to the origin of the gas consumption. According to WHITMAN and MJ BRADLEY & ASSOCIATES (2011), once the country has a significant volume of domestic reserves, the willingness to accept volatility costs is higher. In turn, this country gives room for a more dynamic market.


Final Remarks

Even though the natural gas market are still regional, there is an international trend towards liberalization in the main markets. However, the price formation models of different markets are still extremely different. For either, political, social or structural reasons, each market set its own pricing system. In the Middle East, the political and cultural parameters provided a strong state presence in the industry. In the USA and UK were the most successful places to implement liberalized markets. Instead, the European Union as a whole is dependent of gas imports and then it is vulnerable to the strong bargain power of exporters. Therefore, prices indexed to oil and its products is the standard (Rogers, 2011). One of the most important aspects is the origin of the gas. In cases which most of the consumption is provided domestically, there is an opportunity for authorities to shape the market as they prefer. Since in this case the controls over the exploration, transmission and commercialization are under a single government. Thus, it should be observed coherence with the domestic interests – even if sometimes they are not very clear. In cases which most of the consumption comes from importation, it is observed something different. In most of the cases, the exporter has a high bargain power which impacts directly in the price negotiation. The price formation is a consequence of a contract signed by both parts which might be settled not only regarding domestic interests. Finally, the price formation for natural gas depends not only in technical parameters, but also in the industry structure. Political factors as well as social, geographic and cultural factors are relevant variables in order to analyze gas markets in a certain economic region. It is an illusion to believe that an implementation of price formation model in certain economic region will imply in identical results as observed before in other economies. Therefore, the gas markets are passive of influences of international experiences as well as domestic characteristic of each industry. Then, the regionalized markets tend to follow the path of the international experiences. However, the result will always be an assemblage of regional characteristic and international models. 5. References

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Rio Oil & Gas Expo and Conference 2012 TRANSPORTE DUTOVIÁRIO DE GÁS NATURAL: CRITÉRIOS APLICÁVEIS E PROPOSTA DE POLÍTICA DE PREÇOS. Rio de Janeiro, 2010. 31p. (Notas Técnicas).