Alboran Energy Strategy Consultants and
Delft University of Technology
The gap between North American and European oil and gas prices has widened to historic levels. Because the divergence affects the competitiveness of each continent, convergence of oil and gas prices would help restore an even playing field. This article analyzes reasons for the oil and gas price dichotomy and gives recommendations for a strategic realignment of the two western energy markets.
Unrest in Middle East and North African (MENA) producing countries pushed up oil and gas prices in Europe much faster than in the US as traders worried about tightening supply and rising demand. US prices are increasingly unaffected by world market volatility. The price dynamics for oil and gas in Europe and the US are decoupling: Brent crude, Europe’s benchmark for oil prices, now trades at 15% above the US benchmark price for West Texas Intermediate (Fig. 1a). The price dichotomy is even larger for natural gas: The Continental European gas benchmark given by the Average German Import Price (AGIP) has in 2011 risen further, to nearly three times the Henry Hub reference price used in New York Mercantile Exchange (NYMEX) gas trades (Fig. 1b).
Transatlantic oil and gas price differentials are now larger than ever before. What can these markets learn from each other? What measures could be taken to reduce the price gap?
Gas price dynamics
With gas, the transatlantic price differential is supported by differences in gas supply dynamics. For example, Europe must import half of its natural gas.1 These supplies come from outside the European Union via pipelines from Russia, Algeria, and Lybia, as well as in LNG tankers. Europe’s gas production is set to decline steeply, and imports must grow in step to account for 80% of the projected demand by 2035 (Fig. 2).
Europe has declining gas production and rising gas demand. The result is that European gas prices—also lifted further by oil-indexing—are generally firmer than in the US, due to structural tightness of gas supply.
Price fundamentals of physical gas trades are driven both by real shifts in the supply-demand balance and by perceived impending shifts in that balance. Short supply drives up prices, and oversupply depresses the market’s premium.
Europe’s continued dependency on foreign gas makes stabilization of the pricing mechanism important. The region’s historic coupling of gas prices with oil prices in long-term, oil-indexed wholesale delivery contracts hedges against price spikes when gas supply is short as long as oil prices do not rise in a volatile fashion themselves.2-4
Continental European gas markets can move toward spot-price indexing rather than oil-indexing as soon as real trade liquidity emerges in the European gas market. Such liquidity is now handicapped by the lack of a single price-reference hub5 as is the case in the liquid US gas market. At present there are half a dozen trading centers in Europe, each providing its own reference price for gas derivatives (futures and swaps; Fig. 3). As long as the EU does not adopt a single reference price for its gas contracts, all other measures and efforts to liquefy the EU gas market (European regulator ACER, tariff harmonization, transport regulation, etc.) remain ineffective instruments. Decoupling gas prices from oil-price indexation in long-term (LT) contracts and instead indexing by a single spot gas price reference is the only real measure that could bring more market dynamics to gas pricing in Continental Europe.5
Spot gas trades in a price range that may be nearly half AGIP as occurred in 2009 (Fig. 4). Integration of trading hubs and spot markets can bring further liquidity to the EU gas market and smooth out unnecessary price differentials faster across European regions by better matching supply and demand in real-time trades rather than stay locked into long-term contracts.
Gas prices in Europe cannot be lowered by liquid trading when gas demand continues to rise and supply remains structurally tight. This latter scenario poses a real threat for Europe’s future gas-price stability, in spite of recent advances to establish a pan-European gas infrastructure model. Lowering Europe’s strategic vulnerability to short gas supply will require the building of massive storage capacity to ensure gas volumes remain at hand to match periods of sustained peak demand (winter) and short supply (unrest in supply regions). The current EU gas storage capacity—combining depleted gas field injection, aquifers, salt caverns, and LNG peak shavers—is only 60% of the North American capacity (Fig. 5). At 2011 consumption rates, the European gas storage facility holds less than 2 months’ strategic reserve. Clearly, this is not enough to bridge shortages, when 75% of EU gas must come from overseas in 2030.
What Europe really has completely missed out on, so far, is exploitation of its unconventional gas potential. Starting development of these resources now can realistically lead to a reversal of the decline in conventional gas production by 2020.6-8 Indigenous production from unconventional gas resources could close part of the import lens shown in Fig. 2. Europe would become less vulnerable to supply interruptions and could minimize future decline in tax income and reduce job losses by reviving its gas operations while avoiding spending on dear gas imports.
Surprisingly, the unconventional gas development option has yet to reach the agenda of the EUs Energy Directorate, which still focuses on infrastructure-building rather than stimulating indigenous gas supply. Overstimulation of midstream transport expansions may lead to overbuilding capacity. Additionally, lagging support for supply incentives for the upstream industry could lead to underuse of gas transport capacity due to gas shortage; a more balanced approach seems needed.
US gas prices
The North American gas market is strongly affected by the unconventional gas production boom, which has depressed gas prices due to structural oversupply and stable demand.9-11 The US market receives insignificant net imports from outside North America. LNG terminals are idle and will remain so as long as the reduction in gas rig count does not restore the supply-demand balance.
Downward pressure on US gas prices has steadily increased over the past decade, and gas now trades at far below its calorific parity value with oil (Fig. 6).
Adopting some of Europe’s pricing practices, by introducing a proportion of oil-indexed gas contracts, could help to restore and stabilize the US wholesale gas price. Such oil indexing may be more effective than adopting a price-floor mechanism, proposed earlier11 for the benefit of the US gas industry and adopted in India.
Gas traders in Europe customarily negotiate oil-indexed contracts with suppliers. The gas volumes are then dispatched in the EU gas transmission networks. The seasonal swing in demand and supply, with lower demand in the summer and higher in the winter, leads traders to schedule LT supply contracts accordingly. The uncertainty range in actual demand may result in temporary demand peaks, for which supplementary spot gas and storage gas must be purchased to complement the prior anticipated demand load. This means the spot market has a more limited role in Continental European gas contracts than in the US, where the majority of gas contracts are short-term spot gas-indexed.
In the EU, spot gas prices remain important because they can suppress the gas price when arbitrage sets in to take advantage of lower spot prices by settling take-or-pay terms in long-term contracts. This may happen in unusually warm winters, resulting in demand lag and LT gas oversupply. This also occurs when cheap LNG spot gas becomes available in the world market, as happened over the past 2 years in the Atlantic Basin due to the US diversion of unneeded LNG loads.12
The US gas industry is under severe financial pressure due to investors’ growing impatience with low operating margins.13 A recovery of the US gas price may not occur fast enough.
Producers might be well advised to start offering longer-term gas contracts to gas consumers using oil-indexing (or a mixed indexing of oil and gas spot prices). If the market is not prepared to adopt such contracts, which probably is the case, governmental intervention, however unlikely as well, might stimulate the use of such contracts to moderate short-term volatility in the US gas market in favor of a more profitable and stable gas industry. The US currently uses bilateral negotiated physical contracts (spot gas-indexed) and already benefits from standardized spot market gas contracts.
EU gas markets are still dominated by oil-indexed, bilateral LT gas contracts and a range of spot market contracts (different for BNP, TTF, PEG, and NCG; see footnote, Fig. 3). These contracts need harmonization. Finding more common ground by sharing and adopting best practices of both gas markets could bring convergence of North American and European gas prices. That would help make the gas business more stable for all major stakeholders—producers, consumers, and investors—as well as reduce governments’ concern about supply vulnerability. Such aims might be put on the agenda of such organizations as the World Forum on Energy Regulation (WFER), International Confederation of Energy Regulators (ICER), and International Energy Regulatory Network (IERN).
US, EU oil prices
The US oil market is now starting to feel the impact of shale gas companies’ massive shift from gas to oil drilling.14
In response to a growing premium of oil prices to gas prices, gas rig counts have been halved, and oil rig counts have doubled over the past 2 years (Fig. 7). However, the benefit from oil prices is lower than might otherwise be expected as the WTI benchmark price has begun to lag behind prices outside the US, mainly because of logistical constraints causing a surplus at Cushing, Okla., the settlement point for NYMEX futures contracts based on WTI-like light, sweet crude.
US oil production has stabilized after 3 decades of decline, in part because of the use of horizontal drilling and multistage hydraulic fracturing in unconventional reservoirs, such as the Bakken shale of North Dakota and Montana. Increased onshore production is moving more crude into Cushing than can move away via existing pipelines, depressing WTI prices relative to the European benchmark, Brent (Fig. 1a).
The US still imports about 60% of the crude its refiners use.
Europe imports 70% of its crude and nearly 50% of its natural gas. Security of supply would benefit and prices would come down to US levels with widespread development of Europe’s unconventional oil and gas resources. Serious efforts are needed to defray concerns about oil and gas supply interruptions such as recently occurred due to unrest in the MENA region. The adoption of the drilling and completion techniques in use in unconventional oil and gas plays in the US would improve the vitality of the European oil and gas industry.
So what does the above analysis say about the future of oil and gas prices?
Oil-indexed gas contracts have gradually lifted gas prices in Continental Europe as crude oil prices are firming up. This upward price trend will continue for both commodities as long as the economic recovery does not falter. Continental Europe’s AGIP gas prices have held relatively firm over the recession.
The impact of rapid drops in oil prices during the recession was cushioned as trailing averages of oil prices are used in the oil-indexed LT gas contracts. The time lag is 6-9 months, which explains why the 2009 AGIP traded at double the price of 2009 US spot gas. The rise of oil and gas prices in Europe can be slowed down only in a structural fashion when the development of unconventional oil and gas resources starts to add regional price pressure to oppose the current short supply dynamics. Unless that is realized, expansion of storage capacity is needed, too.
US wholesale gas prices have not yet reacted to the rising trend in US oil prices. However, there still exists a certain link between oil and gas prices—even in the US—as highlighted in several studies:3 15
• Calorific equivalence tends to direct consumer choices such that a loose price link is maintained. For example, power generators use gas for peak cycling but could take residual fuel oil (diesel) as an alternative if gas becomes too expensive. However, burnertip competition is limited due to lack of gas infrastructure in some regions.
• US independents can drill for oil or gas—if the price of one is more advantageous than the other, resources will be deployed accordingly. Although Rogers12 doubted a trend reversion of gas and oil rig counts could still occur, it actually did occur14 in 2010.
US gas prices will eventually recover, and perhaps faster than expected, as the halving of gas rig counts begins to take effect in 2012. Price spikes may occur even faster when the financial woes of the unconventional gas industry trigger shut-ins, as explained elsewhere.14 Adoption of oil-indexed gas contracts, although unlikely, would help to stabilize price-making in the US gas market.
US oil prices themselves will rise further in step with the economic recovery. The discount of US oil with respect to Brent could grow further—especially if US independents continue to produce WTI equivalents into already brimming storage at Cushing.
1. OECD/IEA, Natural Gas Information 2010, International Energy Agency.
2. Stern, J., “Is there a rationale for the continuing link to oil product prices in Continental European long term gas contracts?” Oxford Institute for Energy Studies, Natural Gas Series 19, 2007, http://www.oxfordenergy.org/pdfs/NG19.pdf.
3. Stern, J., “Continental European Long-Term Gas Contracts: is a transition away from oil product-linked pricing inevitable and imminent?” Oxford Institute for Energy Studies, Natural Gas Series 34, 2009, http://www.oxfordenergy.org/pdfs/NG34.pdf.
4. Weijermars, R., McCredie, C., “Gas Pricing—Lifting the Price,” Petroleum Review, Vol. 65, No. 768, March 2011, pp. 14-17.
5. McCredie, C., Weijermars, R., “The Rising Power of the Gas Traders,” Petroleum Review, Vol. 65, No. 771, June 2011, pp. 18-20.
6. Oswald, C., “How unconventional gas fits into the gas market,” Finding Petroleum Conference, Apr. 27, 2010.
7. Geny, F., “Can Unconventional Gas be a Game Changer in European Markets?” Oxford Institue for Energy Studies, Natural Gas Series 46, 2010, http://www.oxfordenergy.org/pdfs/NG46.pdf.
8. Weijermars, R., Drijkoningen, G., Heimovaara, T.J., Rudolph, S., Weltje, G.J, Wolf, K.H.A.A., “Unconventional Gas Research Initiative for Clean Energy Transition in Europe,” Journal of Natural Gas Science & Engineering, doi:10-.1016/j.jngse.2011.04/002, 2011, in press.
9. Berman, A.E., “Lessons from the Barnett Shale imply caution in other shale plays,” World Oil, Vol. 230, No. 8, 2009, p. 17.
10. Berman, A.E., “Shale Gas—Abundance or Mirage? Why The Marcellus Shale Will Disappoint Expectations,” The Oil Drum, Oct. 29, 2010, http://www.theoildrum.com/node/7075#more.
11. Weijermars, R., “Why untenable US natural gas boom may soon need wellhead price-floor regulation for industry survival,” First Break, Vol. 28, No. 9, Sept. 2010, pp. 33-38.
12. Rogers, H., “LNG Trade-flows in the Atlantic Basin: Trends and Discontinuities,” Oxford Institute for Energy Studies, Natural Gas Series NG 41, 2010, http://www.oxfordenergy.org/pdfs/NG41.pdf.
13. Weijermars, R., Watson, S., “Can Technology R&D Close the Unconventional Gas Performance Gap?” First Break, Vol. 29, No. 5, May 2011, pp. 89-93.
14. Weijermars, R., “Price scenarios may alter gas-to-oil strategy for US unconventional,” Oil & Gas Journal, Vol. 109, No. 1, 2011, pp. 74-81.
15. Hartley, P., Medlock, K., Rosthal, J., “The Relationship Between Crude Oil and Natural Gas Prices,” The Energy Journal, Vol. 29, No. 3, 2008, pp. 47-65.