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Reforms in European gas markets: new shoes may hurt

The European Commission seems to be readying for moving the “cold war” into the “hot phase”. Leaks in the mass media and vague hints of European functionaries about intentions to produce financial claims against Gazprom for alleged cases of violation of competition in Eastern European markets testify to this supposition.

The most interesting thing is that the Europeans want to fight against the major gas supplier in the period when the EU’s vulnerability in terms of energy and gas supplies is quite substantial. And in the next 10 to 15 years this weakness will be increasing due to objective reasons: from depletion of its own resources to losing competition for access to new sources of supplies. Hopes for the free market that should provide the European Union with gas at competitive prices were ruined last year when buyers from the Asia Pacific region took not only the whole gas free from long-term contracts but also attracted part of gas initially reserved for the Europeans.

The European Union is stubbornly trying to use the model of liberal markets that works under conditions of the real and prolonged oversupply of gas. The Europeans have an illusion of gas magic: they are confident that application of the new model of pricing will inevitably become a key to success. But they forget that it has to be based on constant and rising surplus of the supply. But there are difficulties with this proviso. An attempt to put on new shoes may be unsuccessful. The situation may become especially dangerous if old shoes are thrown away.

The new report by the National Energy Security Fund analyses the condition of the EU gas market, main results of liberalization of gas trade and prospects of main suppliers, excluding Russia.

The report elaborates on the following topics:

· Results of 10 year efforts to liberalize European gas market;

· European energy concerns are turning into traders, main outcomes;

· Prospects and risks of providing Europe with gas deliveries. Situation with Norway, Northern Africa and the LNG supply;

· Forecast of stability of the gas market model built by Europe.



The downward tendency of natural gas consumption has been observed in the European Union over the past three years. Since 2010 the demand in the EU has gone down 13% (by 73bn cu m). Production has also reduced by 13%. However, before 2010 Europe’s gas consumption had not been that sensitive to the dynamic of domestic production that had been retreating over the previous eight years. In 2002 to 2008 it dropped by 40bn cu m and by another 40bn cu m over the past five years. The British sector of the North Sea is responsible for major part of this fall (70bn out of 80bn cu m), which made the liberalized UK market dependent on imports. The facilities launched to import gas from Norway and the Netherlands, as well as tree new LNG receiving terminals, do not enable the British market to have lower prices than on the continent. To make this possible it was necessary to substantially reduce gas consumption: in 2010 the demand in Great Britain reached 99bn cu m, but in 2012 it dropped to slightly over 77bn cu m.

Amid decline in domestic production reliable and long-term relations with gas exporters should be an absolute priority along with improvement of energy efficiency. This is what the EU energy security will depend on in the next 10 to 15 years. And the long-term potential of gas suppliers differs considerably.

The European Union has four sources of piped gas imports. Russia represented by Gazprom remains the largest gas supplier to the EU – 115bn cu m in 2012. Russian gas exports to EU states last year even dropped below the 2002 result, and the decline was quite substantial compared to the peak year 2008 – 20bn cu m less. The share of Russian gas in EU imports shrank from 48% in 2002 to 36% in 2012. The share of Algeria, including LNG supplies, in EU imports was 13% in 2012, which was 10% lower than 10 years before.

The new structure of gas imports looks more reliable and balanced for European politicians. However, decline in production in the European Union will continue and, probably, will even accelerate. The reason is the beginning of gradual depletion of small deposits in the Netherlands (1bn to 2bn cu m decline per year). And at the beginning of the next decade quick decline in production is expected at the EU’s largest Groningen field. Thus, the question is whether Europe will be able to keep counting on supplies of additional gas from Norway, Algeria and the world LNG market, or it will have to revitalize the Russian direction of international gas cooperation.

Moreover, Norwegian suppliers, according to our estimations, last year reached the peak of their production capacities and, amid the available resource base, they do not have prospects of increase in deliveries. Norway will begin having problems with maintaining production at 100bn cu m already by 2020. Algeria will continue reducing exports to the EU. With the increased demand for LNG in Asia and its supply deficit this kind of gas is not a sufficiently reliable source to satisfy the demand in the EU.

In the second half of the 2000s Western Europe staked on development of the LNG receiving infrastructure. By the end of last year regasification capacities had been raised by four times reaching 133m tons. In other words, they were capable of importing up to 180bn cu m of natural gas, which is more than Russian and Algerian gas exports combined. But it turned out that investments in terminals are not a guarantee of success on the LNG market. In 2012 less than one third of the available capacity was utilized, while the utilization coefficient of facilities built over the past decade was just 15% on average. In 2010 to 2011 growth in liquefied natural gas imports in the EU was an important factor of the excessive supply that influenced strongly pricing policies of traditional suppliers. But in 2012 LNG imports in EU states dropped by 29% (-23bn cu m), while Qatar that had been intensively raising exports to Europe over the previous few years reduced them by 37% (-15bn cu m) last year.

The European strategy of diversifying sources of supplies without liabilities to suppliers has faulted. The Europeans did not contract additional long-term liquefied natural gas supplies hoping that attractiveness of the EU market will be a guarantee of stable gas imports. But it turned out differently. Even part of the contracted LNG was not delivered to Europe. The Europeans simply did not take into account peculiarities of the world LNG trade that enable traders to redirect gas to more profitable markets.

The current situation in Europe is a direct result of reforms initiated by Brussels in the market. As soon as the spread between gas prices in the EU and Asia is larger than additional costs of gas transportation from the Atlantic (in case of deliveries from the Middle East it does not matter) to the Asia Pacific region plus the cost of reservation of regasification capacities, the EU loses gas jeopardizing its own energy security.

The Europeans linked half of Norwegian gas exports to the spot market. According to Statoil, in 2012 half of the exports (about 40bn cu m) was linked to spot prices, although in 2008 its share was just about 25%, i.e. only supplies to Great Britain. But this also led to reduction in energy security of the European market in the medium-term perspective. Simultaneously, liabilities of Statoil under long-term contracts significantly shrank. This means that the company may reduce the supply and production, if the price conjuncture does not meet expectations.

According to our estimations, major part of Statoil liabilities (including the share of Petoro) will have expired by 2022. Moreover, part of contracts is linked to concrete deposits (depletion contracts), and this does not guarantee supplies of a concrete amount of gas to a consumer.

The third energy package was to finally break ties between major wholesale sellers and the gas transit infrastructure, and simultaneously it was not to allow strengthening of market positions of players from outside the European Union, as they objectively have every possibility to occupy a substantial part of the liberalized market. This gave birth to the concept of compulsory sale of gas exports at several hubs near the EU border where consumers and traders could freely transfer gas from, in compliance with the market demand and on the basis of the demand-supply balance. This leads to the desire to ruin the practice of oil links that is the basis of the current system of long-term contracts, but to preserve liabilities of suppliers on guaranteed provision of hubs with gas in the long-term perspective.

The main postulate of this campaign is that the oil link does not meet the market realities, while prices at spot hubs reflect the real balance of the demand and the supply and, correspondingly, provide for forming fair prices on the basis of competition between gas supplies. But this absolutely does not correspond to the reality. The dynamic of the annual average price at Europe’s oldest and most liquid hub, British NBP, is practically fully correlates with fluctuations of oil prices. The exception was in 2006 and 2007, when two import gas pipelines (BBL from the Netherlands and Langeled from Norway) were launched that significantly raised security of the UK gas balance. It is even higher than the BAFA index that shows the average price of gas supplies under long-term contracts to the German border.

However, the EU policy provided for reducing prices of gas imports. Gas prices in Europe became almost half of oil prices, which, taking into account better environmental friendliness of natural gas as fuel, looks absurd, especially considering eco friendly standards of the EU on reducing greenhouse gas emissions.

Meanwhile, consumers in the EU did not feel the increased spread between prices linked to oil and spot indices. Over the past five years the average rise in EU prices for industrial consumers has been €80 per 1,000 cu m, while prices for main consumers have altered by €30 to €40. Over the past five years BAFA prices have expanded the lag from oil parity by €20, while prices for industrial consumers in the EU became €3 closer to the oil parity in 2012 compared to 2008.

Besides, natural gas competitiveness on the market even weakened in some countries following revision of conditions of long-term supplies because of strengthening of the tax burden. Thus, the money withdrawn from exporters was spent on things that did not coincide with official objectives of reforms in the EU gas market.

Another important aspect of the EU energy policy is struggle against large energy concerns on a national level. Having defeated or, at least, having substantially reduced their presence on national markets, the European Commission failed to prevent their expansion in the EU gas market in general. Despite decline in the gas consumption in the EU compared to 2002, the share of main players has risen significantly (by 43bn cu m) on this market.

Solid positions of the big troika (Eni, E.ON and GDF Suez) are secured by long-term contracts on gas purchases from producers inside the EU (largely from the Netherlands-based GasTerra) and gas imported from Russia, Norway, Algeria, Libya and LNG producers. All of them have a very well diversified portfolio of purchases – each company has five and more sources. The three companies control 60% of gas supplies from the Netherlands to other EU states, one third of imports from Russia, 40% of imports from Norway, over half from Algeria and 100% from Libya.

Yet, gas prices for consumers in the EU are linked to hubs, and contracts are limited to not more than four years with the right to change a supplier at any moment. Since contracts on imports with outside suppliers are based inter alia on the liability of a buyer to pay a minimal volume of imports (80% of the contracted volume on average) regardless of the gas volume taken, the profit margin of importers has reduced to almost zero or has even become negative.

Depression on the gas market results in a stalemate. Either traders representing importers should leave the low-margin market ceding the right for direct contracts between consumers and producers, or suppliers should ensure gas deliveries at prices below spot prices, which is commercially unattractive and risky for gas producers, or the pricing system should change regarding guarantees of profitability for importers.

Being pressed by the norms of the third energy package and threats of application of sanctions for violating the antimonopoly legislation, E.ON, Eni and some other smaller concerns began selling their gas transportation assets (OpenGrid Europe, Snam Rete, TAG, Transitgas, Thyssengas, Net4Gas) to financial investors. After that European concerns turned from gas suppliers responsible for gas supplies into gas traders, which, according to our assessments, bears huge risks for Europe’s energy security. Trading certainly is not a problem, and it can serve to balance the system developing different financial instruments on the basis of gas trade. However, players with purely trader psychology and behavior on the market cannot and do not have to ensure reliable gas supplies, i.e. delivering gas to the import dependent balance of the EU. This is a different business with other kinds of risks and demands for investments.

The further logic of development of the trading model of the European gas market implies rejection of the system of long-term contracts on supplies. In the short-term perspective these actions will provide for balancing the market and eliminating the oversupply on the market. But the reduction in long-term liabilities of suppliers will have long-lasting consequences in the sphere of investments in development of new reserves. Their development will be linked to the European market to a lesser degree, or investments may be delayed at all.

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Analytical series “The Fuel and Energy Complex of Russia”:

Services and Mechanical Engineering for Oil and Gas: Are Industry’s Foundations Secure?
Sanctions against Russian Oil and Gas: Pressure Continued
Arctic: Soviet-type Gigantomania or Breakthrough Project?
State regulation of the oil and gas sector in 2018, prospects for 2019
Gazprom on Path to New Reality

All reports for: 2015 , 14 , 13 , 12 , 11 , 10 , 09 , 08 , 07

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