Gas midstream From contracts to hubs

Miguel Vazquez

The previous world
Gas before restructuring
Wholesale markets as we wanted them to be
Wholesale markets as they are
Price formation
Challenges
Outline
2
Producers
National
monopoly
Consumers
Starting point
3
Contracts
Long-term, ToP
Structure
4
Consumer
Gas Sales
Agreement
Transport, Storage
and Distribution
Vertical integration
Ownership
Long-term
contract
Power Plant
Distribution
Cross-border
transmission
National
transmission
Gazprom
Sonatrach
Gasunie
GdF
British Gas
Ruhrgas
Gas industry developed around 60s with Groningen and the North Sea
In early 60s, The Netherlands began to negotiate with neighbors the
export of gas through pipeline
Subsequently
LNG from Algeria
Pipeline from Russia to Eastern Europe
Pipeline from Norway to Northwest Europe
How to price the gas?
Production-cost methodology
Production costs + Transportation + Profits = Gas price
Netback pricing
Gas price based on its market value
The Dutch standard Netback pricing
5
Gas seller finds customers if costs of gas are less than costs of
alternatives
Price formation Market Value
6
Commodity Transport End-use
Cost of alternative
Gas price
End-
use
Transport
Repeat for each consumer
Price discrimination
7
Residential
Industrial
Power
G
a
s

p
r
i
c
e
s

Profits are shared by producer and monopoly
GSA and buyer
8
Consumers willingness to
pay
Average for each sector
Depends on alternative
Monopoly cost
Profits shared by
producer and monopoly
Depends on price of
alternative
GSA indexed to alternative:
Oil indexation
Consumer Gas Sales Agreement
Transport, Storage
and Distribution
One of the factors in the price was the transmission cost
The Netherlands was selling simultaneously to Belgium, France and
Germany
At the Dutch border there were different prices for gas
In principle, cheap gas for distant markets should not be used to serve
closer markets


Solution: Destination clauses. Gas-to-gas competition was excluded
Additional features Destination clauses
9
The market value will change over time
It will change with technology, different alternative fuels, etc



Solution: Price review clauses in the contract Re-opener
Periodic review of prices to account for those changes
Additional features Re-opener
10
At the time, there was no local storage at Groningen field
Solution: Annual Contracted Quantity + Capacity charge
Gas producers would provide load modulation up to the Dutch border
Possible because short distances
Additional features Flexibility
11
ACQ Annual Contract Quantity
Price Defined by netback pricing
Additional clauses
Destination
Price review
Modulation
The Dutch contract - Summary
12
Gas from Russia or Norway was far away
Transportation was significantly more expensive
Flexibility was cheaper if provided by storage close to end-users
Long-distance trades also required big pipeline systems
Huge capital costs
Need for higher commitment
The agreement was the take-or-pay clause
Buyers would pay typically between 80 to 90% of the ACQ
Upwards flex was often set around 115%
Shipper takes the quantity risk, producer takes the price risk


It is a flexibility clause!
Subsequent contracts The ToP clauses
13
Annual Contract Quantity e.g. 2bcm
ToP Clause
Minimum Annual Quantity 85%ACQ
Make-up
Price
P0 x a Price of alternative
Periodic adjustments
The typical ToP contract
14
Might need to prove significant changes (sometimes need to be
unexpected)
The language gives an idea of how to change the contract
Significant changes in buyers market
Allow sellers to economically market gas
Enormous risks involved
GSA with general wording, which results in uncertainty
Long and expensive processes
Price review clause Arbitration
15
Asset specificity
When identity matters, long-term contracts are necessary
E&P is subject to significant uncertainty
When the pipeline is built, the producer is committed to the shipper
And the shipper is committed to the producer
Long-term contracts protected both sides
What does economic theory say?
16
The major objective was to end price discrimination
Introducing competition among suppliers would end monopoly pricing
The main barrier was destination clauses
Restructuring What did we want to achieve?
17

Restructuring End of price discrimination
18
Residential
Industrial
Power
G
a
s

p
r
i
c
e
s

Average
willingness to pay
Price
Consumers pay
for the cheapest
alternative fuel

Restructuring End of oil indexation?
19
Residential
Industrial
Power
G
a
s

p
r
i
c
e
s

Average
willingness to pay
Price
No oil indexation
Consumers pay
for the cost of
supplying gas
Restructuring The need for liquidity
20
We build on gas-to-gas
competition
Resale is
necessary
Incompatible with
destination clauses
Emergence of
spot index
Price reviews
based on index
Fewer arbitration
processes
Liquidity reduces
the need for long-
term contracts
We need more people trading the same in order to reduce specificity
Reducing specificity, contract duration decreases
But is the industry less specific?
End-users typically prefers short-term contract
Producers often prefer long-term contracts
The supplier is in the middle
An increasingly used strategy to deal with this is the integration with
power industry
Tension in contract duration
21
Price discrimination disappears
Commission declares destination clauses invalid
Competition authorities intervene with contract lengths
Hence, lower price for end-users and potential losses for incumbents
Incumbents call for price reviews (market has changed)
Need lower price to market economically
Producer pays the end of price discrimination
Transitions are hard Prices
22
Market value is now set by gas-to-gas competition
There is no liquid index to measure it
Reviews are harder
Transitions are hard Price reviews
23
Restructuring in Europe was aimed at ending price discrimination
End of long-term contracts or oil-indexation are possible (not
necessary) consequences
That requires liquid short-term trading
The scheme needs to be coordinated with a very specific activity: Gas
transmission
The EU market design has essentially been concerned with a
fundamental question: how to facilitate access in order to obtain liquidity?
Transmission is a fundamental barrier
We will see next how to regulate it
Concluding remarks Need for market design
24