Mitigating Market Risk under Long Term Gas Contracts

Energy & Utilities

April 14, 2014

Market authorities, regulators and most active gas market participants are currently addressing the recent changes in the structure of many European natural gas markets. For decades natural gas has been traded based on long-term contracts indexed to products such as fuel oil, gasoil and coal (“Alternative Fuel Contracts” or “AFC”), with the gas price defined according to predetermined formulas. The rationale of indexing natural gas to oil was originally based on the “market value principle”, which was identified by the International Energy Agency (“IEA”) and was widely accepted in Europe. It suggested that price of gas should remain competitive with non-gas fuels also used by final consumers, since they are effectively substitutes. The long-term contracts often last for 20 years or more, and include a degree of flexibility in terms of volume purchased and seasonality.

1.2 The EU has introduced a variety of liberalisation directives since 1998 to strengthen competition in gas markets. A consequence has been the emergence of gas hub markets in Europe providing alternative sources to purchase gas on the spot market. Such gas hubs in many EU markets have been active since the late 2000s.

1.3 The price ratio between natural gas and oil products has changed in recent years due to changes in supply and demand and the emergence of new alternatives such as shale gas. As such, the hubs have reflected cheaper spot gas prices relative to AFCs. The linkage to oil is eroding, especially in Europe, as competition increased and multiple sources of gas have emerged, largely due to liberalisation and the increased use of liquefied natural gas which can be transported globally by specialized ships. Consequently, the market value principle does not apply as effectively anymore as it has become costly for gas users to use oil products as substitutes.1

1.4 The price differential between gas hubs and AFCs has led to gas buyers wishing to renegotiate AFCs or replace AFCs with contracts linked to gas hubs (“Hub Contracts” or “GHC”). This might not always be the best or cheapest solution for buyers: markets change and there may be advantages to keeping AFCs in place to guarantee levels of supply and flexibility in volume. Despite the fact that AFC prices have deviated from those of GHCs, recent developments in gas exchange traded derivatives could allow buyers to hedge the price differential risk. Therefore, hedging the spread between GHCs and AFCs should also be considered as an alternative medium-term solution for buyers. In this context, we introduce the possibility of using commodity derivatives to replicate the gas hub spot price, and assess the limits to doing so.

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