Bíbor Riesz regulatory expert of E.ON Földgáz Trade
24 April 2008
In seven years' time, Hungary's long-term gas supply contracts will expire. In spite of the country's strong sense of its dependency, it is the only nation which has not provided for an extension of its contracts. Bibor Riesz, our company's regulation expert, analyses the reasons for this.
The appearance of long-term contracts for natural gas, crude oil and power markets has historical causes, ones originating in the significant capital requirement of the route between production and utilisation of the product. When an economic relation involves a lasting and transaction-specific investment, the parties typically regulate future commercial relations via the use of long-term contracts.
The primary reason for this is that if one of the parties invests a notable amount of capital into a business, one which is profitable only in the long term (such as bringing a gas field into production, developing a transmission infrastructure) and the alternative application of which brings little value, then the other party has an opportunity to abuse this asymmetrical positioning during the lifetime of the investment (that is, to cut prices); and this is the so-called ‘hold-up' risk one takes.
With natural gas, the production company and the builder of the pipeline also have to face such a risk; the most important factor for the production company is taking over the given quantity - while for the party taking over the product it is determination of a fair price. So these quantity- and price-related risks will need to be managed via long-term contracts, whose basic characteristics are as follows:
Alexei Miller, Deputy Chairman of Gazprom's Executive Board, put this in the following way: ‘One of the unique characteristics of the gas business is that if there is no upstream, there are no sales! And if there are no contracted transmission volumes, there is no upstream. Thus, financing capital and time-intensive production and transmission projects can be exclusively guaranteed via long-term contracts...'
Long-term contracts also protect the buyer, or the customer, as well as the production company, as these contracts form a predictable and easily manageable environment for them for the long term by making the supply side foreseeable and predictable (within certain limits). Given a lack of this, the commercial management of the fluctuations within and across years, as well as hedging risks, would be a lot more expensive.
If, in accordance with professional literature relating to economy, we accept the above-described theory of the development of long-term contracts, we are able to see that aiming at shortening or eliminating such contracts will increase the players' risks - which then need to be dealt with somehow by using the replacing solution. The question is whether or not the benefits provided by the new approach outweigh the extra drawbacks arising due to having to manage such new risks.
In the past decade, in addition to long-term contracts the so-called spot markets have been playing an ever more noteworthy role in Europe's natural gas supply; this process gained impetus for its swift development after there was total liberalisation of the British market in 1998. Nowadays, we can see that Belgium, Germany and Holland - as in the case of Great Britain - intend to construct liquid natural gas commercial centres, i.e. hubs. The boom in short-term natural gas commerce is due to regulation reform coming from the European Committee - thus, Gas Directive no. 98/30 aims at creating a competitive market environment. After reviewing the documents issued by the Committee, there is a delineation of the role(s) intended for long-term contracts in this new market environment.
Thus, one can deduce that long-term contracts are important, though they still need to be treated with caution, due to their incidental competition-restrictive nature; and we should then ask ourselves the question: what really lies beneath such caution-taking, indeed what is it that we fear?
In the first instance we need to stress again: long-term contracts are not concluded in order to restrict sources assigned to a given sales area, but are to minimise hold-up risks. Long-term contracts prove to be problematic if they are tied up with a long-term capacity booking that prevents other players from gaining access to a given transmission pipeline (and storage facilities), thus from supplying customers with their own gas. Especially for this reason, the primary objective in gas directives is to guarantee free access to third parties in relation to the infrastructure. Competition can be distorted if the separation of the commercial activities of a market player with take-or-pay contracts and the operations of the infrastructure is not adequate; for, in such an event, it may happen that capacities are not at all (or are to a restricted extent only) made available to new players, or that new capacities are not created, i.e. so that bottlenecks can be eliminated. Yet we need to see that such a problem is not caused by the existence of long-term contracts - it comes from the competition-restrictive behaviour of the market players.
Intrinsically, in the course of the market liberalisation process, attacks are not only aimed against long-term contracts concluded between a production company and a wholesaler - also, the importer and other traders as well as the importer and his customers are affected. It is true that these latter contracts may effectively exclude given customer groupings; though it is also unambiguous that assuming supply contract-related take-or-pay liabilities is only possible for the importer if the counterparts of such contracts have been concluded with traders/customers (coordinating the termination thereof). Should the importer be obliged to terminate/shorten its supply contracts, the former balance of liability assumption relation is overturned. Should the importer lose its formerly secure sales area, even if the natural gas is still being purchased from the same importer - within the framework of short-term contracts - and if the importer manages to survive the incidental loss of a customer in the short/mid-term following the termination of its long-term take-or-pay contracts, it will presumably adjust its procurements to the sales area conditions and will purchase the required quantity of gas within the framework of similar short-term contracts or on the spot market. This, in turn, entails increased risks and a related price increase (as noted earlier). The big question is whether the objective of liberalisation is really this!
Due to the above-outlined peculiarities, the industry cannot depend on spot sales, in which, in addition to source risk (supply security impairment)-related excess costs, another price-increasing factor also plays a major role: a considerable expansion of the infrastructure is required for the proper operation of spot supply. It is worth taking a look at the map, and at the most liquid gas stock exchange of the United States: nine interstate and four governmental pipelines meet at Henry Hub, which has a storage capacity of 2 billion cubic metres, and which they wish to expand to 5 billion cubic metres by 2010.
However, even if the trader side were willing to pay the spot market price premium entailed by their free choice, a considerable ratio of the sales transactions on the natural gas market would typically be performed within the framework of long-term, bilateral contracts in the future, too, due to the formerly referred to capital intensive nature of the production/transmission business (supply side). The role of the actually-existing competitive market and the stock exchange has a supplementary character; production companies are able to market the extra quantities, while buyers are able to use this to manage the price risk factor.
The opportunities inherent in the spot market price premium would seem, however, to dispose production companies towards fine-tuning the prioritisation of long-term contracts. Energy Review published an interesting article in its issue at the end of 2007, one written by Rik Komduur, analysing Gazprom's sales strategy. The author points out that spot market sales are gaining a more and more important role in Gazprom's business since this provides greater freedom, in that the company is then able to determine on which markets and to which partners they intend to sell; while they can have greater influence on prices or regroup volumes - as they wish - between the European and domestic markets. Seeing that the European market is a demand-led market (that is, demand exceeds supply), if Gazprom actually decides to sell a significant amount of its currently 160 billion cubic metres volume sold to Europe (i.e. 1/3 of the imported total) not on the basis of long-term contracts but via short-term contracts or spot market conditions, then this will automatically entail a price increase.
Otherwise, this scenario is not at all unreal; Gazprom established its European competitive market commercial company, Gazprom Marketing & Trading, in 1999 - and it sold 4.1 billion cubic metres of gas in 2005, 28 billion cubic metres in 2006, and it is still working intensely to increase this volume! In conformity with Gazprom's own statements, if it is beneficial economically, they would put more gas onto the market within the framework of spot transactions, often at a price higher than the contracted one.
Yet it is not only spot market trading which is able to make Russian gas more expensive; Russia intends to strengthen its export activities in the direction of Asia and the United States, and they also intend to exploit opportunities inherent in LNG in the future. The diversification of Russian exports here is unfavourable for Europeans - and it is not accidental that the majority of Western European countries have endeavoured to secure Russian gas for themselves, up until 2025-30, in consequence of such market changes. Hungary, unfortunately, does not belong among these countries.
Mi lesz veled, Magyarország?
The long-term contract concluded for the supply of Russian natural gas, amounting to 85% of the Hungarian natural gas import, expires in 2015, and neither of the parties has initiated an extension of contracts as yet. This is understandable from Gazprom's side, as the contract is still valid for several years, though on the buyer's side a securing of supply would seem to be a natural requirement (as is the case with Western-European contract extensions). However, this requires a reliable and predictable market and, especially, a strict regulatory environment. It is one thing that the protection of take-or-pay contracts has been restricted in Hungary up to now to the degree laid down in the EU directive - and there are no signs of a solution (i.e. which can already be seen in Italy, where this type of contractual volume is a capacity booking priority); the problem lies in the fact that the regulation taking shape in relation to the natural gas market alterations (now occurring) does not create a proper environment for long-term supplies. The market-opening process itself would not constitute a problem as, when the volumes booked for the long term have been defined, the estimated, realistically achievable market shares are able to serve as a suitable starting point. In conformity with the draft of the Gas Act to be adopted, three factors, however, encourage waiting instead of drawing up contracts.
One problem is the difficulty of managing take-or-pay liabilities in the short term. In conformity with current conceptions of this market opening, any customer is entitled to enter the market and can purchase gas from anyone. The legal predecessor of E.ON Földgáz, MOL Földgázellátó, was not able to take into consideration market opening when concluding long-term contracts in the 1990s. The company, fulfilling statutory obligations requiring security of supply for the entire country, assumed a considerable volume of take-or-pay liability in relation to Gazprom, and this Russian partner only consented to a subsequent lowering of volumes in a restricted manner. Although the currently valid Gas Act provides an opportunity for the Hungarian Energy Office to restrict other parties' access to the transmission system if a financial catastrophe threatens E.ON Földgáz due to the market opening, it can only be used a last resort and with a restricted duration (for three years). The company wishes to handle this issue itself at the present time, though until everything is sorted out in a reassuring manner the company is less than motivated when it comes to an extension of contracts.
The management of the long-term contracts concluded between E.ON Földgáz, as regulated market wholesaler, and regulated market suppliers, which is a counterbalancing of take-or-pay supply contracts, causes further uncertainties. Since on the basis of the new gas market model the regulated market will be terminated, an alternative to the automatic termination of such contracts has also emerged. The resulting unbalanced liability assumption position (as mentioned) entails a hardly - or not at all - maintainable operational model in the take-or-pay period of currently valid contracts, and it does not facilitate an extension of contracts for the long-term.
Nevertheless, what causes the greatest difficulty is the instituting of a licensee possessing major market power - and such a thing is being planned. Pursuant to the current Gas Act, the Hungarian Energy Office is entitled to stipulate a supply obligation for players having a significant degree of power on the natural gas wholesale trade market so that the natural gas supply of the universal suppliers can be secured. No precedent can be found as regards a similar form of authorisation in any other European country - which is not surprising, as fulfilment of an obligation like this is should not be expected from any profit-oriented player operating in conformity with market principles; for determination of the obligation by itself and the volumes involved can only lead to uncertainty.
We can but hope that the delineated regulation risks will go down to a tolerable level in the near future, facilitating the earliest possible extension of contracts, and thereby ensuring the long-term supply security of the country.