For all the talk that Brexit would spell the end to the EU drive for energy market liberalization, the European Commission seems to have no intention to halt its ambition to complete the internal energy market.
And especially in West and Northwest Europe, success is already within reach. As a report by the International Gas Union (IGU) showed in early May, 92 percent of all natural gas prices are now determined on spot-based hubs, up from just 27 percent back in 2005.
Overall at the end of 2015, gas-on-gas competition is now the name of the game in most parts of Europe where spot trading makes up 64 percent of all natural gas exchanges, a 49 percentage point increase from a decade ago. Oil-indexed prices are becoming more and more outdated as a global gas glut has transformed Europe into a buyer’s market, in which abundant liquidity and a diversity of suppliers have removed the incentive for long-term contracts.
Hub-based gas-on-gas competition contributes to more contractual transparency and market efficiency that, among other consequences, have contributed to the attractiveness of natural gas for utilities around Europe. Crude oil, still used anachronistically as a reference commodity that is no longer a replacement for gas, is too vulnerable to market swings to provide for long-term planning for consumers. With oil price in 2016 at 2002/3 levels, oil-indexation does not help producers much either.
Nonetheless, there is one big regional exception to the above-mentioned trend and this Southeast Europe. While the countries from the Viseegrad 4 Group used the 2009 Ukraine gas supply crisis to accelerate their diversification strategy based on getting access to the Western European gas market, the Balkans have been stuck back in time.
In Central Europe, not a single contract was spot-based in 2005, now more than half of all natural gas supply is imported from German hubs on reverse-flow links. Hence, Poland is able to now obtain up to 90 percent of its natural gas needs from Germany and the Vienna-based Baumgarten hub via the Czech Republic. Not surprisingly, the Polish government claims that it would no longer need to import gas directly from Russia after its long-term contract with Gazprom ends in 2022.
The launch of the reverse flow capabilities on the Czech-German border is now allowing the Czech Republic to become a regional gas hub as it can now technically transit more than 60 bcm/yr of gas coming from Norway and Germany via Slovakia to Ukraine, Hungary and Austria. The integration of the CEE regional gas market has led to a price convergence with liquid hubs in Western Europe. The launch of an LNG terminal at the Polish port of ?winouj?cie would accelerate the process and further open the region to the global gas market soon to be flooded with new LNG supply from the U.S, Australia, Canada, Malaysia and Qatar.
All along this massive shift in gas market dynamics in CEE, the Southeast Europe region has remained an energy island or in fact an archipelago of islands, identified by the EU as the weakest gas security link in Europe. Bulgaria and most of the Western Balkans are still dependent on one gas pipeline and one supplier, namely Gazprom. As the IGU contends in its 2015 report, less than 5 percent of all gas in the SEE market was traded on spot basis. Moreover, national gas systems in the region are still not interconnected, while LNG and storage capacity is insufficient to meet even short-term gas supply cuts.
Yet the European Commission seems committed to change the status-quo this time around. After two years of intense negotiations, at the end of June, the Bulgarian gas transmission operator, Bulgartransgaz, and its Greek counterpart, DESFA, signed an agreement to allow virtual reverse flow on the Transbalkan pipeline carrying Russian gas to the region. The deal took seven years to come by as Gazprom was openly protesting the plans for virtual gas swaps citing contractual clauses in its ship-or-pay transit contract. It was not until the Commission launched an anti-trust probe case against Gazprom’s bilateral dealings in Eastern Europe that the Russian gas company grudgingly and gradually agreed to let go of its virtual control of the cross-border interconnection points. The change of mind coincided with a decision by Gazprom from March this year, that it is seeking a “mutually acceptable” solution to the Commission’s monopoly case, which threatened to end with a USD7.6bn fine for the Russian company, already in a poor financial state because of the falling gas prices in the past two years.
History shows though that Gazprom will not give up easily its market share in the region. Past experience has shown that the company’s strong “political” influence over the decision-making of national gas majors should not be underestimated, and could make the actual implementation of the cross-border trade unpredictable, thus, reducing the interest of gas traders to sell alternative gas from LNG terminals or from the Caspian basin into the region. Gazprom is particularly worried that if it does not act to stop the SEE regional market integration, it faces future competition from potentially cheaper LNG, Azeri or Iranian gas in the more liquid Central European markets where it potentially stands to lose more than 25 bcm of gas demand per year or face steep price cuts to preserve it.
Although it is no longer able to charge the same price premiums there, it still controls a commanding market share in most countries east of Germany.
Governments in SEE would therefore be well-advised to prepare for alternative scenarios in Gazprom’s behavior in the coming years. There are several ways, in which Gazprom could potentially try to stop the liberalization of the market in SEE:
First Scenario: Due to its very low production costs, Gazprom can still undercut most alternative gas suppliers in Europe to defend its European market share, currently at around 30 percent. This has already been happening. Gazprom previously estimated that the gas price to its European clients will fall by 40 percent after 2014 to around USD 200 per 1,000 cubic meters in 2016.
The reduction has been already steeper with most of Gazprom’s gas being sold at around USD 150 today ($4.2/MMBtu). The fall has been largely driven by the decline in the crude oil price but there have already been indications that Gazprom is cutting the price below the oil-indexation mark to preserve its market share. Related: Oil Is Facing The Perfect Storm
Gazprom’s price is still higher than the quotes at the U.S. Henry Hub of around $2/MMBtu and could even go higher if the oil price starts rising again. The still high transportation costs, the limited LNG infrastructure and contractual congestion in the SEE region is unlikely to make U.S. LNG competitive in the short run. However, Gazprom might need to decouple its gas pricing formula from crude oil in the future if it is to preserve market share and prevent large-scale alternative gas supply to reach its key clients in Europe. Many long-term gas contracts in the region are ending by the end of the decade, and Gazprom may need to provide steep discounts and better terms along the lines of the new supply contracts in Central Europe, where the take-or-pay condition has been largely removed.
Second Scenario: The success of the regional gas market integration and liberalization will largely depend on the political will of governments. The latter has been available in only limited volumes as many leaders have decided to place their bets on Gazprom-led projects such as South Stream and more recently the extension of the Turkish Stream project, TESLA.
Despite the projects’ lack of financial sustainability, regulatory obstacles and unclear geopolitical benefits, most governments have supported one or another version of a Russian pipeline via the Black Sea. One of the supporters has been the Bulgarian government, which has promoted the idea of a natural gas hub at the Black Sea port of Varna that would serve also as the landing point for a new version of the South Stream. The European Commission has cautiously backed the idea but only under the condition that Bulgaria would first liberalise its cross-border trading along the Russian-used gas transit networks and that it constructs a new gas pipeline with Greece.
However, Gazprom has been very active in teasing the popular appeal of a large infrastructure project passing through the region, playing countries on one another as alternative routes to dissuade governments to be more pro-active in this gas diversification policy.
Third Scenario: Low administrative capacity and the ability of Gazprom to capture key energy decision-makers have significantly delayed the construction of new interconnectors with neighboring countries emulating the Central European model, LNG infrastructure on the Aegean and Adriatic coasts and the expansion of underground gas storages .
Seemingly cheap projects that on top have been earmarked by the European Commission for funding, have stalled for years. The most recent advancement of the Bulgaria-Romania and Greece-Bulgaria links has come only after strong pressure from the US government and Brussels. The financial planning of the projects, though, has placed them on shaky commercial grounds pushing away gas traders interested in entering the market. The new infrastructure could grant the region access to alternative gas supply but only if the authorities are ready to enforce the EU energy market law in a coordinated manner to open the possibility for large gas flows to reach the Central European gas hubs.
Gazprom could very easily try to use its political card to make sure that regional divisions take precedent over gas cooperation. It already tried to do so on New Year’s eve when the Russian company halted gas supplies to the largest retail gas distributor in Bulgaria, Overgaz (also a Gazprom subsidiary), causing short but intense intervention from as high as the Bulgarian Prime-Minister. Related: EIA Expects Uptick In U.S. NatGas Production As Prices Soar
The Commission’s efforts to integrate the SEE region into the EU internal market and diversify its gas supply away from a single supplier along the Central European model have started to pay off. Yet risks lie ahead and it would be naive to think that Gazprom would not try to prevent liberalisation.
By making Russian gas more competitive, Gazprom could weaken the general argument among energy policy-makers that the alternative gas could be cheaper and that diversification investment pays off. Many energy policy-makers in the region share this opinion.
However, Gazprom’s decision to cut prices in the face of potential competition shows nervousness about the prospect of new gas arriving on the regional market. Hence, instead of delaying further liberalization efforts, now is the time to actually step up the regional cooperation between regulators and national gas companies. This would further improve the region’s bargaining position vis-à-vis Russia ahead of talks for a new long-term contracts in early 2020s.
In this context, the recent example of Lithuania cannot be stressed further. By completing its floating LNG terminal near Klaipeda, the Lithuanian government secured a nearly 25 percent cut in the price Gazprom charged its national gas supplier. With global gas supply competition rising, there has never been a better moment for SEE to try to tap into the world market and to connect the archipelago of energy islands to the mainland.
By Martin Vladimirov for Oilprice.com
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