Natural Gas Pricing Structure Economics Essay

Natural gas pricing structure: A comparative study between India and Europe. There is a vast difference in the pricing mechanism for natural gas markets when we compare the two economies, i.e. India and Europe. The complexity and the heterogeneity in the pricing structure will be studied by covering the various aspects of the market regulations in the pricing mechanism.

BACKGROUND

STUDY OF GAS MARKETS OF THE TWO ECONOMIES

EUROPE

BRIEF DESCRIPTION OF THE EUROPEAN CONTINENTAL GAS MARKETS

Natural gas consumption in EU member states was around 445 mtoe in 2008 and is expected to increase to about 625 mtoe in 2030, which is an increase of 43%. The share of natural gas in the European primary energy demand will rise from 23,9% in 2005 to 29.9% in 2030 (18% in 1990). At 60% of the total demand increase, most of the growth will come from power generation. In the residential and commercial sector, gas consumption has steadily increased in line with the expansion of the infrastructure and the associated rise in the number of gas users. Over the last 15 years, gas consumption has seen a 2.8% growth p.a. to 175 mtoe. Gas currently holds a market share of approx. 35 %, which makes it the market leader in this sector.

Gas currently accounts for 33 % of industrial final energy consumption (excluding industrial power stations) and is thus a major source of energy in this market, too.

The development of the modern natural gas industry in the Western parts of Europe started with the discovery of the Groningen field in 1959. Further drilling proved it to be a super-giant field. It was clear that its gas could not solely be consumed in the Netherlands, but that, in order to valorize the gas reserves of the field, part of its production had to be exported. Groningen gas was the first large gas-export project worldwide and became the reference case for all other gas imports into Continental Europe.

After the first oil shock, Western economies were given new impetus to diversify their energy mix. Although the United States in particular opposed European dependence on Soviet Union gas, the huge Siberian gas fields were able to provide Europe with a non-OPEC source of energy. A compromise was agreed whereby the Europeans would restrict their dependence on Soviet Union to 30%, and the development of Norway’s Troll field would be promoted as a counterweight to Russian influence

THE LIBERALIZATION PROCESS: 1998 – 2009

The aim to build a single market for gas and electricity is a principle embedded in the creation of the European Union. Making the energy sector in Europe competitive and more efficient was viewed as part of the response to growing concerns on the competitiveness of European industries in globalizing markets.

Negotiations between the EU authorities, the member states and the market stakeholders during the 1990s culminated in an Electricity Directive and, two years later, in a Gas Directive introducing a first set of common rules for the EU energy markets. On natural gas, the new legal framework was aimed at opening the gas networks to third parties. This was to be achieved through unbundling of the vertically integrated historical gas operators, thus allowing competition for supplies and customers within the natural monopoly network. The European Commission encouraged the industrial re-organization within each country to be supervised by an independent regulatory authority, but this was not mandated.

Initially, the opening to competition granted the choice of supplier to big gas customers such as power plants and big industrial facilities. Even before the implementation of the first Gas Directive there was already a push to accelerate gas and electricity liberalization. The European Council, held in Lisbon in March 2000, requested that the Commission undertake further steps towards the completion of the internal energy market. The EU Council at Barcelona in March 2002 decided on full market opening for industrial gas consumers in 2004 while total market opening was intended for 2005. It launched the preparation of a new legislation to implement these decisions. A year later, the second Gas Directive was adopted. The 6th benchmarking report was issued in January 2007 and provided a general overview of the future energy policy of the EU. It envisaged a “third package” of legislative proposals for the European gas and electricity markets. The rationale of this third package is the integration of the energy and the environment objectives of the EU through the use of market based environmental and other measures.

The EU Commission proposed ambitious and far-ranging measures such as complete disintegration of the gas operators through ownership unbundling and further institutions to back-up the creation of an integrated EU gas market (European regulatory agency).

CURRENT PRICING SYSTEM IN EUROPE

Continental Europe relies increasingly on gas imports. Transactions generally regard large volumes extracted from giant fields. Natural gas is imported through long-term contracts from Russia, Algeria, Norway, Nigeria or Libya. In Continental Europe, the pricing is based on the “replacement value” of gas, which corresponds to the value of alternative energies on the final gas markets inside the buyer’s country. Historically, this concept of long-term contract with a price based on replacement value was designed first for exports from the Dutch field of Groningen (first large reserve discovery in Europe).

Moreover, contracts include a review clause: price is adapted regularly in line with the development of the competitive situation of gas in each of the residential, industrial and power sectors. In other words, the price formula is re-calculated (usually every three months) in order to reflect movements in the share of gas in power generation, and changes in the mix of the competing fuels, mainly light fuel oil and heavy fuel oil but also crude oil, coal, electricity or inflation. The Energy Sector Inquiry empirically confirms that the rates of

European long-term contracts are mainly linked to oil and oil derivatives, according to a volume-weighted indexation. The indexation pattern varies by import source and also varies according to the purchaser’s region, with a big split between the UK and Continental Europe.

Despite substantial measures aimed at creating a single competitive gas market (removal of destination clauses and take-or-pay obligations, mandatory Third Party Access), long-term contracts still remain the dominant practice for imports of natural gas, although with a fostered flexibility. Owing to the new regulatory environment there are several trading hubs for natural gas in Europe, but these are relatively new compared to the Henry Hub in the United States. The virtual trading hub, National Balancing Point (NBP), located in the United Kingdom is considered to be the most mature market in Europe, while the two continental trading hubs Zeebrugge and Title Transfer Facility (TTF) located in Belgium and the Netherlands, respectively, are considered to be the dominant trading hubs in continental Europe. Three natural gas trading hubs are emerging: the Point d’Échange de Gaz (PEG) Nord for the French market, NetConnect Germany (NCG) and Gas pool (GPL) trading hubs for the German market.

In Continental Europe, LNG imports rely on traditional long-term contracts mainly from Algeria, and also from Nigeria or Trinidad. Price is pegged to crude oil or oil products, but due to increasing competition from pipeline gas, the indexation pattern for LNG tends to follows the same structure as on-shore gas, with references to coal, electricity. More generally, the liberalization process on the Continent is making LNG pricing more competitive.

INDIA

BRIEF HISTORY OF NATURAL GAS MARKET IN INDIA

Natural gas is a scarce resource in India and Govt. of India plays an important role in its allocation. Historically, gas has been allocated in priority to end-users such as fertilizer producers and power plants. In 2007, the Govt. of India started working on a new Gas Utilization Policy. This was mostly a consequence of the dispute between the Ambani brothers and the related issues on gas pricing and utilization, which created a very hot debate in India. In 2007, a price was agreed between RIL and the government under the PSC so that RIL was to sell gas at USD 4.2/ Million British thermal units for the first five years of production.

This and the large gap between demand and available supplies prompted the government to develop a Gas Utilization Policy and to go back to administrative control over prices (Govt. of India introduced a price formula for all discoveries under the first six NELP rounds) and over volumes to be allocated to end-consumers. Therefore, in 2008, the government introduced Natural Gas in India new guidelines called the Gas Utilization Policy, which effectively took away gas producers’ rights to sell the gas they discover on the open market. These guidelines would be applicable for the next five years and be reviewed afterwards. The recent ruling of the Supreme Court in May 2010 regarding the dispute between RIL (Reliance Industries Ltd.) and RNRL (Reliance Natural Resources Ltd.) reaffirms the role of the government in the allocation and pricing of gas. Currently, the rules of the General Policy for the gas market imply that gas will be allocated according to industry-wise priorities set up by the government.

DEVELOPMENT OF THE NATURAL GAS MARKETS IN INDIA

India is the world’s seventh largest energy producer, accounting for 2.49% of the world’s total annual energy production. It is the fifth largest energy consumer, accounting for about 3.45% of total energy consumption in 2004, which has been increasing by an average of 4.8% percent a year since 1990.

The share of commercial energy in total primary energy consumption increased from 59.7% in 1980- 81 to 79.3% in 2008-09.

India’s GDP has grown at more than 8-8.5% during the last few years, and is expected to grow at least at 6.5-7% in the coming few years. The growth has taken place despite the huge deficit in energy infrastructure and infrastructure. Even today, half of the country’s population does not have access to electricity or any other form of commercial energy, and still use non-commercial fuels such as firewood, crop residues end during cakes as a primary source of energy for cooking in over two thirds of households. The future growth of the country would demand a move to large scale commercial energy forms. In particular, natural gas as a clean energy source holds the highest promise for the country.

World’s resources of natural gas, although finite, are enormous. Estimates of its size continue to grow as a result of innovations in exploration and extraction techniques. Natural gas resources are widely and plentifully distributed around the globe. It is estimated that a significant amount of natural gas remains to be discovered. Natural gas has emerged as the most preferred fuel due to its inherent environmentally benign nature, greater efficiency and cost effectiveness.

The demand of natural gas has sharply increased in the last two decades at the global level. In India natural gas was first discovered off the west coast in 1970s, and today, it constitutes 10% of India’s total energy consumption. Over the last decade it has gained importance as a source of energy and its share is slated to increase to about 25% of the total energy basket by 2025-2030.

CURRENT PRICING SYSTEM IN INDIA

The natural gas pricing scenario in India is complex and heterogeneous in nature. There are wide varieties of gas price in the country. At present, there are broadly two pricing regimes for gas in the country – gas priced under APM and non-APM or free market gas. The price of APM gas is set by the Government. As regards non-APM/free market gas, this could also be broadly divided into two categories, namely, domestically produced gas from JV fields and imported LNG. The pricing of JV gas is governed in terms of the PSC (Production Sharing Contract) provisions. It is expected that substantial gas production would commence from the gas fields awarded by the Government under the New Exploration Licensing Policy (NELP). As regards LNG, while the price of LNG imported under term contracts is governed by the SPA (Special Purchase Agreement) between the LNG seller and the buyer, the spot cargoes are purchased on mutually agreeable commercial terms.

APM (Administered Pricing Mechanism) Gas Pricing

Pricing of Gas under Pre-NELP Production Sharing Contracts (PSC)

Pricing of Gas with reference to NELP Provisions

Import Gas (LNG) Pricing

MOTIVATION FOR THE RESEARCH:

As it is a known fact that there is a huge depletion in the oil reserves if we compare the two time periods, i.e. the time when the oil was discovered and the today’s era, but the fact cannot be ignored that demand for energy to various segments are on hike. So in order to meet the increasing demand by customers oil has to be replaced by an alternative source. The discovery of huge reserves of natural gas in last few decades has proved to be a replacement to oil demand to a large extent. But the demand- supply of natural gas largely depends on the imports and exports from various countries which largely affects the pricing mechanism. So in order to understand the pricing mechanism of the natural gas a comparative study is done between the domestic country, India and the one of the market leader, Europe.

OBJECTIVES

The topic undertaken is very wide and complex. There are several issues related to the topic which are in the hot debate every now and then. But this study is conducted to cover and focus on certain objectives which are stated below:

Prospect of natural gas pricing structure in india

Natural gas reserves

The increasing role of LNG

Worldwide consumption and supply of gas in recent years.

Natural gas importing means and the trade movements across regions worldwide.

SCOPE OF RESEARCH:

The type of research that would be used for the study is descriptive in nature, which is also called statistical research. Although the data description is factual, accurate and systematic, the research cannot describe what caused a situation. The description is used for frequencies, averages and other statistical calculations.

RESEARCH METHODOLOGY

THEORITICAL FRAMEWORK

The study would include the existing theories which are closely related to the topic of consideration. This will cover the data from past research and studies and articles from relevant journals, books, newspapers, etc.

References would be provided for further clarifications and studies.

SOURCES OF DATA:

All the data collected is secondary in nature. The data is collected through various sources like books, newspapers, organizational records and data collected through qualitative methodologies or qualitative research. The good amount of articles and journals by different authors are also studied. The data from different websites and links on the internet is collected.

The data collected would further be explained and enhanced with appropriate graphs and charts wherever required.

REVIEW OF LITERATURE:

“A Dynamic simulation of market power in the liberalized European natural gas market” an abstract by Wietze Lise and Benjamin F. Hobbs published in journal named The Energy journal (2009, pages 119-136) states that the recent increases in the world price of oil have led to higher gas prices in Europe, possibly leading to greater opportunities for exercising market power. The effect of different gas producer strategies upon price levels in the liberalised European gas market over the period 2005-2030 is analysed using a dynamic gas market model that accounts for demand, supply, and investments in pipeline transport, LNG, and storage. The multi-period model formulation allows exploration of the dynamics of market power as transportation and storage capacities are augmented and interact with demand growth. The combined effects of spatial configuration of the supply network and supplier location upon intensity of competition in ten different regions in Europe are considered. Differences in prices are due to the interaction of (1) inherent ability of producers to exercise market power (determined by production capacity and costs) with the (2) accessibility of the market (determined by gas transport infrastructure).

“European natural gas markets: Resource constraints and market powers” an abstract by Gijsbert Zwart published in journal named The Energy journal (2009, pages 151-166) states that the European natural gas market is characterized by declining indigenous resources, particularly in the UK and the Netherlands, and a growing dependence on a small number of large exporters who, as a consequence, see their market power increasing. In this paper long-run scenarios for the European natural gas markets in a model, NATGAS, that explicitly includes both factors, resource constraints and producers market power are analyzed. It has been analyzed that finite resources lead to interdependencies of current production decisions and future opportunities. These decisions in turn depend on the potential for large producers to set market prices above marginal costs. Further the impact of conditions on the global LNG market on market shares of pipeline gas suppliers, as well as on the speed of depletion of indigenous European resources are focused. The paper also considers the fact that how shadow prices of resource constraints affect substitution patterns in the various scenarios.

“The rising price of Russian natural gas” an article by Mark Mozur (2011) states that as Gazprom remains the dominant company in Russia in natural gas industry but may be due to several reasons like externally, depressed European demand for natural gas due to the economic recession of 2008-2009, together with a global supply glut brought on by a U.S. shale gas boom and increased LNG shipments to Europe weakened Gazprom’s market position, as the company chose to take a hit on its export volumes instead of renegotiate prices.  Including Turkey, from 2008-2009, Gazprom’s share of total European gas imports fell from 42.7% to 37.9%, an absolute dropoff of 23.6 billion cubic meters (bcm). There is also a debate about natural gas supply contract fundamentals which includes long-term oil linked prices, and take-or-pay provisions would intensify. And while analyzing Russia it has also been noticed that although Gazprom remains dominant, companies such as Novatek are growing rapidly and are seeking innovative ways to market their gas. The article by Simon Pirani in 2011 has assessed Russia’s plans for domestic gas sector reform. As projected by the government there is domestic gas price increase of 15% per year, reaching European netback equivalence by 2015, and as known,  more specifically, the gas sector reform is based on the principle of “equal profitability” of domestic sales and exports, and some analysts put domestic price increases as reaching 40% of European Union (EU) levels by 2014. The article also focuses on Russia’s domestic gas transit tariffs.  Russia’s Unified Gas Supply System (UGSS) is owned and operated by Gazprom, which currently determines capacity access and transit tariffs in an opaque manner in collaboration with the Federal Tariff Service (FTS).  As gas sector liberalization continues and the possibility of independent producers gaining significant pipeline capacity access becomes less remote, anticipating levels of transit tariff payments could be instructive in considering export scenarios.  That is, how likely is it, given plans for domestic gas sector reform and the subsequent effect on transit tariffs, that independent producers will gain a share of Russian gas exports in the coming years. As Gazprom’s chairman says that by 2014 domestic gas sales would be equivalent to gas exports in terms of net revenue.  In his words, this means that industrial consumers in Russia can expect prices that are 60% of European levels (based on netback), which would be a 150% increase over current prices. And it has also been calculated that while European gas prices have fluctuated based on oil price movements, Russian gas prices have moved upwards in stages.  In order to reach 60% of European levels (say, $400/mcm) by 2014, Russian domestic prices would have to increase by around 27% per year, compared to historical growth rates between 15-25%.  This comes at a time when any price increases will have political ramifications, and when it has been publicly stated that annual increases will not exceed 15%. It has also been stated that due to gas price liberalization the Russian administration is gradually moving towards an independent regulator for the gas transport system. Gazprom has been ordered to split its transport business into a separate subsidiary that can ultimately provide arms-length transport services to Gazprom and third parties. This move towards transparency in capacity allocation could lead to greater efficiency in the Russian gas sector, and also, via a nominally independent regulator, could enable the government to adjust policy to achieve certain outcomes, such as mandatory levels of investment in the UGSS, or creating incentives to independent gas producers. Thus, reform of the transport system is being observed concurrently with plans to liberalize gas prices and, taken together; these developments will impact opportunities for independent gas producers.

“The European hubs for natural gas: integration towards a single area” paper by Gianfreda, A. Grossi, L. Carlotto, A. (2012, pages 1-5) states that the regulators hope that competitive forces will be enough to create efficiency, and hence we see their persistent policy concerns about market structure, resource adequacy and regional interconnection. Facilitating the latter, in particular, through greater network interconnection capacities, and the harmonization of trading at various local hubs is going to be actively pursued in many parts of Europe with the aim of improving both market efficiency and system reliability. This paper seeks to advance our understanding of the efficiency of European gas spot prices by looking at several regional markets. We pursue this through an analysis of spot prices collected on the following markets: NBP, TTF, Zeebrugge, PSV and Baumgarten. Hence, this paper is going to investigate empirical properties of European Natural gas spot prices, which drives electricity prices across Europe. Furthermore here we propose to understand the state of integration of these markets toward a single European area as suggested by the European Commission and followed by ENTSO-G. Therefore applying Granger’s causality tests and Vector Error Correction Models, we test the hypothesis of both short and long run integration process and try to understand which the nature of interactions among such prices is across the European area.