European natural gas prices: analysis of dynamics and drivers Anna Galkina The Energy Research Institute of the Russian Academy of Sciences

Ljubljana June 2, 2016

European gas market transformed irreversibly

In case if energy efficiency and RES target in the EU are met European energy consumption is estimated to decrease to about 1500 mtoe, while natural gas consumption falls to 450 bcm by 2040 Natural gas consumption in Europe by scenario

Europe includes 37 countries, South-Eastern Europe includes Bulgaria, Croatia, Hungary, Romania, Slovenia, Albania, Bosnia and Herzegovina, FYR Macedonia, Serbia Source: Author, Nexant.

Gas consumption in South-Eastern Europe doesn’t grow and will be in the range of 20-35 bcm dependent on GDP growth, energy policy, prices, interfuel competition and other factors

European gas market is locked in the TOP contracts. In all realistic scenarios Russia remains key supplier to the European market. However the perspectives of Russian exports growth to Europe are very limited European* gas balance bcm 700 ACQ pipeline gas

600 ACQ LNG 500 MCQ pipeline gas 400 MCQ LNG

300 Indigenous production 200 Demand range 100 Demand

0

* Europe-41 without Turkey Source: Gas market of Europe: lost illusions, timid hopes, ERI RAS, HSE Energy Institute, September 2015 (in Russian)

By 2025 in Europe 50% of the current contracts will expire. Russia has the largest contract portfolio, which guarantees it at least 120 bcma exports; everything on top of that will be spot-based Contracted gas supplies to Europe by major suppliers up to 2025

Source: Gas market of Europe: lost illusions, timid hopes, ERI RAS, HSE Energy Institute, September 2015 (in Russian)

Existing long-term contracts to Europe leave little room for additional gas supplies up to 2020-2025 Gas supply contracts and net imports to North West Europe, bcm

Gas supply contracts and net imports to Central Europe, bcm

Gas supply contracts and net imports to Mediterranean Europe, bcm

Gas supply contracts and net imports to South East Europe, bcm

Source: Nexant, IEA database

More than 60% of the European gas consumption is now contracted on terms of oil indexed prices. Supplies from Russian account for a half of the existing long-term gas supply contracts to Europe. ACQ of gas supply contracts indexed to spot gas prices amount to about 90 bcm and assume much lower TOP levels.

In 2005-2014 load factor of the European LNG terminals fell three times. LNG will claim more significant share of European gas demand as domestic production declines. Europe can import more LNG if it chooses, but it depends on the price it is willing to pay. Capacities of the European LNG terminals and LNG imports

Source: IEA, Gas infrastructure Europe, Gas market of Europe: lost illusions, timid hopes, ERI RAS, HSE Energy Institute, September 2015 (in Russian)

Source: Olivier Lebois, Flame 2016

If all proposed pipeline projects come into operation pipeline import capacity to Europe would increase by 70% Pipeline gas supply projects to Europe – operating, contsructed and planned before 2025

Sources: Gas infrastructure Europe, Gas market of Europe: lost illusions, timid hopes, ERI RAS, HSE Energy Institute, September 2015 (in Russian)

In 2015 operating capacities for pipeline gas supply to Europe equaled to 369 bcm. The total capacity of proposed projects to supply additional pipeline gas to Europe accounts for 260 bcm from 8 countries outside Europe.

Pipeline gas supplies have been the basis for European gas imports in 20th century and preserve this role in 21nd century Pipeline and LNG imports to Europe in 1980-2014

Sources: Gas infrastructure Europe, Gas market of Europe: lost illusions, timid hopes, ERI RAS, HSE Energy Institute, September 2015 (in Russian)

European gas demand decrease after 2010 has happened mainly by reducing LNG imports

Elimination of LNG prices differential between Europe and Asia makes European market more attractive

At the world’s most-developed gas market, that of the United States, the wellhead price, reflecting production costs and deregulated in 1978–1985, became the basis for spot prices

In the 1997–2012 period coefficient of correlation at the monthly level of detail was 0.94. Thus, it is the supply side that determines the level of Henry hub price. Sources: EIA

In the US correlation with the oil prices reversed

Sources: EIA

At the US market the correlation between WTI and Henry hub prices was historically quite low (coefficient of correlation amounted to 0,34 in Jan 1997 - Dec 2015). Recent dynamics shows the inverse correlation between WTI and Henry Hub prices that can be explained by simultaneous production of shale oil and shale gas in the US.

In Europe pot gas prices in Europe strongly correlate to oil price (coefficient of correlation between Brent and TTF price amounted to 0,74 for Jan2005-Apr2016)

Sources: EIA, NCG, Bloomberg

In 2005-2014 oil-indexed gas supplies set an upper limit of the European gas prices European gas prices in 2005-2016

Sources: EIA, NCG, Powernext, Bloomberg, IMF

Lower level of gas hub prices was the main reason for long-term contracts renegotiations, when price discounts were provided, take-or-pay obligations were eased and some spot component was introduced

The gap between oil-indexed and spot prices is narrowing, pressure from the consumer side is decreasing

Sources: NCG, IMF.

Oil indexed natural gas prices in Europe are declining followed by oil price while becoming quite attractive compared to the levels of spot gas prices. The traditional Russian gas export strategy is being adapted to the new market conjuncture and regulatory framework

With the lower oil prices Russia’s export volumes and market niche in Europe have almost recovered

Sources: Federal Customs Service, Russian Central Bank

Russia would try to protect, modernize and prolong existing LTCs, as complete switching to spot sales is leading to significant loss in revenues, as well as protection of oil indexation Russian gas export revenues under different scenarios Bln. $ Cancellation of the LTCs, gas sales on spot

Oil indexation

100% spot indexation in LTCs

50% spot indexation in LTCs

Baseline scenario

Source: Gas market of Europe: lost illusions, timid hopes, ERI RAS, HSE Energy Institute, September 2015 (in Russian)

TTF became not only biggest European hub, but also a ‘floor’ for European hub prices Main European gas hubs and exchanges and average price differentials

Virtual hubs Exchanges Price differential with TTF, $/mcm

Source: Gas market of Europe: lost illusions, timid hopes, ERI RAS, HSE Energy Institute, September 2015 (in Russian)

In North-Western Europe gas prices at hubs are the lowest among other European regions

Even by 2020 only North-Western Europe will be able to completely de-link from oil

Russia will try to avoid a complete switch to spot indexation as long as possible Russia is adapting to the dramatic changes occurring in the European gas market, though in a “concealed” manner; formally adhering to the principle of oil indexation, while de-facto providing price discounts and linking pricing to spot prices via the retroactive payments model. • At least in the next 7-10 years position of Gazprom in the European market is completely guaranteed by LTCs. • In the longer term, with the growth of alternative supply, primarily with the coming wave of LNG, Russia will experience stronger pressure from the customers and it will have to adapt, providing additional discounts and introducing an explicit spot price component. • Russia will try to avoid a complete switch to spot indexation as long as possible, as this will lead to a significant loss in revenues, which cannot be replaced by increased sales volumes. • “Price war” does not seem to be Russia`s choice from the economic perspective, but it cannot be completely excluded for the geopolitical reasons.

What if Russia completely moves to spot?

Will European consumers be ready to buy gas at Saint-Petersburg exchange for roubles and at the Turkish hub?

For Gazprom at oil price below $45/bbl gas supply to Europe becomes less profitable than to Russian Central Federal district as the regulated domestic prices becomes higher than the price of equal profitability

There is increasing pressure for domestic gas price freeze or even reduction from the global market dynamics and growing domestic oversupply

Russia is well placed to defend its market share on European gas markets if needed  The EU wants to diversify away from Russia, but there are few alternatives and the EU knows it. Little gas available through the Southern Corridor, limited capability by Norway to increase production, declining production in North Africa due to political unrest and mismanagement.

 The next fight for EU gas market share will therefore be a fight between Russian gas and LNG (first of all US LNG). If Russian gas will be threatened, Russia will no longer fight for high gas prices (as in 2009), but for market share, even if this means low prices.  Compared to most of its new competitors, Russia has a lower cost gas supply base and can thus engage on a price war if needed.

Source: Author The shown gas supply costs are short-run marginal costs and don’t equal to market prices.

 Nevertheless Russia would prefer to avoid price war with the US and Qatar LNG in order to maintain export revenues.

Russian gas supply costs to South-Eastern Europe are lower than those of US LNG

The shown gas supply costs are short-run marginal costs and don’t equal to market prices. Source: Gazprom official site (for Russian production costs http://www.gazprom.ru/f/posts/75/625586/gazprom-investor-daypresentation-2016.pdf), Russian FAS (for gas transportation tarrifs http://www.fstrf.ru/tariffs/info_tarif/gas/organizations/749), Nexant (for Russian gas contract price to Slovenia, US production and LNG liquefaction, transportation and regasification costs).

Exports duty accounts for 30% of Russial gas exports price.

In case if no long-term contracts to supply gas to Europe are extended share of US LNG at the European market increases Volume and share of the US LNG in the European gas market by scenario, bcm (left scale), per cent (right scale)

LNG imports from the US will only partially substitute for Russian gas as contracts between the European companies and Gazprom expire. Share of the US LNG in the European gas market will reach about 8% by 2040

In 2011-2014 there have been almost no additional LNG plants coming into operation, but in the next 5 years a new LNG glut is anticipated

Sources: Agata Loskot-Strachota. Great expectations: LNG on the European gas market. OSW Centre for Eastern Studies

Within a decade there will be a sharp increase in world LNG liquefaction capacities. New LNG suppliers actively sign contracts to supply gas from new LNG plants, reducing market niche for other suppliers Operating, constructed in 2015 and planned LNG plants up to 2025

Source: Gas market of Europe: lost illusions, timid hopes, ERI RAS, HSE Energy Institute, September 2015 (in Russian)

Significant share of these projects obviously is speculative, however even if small part of them enters the market it will visibly influence European gas balance

Pipeline plans are driven by the geopolitical desire to terminate Ukrainian transit, but the final decision will depend largely on the OPAL issue solution and geopolitical environment No Nord Stream expansion, OPAL resolution

Nord Stream-3

Nord Stream-3 and 4

No Turkish Stream

Transit through Ukraine ~ 33 bcma

Transit through Ukraine ~ 5 bcma

No transit through Ukraine

Turkish Stream 1

Transit through Ukraine ~ 18 bcma

No transit through Ukraine

No transit through Ukraine

Turkish Stream 1 and 2

No transit through Ukraine

No transit through Ukraine

No transit through Ukraine

Higher probability

Lower probability

28

Сonclusions  In the European market situation is unfavorable for Russian gas exports in terms of the demand dynamics, changes in pricing, regulation and rising competition.  There is no market niche for additional gas in Europe up to 2017. After that a new LNG glut is expected as new LNG supplies enter the market. They can potentially double world LNG supply, but won’t probably be able to do that because of regulatory barriers and LNG projects delays.  LNG will claim more significant share of European gas demand as domestic production declines. Europe can import more LNG if it chooses, but it depends on the price it is willing to pay.  The portfolio of long-term oil-indexed contracts substantially influences the dynamics of gas spot prices. Their relatively low level, in turn, induced renegotiations of contracts terms and already lead to gradual changes in gas contractual structure, caused narrowing of the gap between spot and oil-indexed long-term contract prices.  Correlation with the oil prices remains even in the most liberalized markets in UK, while Eastern Europe simply does not have liquid hubs.

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