Decoupling gas price from oil price according to Gazprom: “Great idea, but we’re probably not gonna do it”

The Financieel Dagblad (link in Dutch) writes about the desire of EON Ruhrgas, a subsidiary of German energy behemoth EON, to decouple the natural gas price from the oil price. The fact that these prices are coupled now forces EON Ruhrgas to pay an estimated extra €1.5 bln in 2011 (compared to the current prices on the spot market) for the purchase of the amount of natural gas that EON must deliver to its contract partners. Here are the pertinent snips of the article:

EON has a problem. A subsidiary of the German energy behemoth got itself into big trouble. It is not relevant whether it is guilty of creating this mess. Fact is the subsidiary promised things it is rather not remembered of. 

The subsidiary is EON Ruhrgas, the biggest LNG (liquid natural gas) supplier of Europe. To meet its obligations for the delivery of gas to large, energy-intensive companies (steel mills a.o.) and operators of gas fueled energy plants, EON Ruhrgas has negotiated longterm contracts with gas suppliers. 

In 2010 these contracts covered the delivery of 684.5 billion KWh in gas. This was announced at the publication of the annual results of EON. In 2010 the gas was delivered by the following countries:

-         Russia               27%

-         Norway             25%

-         Germany           23%

-         Netherlands        17%

-         Other                8% 

The problem surrounding the longterm gas contracts with these countries is that the gas price is coupled to the oil price, with a delay of a half year. When the oil price goes skyhigh like now, the gas price that EON Ruhrgas pays moves up too within 6 months. 

The aftermath of the economic crisis and new gas production in the United States brought the vulnerability of this system to light. Demand drops and supply rises, causing a surplus in LNG. This surplus causes prices on the LNG spot market to be much lower than the longterm contract prices that were negotiated between EON Ruhrgas and its suppliers, like Russia and Norway. The result is that EON’s main customers say: “drop your gas prices, or else we buy our gas on the spot market”. 

Momentarily the difference between the spot prices for gas and the oil-coupled prices is €2 per MWh (megawatt hour) and rising. Multiplied with the total amount of gas purchased in 2010 this causes a potential financial loss of €1.37 bln. With the current extreme oil prices this loss will only be higher[…].

Longterm energy contracts with a fixed price base (price based on fixed criteria, like f.i. the oil price) have a big advantage and a big disadvantage:

Advantage:

-     The price is fixed for a long time, so you don’t get any surprises if the spot market prices are suddenly rising extremely fast, compared to the fixed price base.

Disadvantage

-     The price is fixed for a long time, so you don’t get any benefits if the spot market prices are suddenly dropping.

EON Ruhrgas had these longterm contracts especially to prevent itself from being a victim of extreme volatility on the spot market. In this way they were able to give their main customers a stable and predictable price. This worked out fine for many years.

However, now the spot market prices for LNG are much lower than the fixed coupled rates from the likes of Gazprom and the NAM (Dutch state-owned oil and gas company), EON runs a large financial risk as their customers are NOT willing to pay the future extreme gas prices that are the result of this coupling.

Will f.i. Gazprom be willing to lower the gas prices when asked by EON Ruhrgas? Johan Teyssen, CEO of EON Ruhrgas, was firing a warning shot by stating: “…that it would be a shame for Russia when the Russian gas is replaced by gas from f.i. Qatar”.

Knowing Alexei Miller of Gazprom and Vladimir Putin, I would say that they both don’t sleep one second less of this threat by EON. It is not common in the Russian culture to be impressed at all by threats of people and companies from smaller countries. Also they know very well that an amount of 185 bln KWh in LNG is a lot of supertankers full of gas and it is the question if the gas storage infrastructure in the Dutch and German ports can handle these amounts in LNG.

Does that mean that EON doesn’t have an escape route anymore? That depends: probably not, but there might be a way out. Gazprom is a stateowned company and the interest of Russia is the interest of Gazprom (also vice versa). EON could send Angela Merkel on a journey to Russia to negotiate these lower gas prices, as Germany can probably make Vladimir Putin an offer he can’t refuse. You could think here of:

-     New Volkswagen, Mercedes or BMW car plants in Russia

-     New subsidiaries in Russia for companies like Siemens, Bayer, Basf etc.

-     (Even) the delivery of weapons and weapon systems

As Vladimir Putin wants to become the next president of Russia and the creation of lots of new jobs could help this intention enormously, he can be expected to be all ears, when Angela Merkel comes with the right message. Knowing the intelligence of Angela Merkel, she probably will understand this message too.