How to deal with more volatile gas prices

by: Hans van Cleef

After its introduction in 2003, the Dutch Title Transfer Facility (TTF) has become the most traded and liquid gas market in Europe. This gas trading market (with a postponed physical deliver) was established primarily to make gas trading easier. For a long time, the security of gas supply was regulated by means of contracts with a duration of 20 to 30 years. The price was, due to a lack of a better alternative, linked to the oil price. These long-term contracts had the advantage that the gas supplier could safely invest in the production of gas. After all, he knew that the produced volume would be sold. A guaranteed access to supply was the most important benefit for the buyer. Both buyer and seller therefore knew that their business was secured for a longer period of time.

The current gas market hubs also have future contracts (contracts with physical gas delivery in the future). But in contrast to the old contracts, liquidity is only present in the first three years of the curve, and especially in the first year. The advantage of this is that parties are not bound for a long-term contract. They can benefit  from price movements on the spot market and adjust volumes to consumer needs  and changing demand. Although TTF as a trading center still has physical supply of gas as underlying basis, the trade before physical delivery is increasing as a result of this flexibility for gas producers, consumers and… market speculators.

“You may wonder whether you, as a net importer, would like to be completely exposed to the spot market”

More trade and certain gas supplies at the same time seem contradictory. After all, gas production from the Groningen field is rapidly being reduced and gas production from small fields is also declining. It is not without reason that the Netherlands became a net importer of natural gas for the first time in the past year after having been a net exporter for decades. But what does that mean for the security of gas supply in the Netherlands now that we are producing less, but we cannot do without it for the time being? And does TTF have a future now that the foundation under the trading platform is changing? Finally, you may wonder whether you, as a net importer, would like to be completely exposed to the spot market. So, let’s zoom into these questions.

Although national gas production is declining rapidly, we will continue to be a serious gas producer for years to come, especially for our own consumption. Nevertheless, we already have to import gas to meet our own needs. This import capacity is already there, for example the Rotterdam GATE LNG terminal is being used more and more. On top of that, the new pipeline from Russia to Germany will also contribute to sufficient gas import capacity to Western Europe, and therefore the Netherlands. In addition, the existing capacity of nitrogen plants is being expanded. In those factories, imported gas from, for example, Norway and Russia can be enriched with nitrogen to the same quality level as that from gas from the Groningen field.

“What sets us apart from experienced European net gas importers is our gas storage capacity”

What sets us apart from experienced European net gas importers such as France, Austria and Italy is our gas storage capacity. By building up large stocks in time, we will have less exposure to the whims of the spot market. It seems wise to consider whether it is better not to conclude longer term contracts (> 3 years) for part of your gas stocks in addition to the short-term trade on the TTF. This would ensure some spreading of price risks. It could also offer higher security of supply in the event of supply calamities and/or unexpectedly large increases in demand for gas in other parts of the world. For instance, after the tsunami at Fukushima, Japan, the demand for LNG in Japan increased sharply due to the sudden closure of many nuclear power plants. This led to an unexpected worldwide jump in gas prices.

Does the TTF have a future as the most important gas trading market? The availability of gas in the Netherlands will decrease if local production is not balanced by rising gas imports. These imports appear to be guaranteed for the time being. The time will have to show whether gas buyers in the Netherlands are able to continue to buy the correct volumes in time to guarantee future deliveries. The trade and market speculation will play an increasingly important role. For the time being, the future for TTF therefore appears to be guaranteed. However, gas must be supplied at the end of a contract – regardless of how often it has changed ownership. Given this obligation for gas supply in the future, the government also has an important role to play here and long-term policy is desirable.

“Without the rigor of long-term contracts with the right price structure, you as a net importer are ultimately at the mercy of the whims of the market”

Then the last question regarding dependence on spot markets. Long-term oil price linked contracts have many disadvantages. The limited flexibility and price dependence of a market that can behave differently from the gas market makes the alternative of a gas benchmark attractive, especially for short-term trading. But now we seem to be heading in the other direction. The gas price is determined by supply and demand. These can vary greatly. Certainly in times of extreme weather conditions, production disruptions and geopolitical conflicts, demand can rise rapidly or supply can fall rapidly. With more and more market parties speculating on these price movements, the threat of a change in supply or demand may already be a reason for large price fluctuations. Without the rigor of long-term contracts with the right price structure, you as a net importer are ultimately at the mercy of the whims of the market. From this price risk perspective you can also argue that at least part of the expected delivery volumes should be laid down in long-term contracts.

 

This column was published earlier in Dutch on Energiepodium.nl