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Will Covid-19 End The Oil Indexation Of Gas Prices?

With a historic drop of 75 bcm in gas consumption, it would be legitimate to say that 2020 has been a turbulent year for natural gas. However, even though successive lockdowns have slapped the gas supply-chains and created uncertainty in an already volatile market, gas has been much more resilient than other fuels during this year. The IEA remains optimistic for its prospects, predicting that gas prices will reach pre-pandemic levels in 2021. And as the world slowly recovers from the crisis, global gas markets will be reshaped in-depth and may witness a moment of change for future price setting patterns. One possible scenario could be the end of oil-indexation of natural gas. 

A Roller Coaster of Gas Prices

Beyond the structural decline in demand in 2020, gas markets have been characterized by strong volatility throughout the year, with record-low prices during the summer and then soaring back from December to February 2021. These variations resulted from the high sensitivity of gas prices to external shocks - such as cold snaps, the Suez Canal crisis, or the Covid pandemic - leading to major demand and supply disruptions. 

Let’s look at some examples. As a result of the Texas storm in February, gas spot prices had skyrocketed to $1250/Mmbtu in the middle of February, multiplied by 100 in one week. In a lesser proportion, this surge was visible in China, also hit by a cold snap, with gas prices fluctuating between $2 per Mmbtu in December 2020 and $34 in the middle of February. In these conditions, LNG cargoes mostly went to Asia rather than to Europe, which is considered as the market of last resort for LNG. 

Related: Goldman: Oil To Hit $80 On Largest Ever Demand Jump

Indeed, Europe currently gets only the LNG surplus that did not meet demand in the Asian “premium” market. And this lower availability of LNG obliged Europe to increase its pipeline imports and take gas from underground storage, which also pushed prices up. In addition, a series of unplanned liquefaction outages and planned maintenance works on the Norwegian pipeline pushed the prices up even further.

Asia Eyeing Gas Hub Creation 

The reason behind structurally higher prices in Asia compared to other regions lies in their traditional oil indexation of natural gas. But today, the trends of commoditization and globalization of LNG trade are marking a fundamental shift in gas pricing mechanisms. The LNG trade has become more flexible and does no longer lean on long term commitments, hence, LNG contracts will be priced from its own benchmarks, distinct from oil. 

Asia is one of the key regions driving that change. In fact, being one of the regions with most gas consumers in the world, Asia largely lacks pipeline infrastructure, hence preferred LNG (which contracts were linked to oil prices). But this year, it broke the tradition : LNG supplied from Qatar was indexed to oil only at 10 to 11%. 

As such, the Covid-19 crisis revealed the obsolete character of the oil benchmarking of natural gas, and marked a move towards the generalization of gas-on-gas (GOG) hub-based pricing. Indeed, gas prices indexed to oil do not follow the supply and demand patterns of the gas sector, which distorts the market. They are sensitive to changes in oil demand, and do not reflect neither the costs of gas production nor the value customers give to it. The correlation between the Brent index and LNG prices is gradually becoming less and less significant, casting doubt on the relevance of oil as a benchmark. 

But making a hub takes time, and requires to be recognized by other market players and have domestic gas reserves - such as the TTF, created in the Netherlands notably because of the abundance of gas in the Groningen field. India and Singapore have made attempts in this direction, without succeeding for now.

A déjà-vu of LNG indexes convergence?  

As a result of the pandemic, we could imagine a lower spread between indexes, which would make the LNG market more global and price signals more harmonized. This is notably the prediction of the Gas Exporting Countries Forum, hoping to create a global and interconnected gas market with lower price volatility. However, for the United States, this new paradigm of price convergence would result in a change of export strategy: for now, Washington has been taking advantage of low cost domestic gas production and higher international sales prices. 

Such a convergence was already expected due to LNG trade expansion between 2008 and 2014, but it did not happen due to the fact that gas prices were still linked to oil, which remained high. In fact, the spread was even more significant since LNG started to be traded globally. 

In the long run, several additional sources of uncertainty can be identified for natural gas prices. The main one is the move towards less carbon intensive sources, as several EU countries have adopted a “coal to gas” strategy and a nuclear power phase-out, structurally improving demand for natural gas in the long term. The potential inclusion of natural gas in the EU taxonomy and a potential Emissions Trading Scheme (ETS) could also affect prices.

By Tatiana Serova for Oilprice.com

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