International Politics

	Vol. 226 No. 4
ØYSTEIN NORENG, CONTRIBUTING EDITOR, NORTH SEA

Gas challenges await Norway and the UK. Norway has become the world’s third largest natural gas exporter, and the second largest supplier to Europe. The supply potential is considerable, but costs matter, and Norway faces some awkward dilemmas. Historically, Norway’s natural gas exports were constrained by markets. However, opening of markets, competition and lower LNG costs have moved the constraints to supplies and costs. Thus, new commercial opportunities present new challenges to companies and governmental policies. 

In the past, Norway has exported natural gas by pipeline to the European continent on long-term, take-or-pay deals. These sales were essentially negotiated between a sales monopoly and single buyers, with the major markets being France and Germany. The UK is emerging as a new market, but with a multitude of buyers.

Indeed, the general opening of Europe means more competition among buyers and sellers. The long-term outlook for rising gas needs in Europe contrasts with a short-term risk of oversupply on the continent and eventually declining prices. On one hand, Norway needs to license new areas to keep the supply momentum, yet it needs to watch markets and prices to adjust policies.

Gas prices in Europe are usually indexed to prices of crude oil as well as oil products, and in some cases, coal and even average energy price indicators. Generally, gas prices follow crude prices with a six-month delay. Accordingly, gas prices are set indirectly and retroactively, with little regard for the actual balance between supply and demand.

Contracts have mostly been long-term, with take-or-pay clauses ensuring some volume flexibility in both directions, often with a tolerance of 80% to 125%. In 2003, the average beachhead price of Norwegian gas, measured by heat value, could be estimated at around 70% of the Brent Blend parity. However, this figure masks significant differences between relatively high UK prices and lower continental rates. 

The physical connection of the UK to the continental gas market complicates the picture, as the UK’s gas market for years has been liberalized and unbundled. It has been subject to transport access and tariff regulation, with prices set in a gas-to-gas competition that the continental gas merchants have sought to avoid. 

The Interconnector (linking Belgium and the UK) and new links from Norway mean that gas trade in Northwest Europe is marked by the interaction between two systems. Norway – exporting gas directly to both the European continent and the UK – faces a trade-off between two different markets, with distinct trading and pricing.

Introduction of UK gas exports to continental Europe via the Interconnector pipeline (above) has complicated the European gas pricing structure.

The role of UK prices. The UK spot market and its prices have been set by domestic supply and demand balances, but arbitrage with Europe is increasingly important. On the continent, gas prices have been linked to oil prices, set largely by external input parameters, such as crude and oil product prices, and US dollar exchange rates.

However, UK spot prices are becoming increasingly important as a reference, at least for shorter deals and emerging spot trading. Continental gas prices are largely a function of gas-oil and fuel oil prices, as well as currency exchange rates. The complexity of indexed gas pricing is underlined by gas and fuel oil being derivatives of crude – with independent and changing relationships – and by crude oil being priced in US dollars. However, gas-oil and fuel oil are priced in euros and pounds.

In the longer run, UK gas prices are linked to continental rates, but they diverge in the short run, sending signals either way. British marginal gas is priced against sales opportunities abroad, when available for exports in the summer. In the winter, when the UK has a gas deficit, UK prices and netbacks establish the benchmarks for most sales in Northwest Europe, as other markets compete with this alternative. Against this backdrop, fluctuating British gas imbalances will continue, with UK netback prices as the benchmark. 

Long-term, the greater flexibility of the open UK system of gas trading and pricing is likely to erode rigidities of continental oil-indexed pricing. This would require, however, that a gas exchange can cover trade in Northwest Europe, not just in the UK, and that regulatory regimes are harmonized or merged under EU auspices. An efficient European gas exchange would obviously operate in euros.

A Northwest European electricity exchange, Nord Pool, has operated for years; from 2006 it will trade in euros. Increasing convergence of electricity and gas markets, in the UK and the US, underlines the rationality of a gas exchange to operate in conjunction with the power market. The pressure is for gas prices to align with spot and futures electricity prices. Thus, the link with crude oil and oil products prices is an obstacle to an efficient gas market. 

The precondition for a gas exchange is a surplus that suppliers would prefer to auction in an open market, and the willingness to assume price and volume risk, which is not yet the case. Norway and other major gas exporters also need to watch consumer countries’ natural gas taxation. If needed, they could counteract by taxing gas extraction. High downstream profits and consumer taxes, as is the case in Germany, indicate that import prices are too low. For Norway, an open gas market would facilitate a government-set norm price for tax calculation purposes, as is the case with crude oil. 

Øystein Noreng is Professor, Norwegian School of Management, and he holds the Total chair in petroleum economics and management. He is a regular contributor to this column.