The European Union’s Issues with Russia’s Gazprom
Andrea L. Sestanovich, The Eurasian Center/EBC, February 2014
The Russian energy company, Gazprom, has been using long-term contracts (LTCs) and oil-indexation for years without issue. Since the rise in global oil prices, indexing the price of gas to the price of oil has caused gas consumers to pay for gas a price considerably higher than market value. Now Lithuania, a country that receives all of its gas from Russia, has two lawsuits against Gazprom for charging too much for gas.
The history of long-term contracts dates back to the Natural Gas Act of 1938. The purpose of LTCs is to ensure companies of future consumers and a return on investments in gas field development, exploration, and pipeline construction. Oil-indexation became a popular pricing mechanism in LTCs in order to protect consumers from spot price volatility of natural gas. Companies across the world adopted this pricing mechanism.
Until relatively recently, the price of oil was considerably cheaper than the price of gas. However, since the 2000s the price of crude oil per barrel has been increasing yearly. In 2011, the cost per barrel reached prices not seen since the 1860s. This has clear implications for positively correlated gas and oil prices - it is causing oil-indexed gas prices to be significantly higher than spot prices.
Countries that are purchasing oil-indexed gas are no longer willing to pay for gas at a price above market value, mainly due to the ability to purchase gas from some suppliers at spot prices and cheap liquefied natural gas (LNG) from the U.S. Unfortunately, due to LTCs countries are bound to the prices and quantities established in the contract with Gazprom for the contractual term. In the past few years, several countries, notably Germany and Italy, successfully renegotiated gas prices with Gazprom. Lithuania attempted similar negotiations, but was not successful in reaching a deal. Now Lithuania is starting a legal battle with Russia’s energy giant that is likely to be long and ugly.
The European Commission (the Commission) has also responded to Gazprom’s natural gas prices by launching a raid into the company in 2011 over suspicions that Gazprom had been violating EU competition law. One year later, the Commission launched an official investigation into the company and believes that Gazprom is guilty of unfair pricing, limiting the gas supply diversification, and dividing gas markets, in direct violation of Article 102 of the Treaty of the Functioning of the European Union (TFEU). If the parties fail to reach a commitment decision under Article 9 of Regulation 1/2003, the Commission will issue a prohibition decision against Gazprom. This decision would allow the Commission to issue remedies that would correct the market effects of company’s unfair practices.
Regardless of the outcome of this case, I believe Gazprom will move toward a pricing mechanism that incorporates spot prices into the equation for determining gas prices in LTCs. Although the outcome of this case may determine how quickly Gazprom reforms its pricing practices, it is inevitable that gas companies will eventually reform their practices to reflect market trends. Gazprom likely will find a middle ground, keeping oil-indexation, but allowing some flexibility or renegotiation if the spot price remains substantially higher than indexed prices for a period of time.
Norway’s Statoil is the EU’s largest supplier of natural gas. Statoil, like other energy companies, determined the price of gas in LTCs using oil-indexation. In November 2013, the company announced that it would begin to incorporate spot prices to determine gas prices in LTCs. However, due to the nature of the product Gazprom exports to the EU, it is unlikely that this switch by its biggest competitor will have devastating effects on the Russian energy giant.
The EU cannot import less gas from Gazprom, and if it does, it will have to pay for the minimum amount of gas that is established in the contracts. Essentially, Gazprom does not have to react immediately to a changing market, because of LTCs and because gas users will not disappear overnight. Even though Europeans are unhappy that they are overpaying for gas right now, they still have to buy Gazprom’s energy to heat their homes and to use electricity. However, this practice is unsustainable, and will deter Gazprom consumers in the long-term.
Despite the recent increase in prices, oil-indexed gas may prove to be beneficial to Europeans after all. Gas prices are likely to remain volatile, and in the future spot prices for gas are susceptible to sharp increases as they have always been. In January 2006, the spot price for gas in the United Kingdom was twice as expensive as oil-indexed gas. If history proves to be an indicator of the future, oil-indexed prices may at some times be preferable to spot prices, and Europeans may attempt to befriend the Russian energy giant once again.