8/3/2019 081120 Factsheet - Pricing Mechanism for Natural Gas in Europe

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Pricing Mechanisms for Natural GasFactsheet 

In contrast to the global oil market, natural gas is traded on

regional markets where gas prices are set

through two different pricing mechanisms.

North America and the UK are the only mar-

kets where gas prices are determined at gas

trading hubs. The gas markets of Continental

Europe and Asia are characterized by the

dominance of long-term contracts betweengas producers and consumers. These long-

term contracts include pricing mechanisms which

Q  Decoupling does not necessarily lead to lower gas prices. One can only expect floating prices to drop below oil-

indexed price levels in an oversupply situation. But amid a growing energy deficit, it would be naïve to bank on the

emergence of a buyer’s market on the continent within the foreseeable future.

Q  Long-term supply contracts allow planning stability and contribute to Europe’s energy security. Decoupling would

only lead to increased price volatility - which creates opportunities for speculators, but does not serve the interest

of end consumers. At the same time, the oil-peg makes the continental gas market immune against the dominant

position of major suppliers. With decoupling, this advantage would be lost.

index the gas price to oil or a basket of oil products.

At times of rising oil prices, some policy-makers in

Europe have proposed de-coupling gas prices

from oil prices and moving towards the Anglo-

Saxon model of free floating gas prices. This sug-

gestion is based on the hope that gas-indexed

prices would be lower. This background paper

explains why gas trading is organized differently inregional markets, how long-term contracts con-

tribute to Europe’s energy security, and why de-

WOULD DECOUPLING OF GAS PRICES FROM OIL PRICES LEAD TO LOWER 

universal motor fuel that will replace oil. And gas has lower

carbon emissions per thermal unit than oil or coal. In the long

term, this development will strengthen the oil-gas tandem.

In the short term, LNG is helping to make the world’s gas

markets truly global. In the absence of competition from

cheaper pipeline gas, Asian markets are attracting ever-greater

volumes of relatively expensive LNG, which, in turn, are starting

to serve as the price target for both sides of the Atlantic.

The long-term comparison of the oil-indexed German

Border Price (GBP) with the spot price of the most

important gas trading hubs in North America (Henry Hub)

and the UK (National Balancing Point) reveals that gas prices

in the US and the UK continue to correlate with oil-indexed

prices, even in the absence of any contractual peg. This

usually occurs during periods when demand and supply are

balanced.

However, the short-term volatility of gas prices issignificantly higher on spot markets. This volatility creates

arbitrage opportunities for gas traders and speculators, but

fails to lower prices for end consumers.

On a joule-for-joule basis, the price of natural gas does not

exceed 70 percent of the price of oil. This discount is

explained by the superior properties of oil as a commodity.

It is the fuel of choice in the transportation sector and can

be stored and transported much easier than gas.

However, the gas price discount to oil prices is most likely to

disappear. Liquefied natural gas (LNG) leads to a

convergence of the commodity properties of oil and gas. In

both cases, we are dealing with liquids that are shipped by

tankers and poured into special tanks for storage. Gas-to-

liquids (GTL) are potentially capable of turning into a

KEY FINDINGS 

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TRADE IN NATURAL GAS: THE CURRENT SITUATION 

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Pricing mechanisms for natural gasFactsheet 

WOULD IT BE POSSIBLE TO ESTABLISH FREE FLOATING GAS PRICES IN EUROPE?

very few market players on each side. This creates a situation in

which a small number of suppliers and buyers have to hedge

investment risks and distribute rewards in order to uphold a

reasonable level of planning security.

This is typically done through long-term

contracts which include negotiated

pricing mechanisms in order to ensure

that one side cannot unilaterally dictate

price levels. In other words, for import-

dependent markets such as Europe, long-

term contracts provide the fundamental

basis of energy security.

LNG transport, which is particularly

developed in Asia, allows more flexibility

than pipeline systems, because there is

no physical reason why LNG tankers cannot be re-directed to

different destinations. However, due to the capital-intensivenature of investments in LNG facilities, together with high

production and transportation costs, most LNG is sold through

long-term contracts. It should also be noted that LNG currently

represents only a small fraction of the global gas market 

WHY DO GAS PRICING MECHANISMS DIFFER ACROSS REGIONS?

For the foreseeable future, a transition to free-floating gas

prices could not be accomplished simply because there is no

European reference point for gas prices. Europe’s gasmarket remains fragmented, and the liquidity of the small

trading hubs in Continental Europe is too low for any of 

them to provide a reference point.

The replacement of the existing system would be a major legal

and logistical challenge, given that 90% of the gas consumed in

Continental Europe is sold under long-term contracts with oilprice indexation, many of which have recently been extended

beyond 2030.

To overcome this constraint, gas can nowadays be

transformed into liquefied natural gas (LNG). But this

process is very energy intensive and can cost up to one

third of the original energy in the gas. This is why the

gas market is and will stay to a high degree a regional

Due to its high energy density and its liquid form,

oil can be transported and stored at lower cost

than other fossil fuels. Moreover, it can be shipped

and stored in a flexible way, which is why oil is

easily traded on a truly global market.Because of its low energy intensity and its fugitive

form, both the transportation and storage of gas is

expensive compared to oil. Traditionally, natural

gas is transported in pipelines. Pipelines can only

be built with high capital investment and over

limited distances from production sites to

consumers. Once built, pipelines offer no flexibility

to re-route supplies, and establish a long-term

business relationship between a limited number of 

producers and consumers.

The regional differences between the price mechanisms can

be attributed to differences in geography and resource

endowments. Until the end of the 20th century, both the US

and the UK were self-sufficient or

even net exporters of gas. At the

same time, gas reserves in both

countries are located in small to

medium-sized gas fields which can

be exploited by a large number of 

smaller undertakings. In this

situation, governments can decide

to set a general regulatory

framework for the domestic gas

value chain and then leave

production and sales decisions to

the market.

In Continental Europe, the situation is significantly different.Here, key gas consuming countries have always been

dependent on gas imports from gas fields situated in

Algeria, Norway, the Netherlands and Russia. Cross-border

supply pipelines are capital-intensive and often have only

WHY IS GAS NOT TRADED ON A GLOBAL COMMODITY MARKET LIKE OIL? 

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I. Further reading: Energy Charter Secretariat (2007): Putting a Price on Energy, International Pricing Mechanisms for Oil and Gas. II. The indicator for liquidity is called “churn”. Churn is the ratio between traded volumes and delivered volumes. A churn of at least 15 is usually considered to be the

threshold for a liquid market. Henry Hub, the main gas hub in North America, has a churn of 100, while the National Balancing Point in the UK oscillates between a

churn of 10 and 15. The few existing Continental European hubs all have a churn of clearly below 10, while Asia has no hubs at all. For comparison: on the oil side, the

churn of WTI and Brent is about 500. Source: Energy Charter Secretariat (2007).