Spot trade or long term contracting a strategic perspective

Karsten Neuhoff

Based on Work with Christian von Hirschhausen

Cambridge, December 2005

2

Do we need long-term contracts for gas producers?

• EU sector enquiry – are current LT contracts collusive?

– No resell provisions

Source: Sector Inquiry of Commission

3

Do we need long-term contracts for gas producers?

• EU sector enquiry – are current LT contracts collusive?

– No resell provisions

• Should we move to liquid spot trading?

– UK forward prices failed to predict lower production

4

Forward prices failed to anticipate current price spike

0

20

40

60

80

100

120

Mar-03 Oct-03 Apr-04 Nov-04 May-05 Dec-05

NBP

Zeebrugge

TTF

p / therm

Oil price

increase

Transmissionon continent

Work with Anne Neumann

5

Do we need long-term contracts for gas producers?

• EU sector enquiry – are current LT contracts collusive?

– No resell provisions

• Should we move to liquid spot trading?

– UK forward prices failed to predict lower production

– Russia – does Gasprom invest in production/T?

– LNG terminals – but where are ships and gas?

6

…. and will we get all that LNG investment?

Liquefaction Capacities Worldwide

0,0

50,0

100,0

150,0

200,0

250,0

2005 2006 2007 2008 2009 2010

mtp

a

Norway

Australia

Russia

Asia Oceania

Middle East

West Africa

North Africa

Latin America

North America

Source: Sophia Ruester

7

Do we need long-term contracts for gas producers?

• EU sector enquiry – are current LT contracts collusive?

– No resell provisions

• Should we move to liquid spot trading?

– UK forward prices failed to predict lower production

– Russia – does Gasprom invest in production/T?

– LNG terminals – but where are ships and gas?

• Or should we move to transparent fixed price contracts?

– Free resell, not restricting spot market liquidity

– Producers don’t want to abandon successful cartel

– Domestic retail competition constrains counter party

8

The benefits of spot trading

Production

DemandDemanduncertainty

Price

Resourceuncertainty

priceresponse

priceresponse

• Spot trading ensures efficient response to uncertainty

• But exposes all market participant to price volatility

9

combined with the benefits of long-term contracts

Production

Demand

contractprice

priceresponse

priceresponse

Resourceuncertainty

Demanduncertainty

• Fixed price long-term contracts eliminate price volatility

• While retaining efficient re-allocation in spot market

(assuming free resell etc.)

spotprice

10

1. Benefit of LT contract: Hedging price risk

• Price risk difficult to hedge in financial markets

• Investors require higher rate of return on capital

(limited risk appetite, regulatory risk)

• Increases production costs and expected gas price

• Consumers prefer stable energy bill if they do not sell

output on markets linked to gas price

• Replicate LT by overlapping ST contracts ?

11

LT contract priced relative to oil

• Historically 15-20 year take or pay contracts

• With increasing regulatory uncertainty contract length decreased

• Historic oil price link

Source: Sector Inquiry of Commission

12

Future of oil price link?

• Remove oil price link today?

– In power sector main substitute coal

– Reduces revenue volatility for exporting/importing economies

• Retain oil price link?

– If collusion among producers, likely to resist renegotiations

– First moving electricity generator increases risk with fixed gas prices if electricity prices remain

linked to volatile gas price

• Shift towards fixed pricing via S-curve?

13

2. Benefit of LT contract: Securing investment

• Stable revenue streams facilitate financing

• Assume competitive market/spot sales:

– downside risk is excess capacity and low prices

– risk averse producers reduce investment

• Assume competitive market/LT sales

– downside risk is failing to meet contract obligation

– risk averse producers increase investment

14

Effect of uncertainty about future production

Assume:

• Fixed investment costs c per unit of capacity

• Technology uncertainty can shift future output +/-15%

• Competitive market invests while profits are positive

• Risk averse investors weight losses (1+r) times profits

Gas producersselling spot

0.30.20.10

8.75

8.5

8.25

8

7.75

Risk aversion of gas producers (r)

Insta

lled g

as

pro

duction c

apacity

Gas producersselling spot

0.30.20.10

15

Contracting changes investment choices

Assume:

• Producers sell 95% of output with long-term contracts

• Then decide on investment in production

• Producers can sell or buy on spot market

Gas producersselling long term

Gas producersselling spot

0.30.20.10

8.75

8.5

8.25

8

7.75

Risk aversion of gas producers (r)

Insta

lled g

as p

rodu

ctio

n c

apa

city

Gas producersselling long term

Gas producersselling spot

0.30.20.10

8.75

8.5

8.25

8

7.75

Risk aversion of gas producers (r)

Insta

lled g

as p

rodu

ctio

n c

apa

city

16

3. Benefit of LT contract: Revelation of information

• If most sales spot, producers signal excess supply

– Prevents entry of competitors

– Reduces investment

– Increases future prices and revenues

• If most sales long term, producers signal short supply

– Demand buys long-term contracts at high prices

• With long-term contracts

– Demand/supply expectation revealed in contracting decision

• Without long-term contracts

– Forward market reveals market expectations

– But recent experience unsatisfactory

17

4. Benefit of LT contract: Reducing market power

• Strategic value for sellers

• Additional sales stage reduces MP

18

0

1

2

3

4

5

6

7

8

9

10

0 2 4 6 8

Long-term contracts commit producer to lower prices

p

Q

Demand

Neuhoff, K. and von Hirschhausen, C. (2005) ‘Long-term ve. Short-term Contracts; A European perspective on natural gas’, CWPE 0538 (EPRG 05)

•Long-term contracts reduce prices

•In traditional models long-term contracts reduce producer profit

Price without LT

Price with LT

Long-term contracted

19

Demand more elastic short-term than long-term

psp

q

pl

Rational Expectations, Pl = PS

Qe

ps

Qe,long-term

• Fuel choice at time of investment decisive

20

0

1

2

3

4

5

6

7

8

9

10

0 2 4 6 8

Investment/ output choice with rational expectations

p

Q

LT demand

ST demand

no cont

ST demand

contracting

21

Producers‘ profits with(out) long-term contracts

γ*~ 5, corresponding to elasticity estimates by Al Sahlawi (1989) for industrial gas demand and Estrada and Fugleberg (1989)

108642

12.5

10

7.5

Ratio between long-term and short-term elasticity (γ*)

Pro

fit o

f duop

olis

t

Without long-term

contracts

With long-term

contracts

108642

12.5

10

7.5

Without long-term

contracts

With long-term

contracts

22

When are producers better of with LT contracts?

54321

30

25

20

15

10

5

0

Number of players

Producers profit from

long -term contracting

54321

30

25

20

15

10

5

0

Number of players

Producers profit from

long -term contracting

Ratio b

etw

een lon

g-t

erm

and

short

-term

ela

sticity (

γ*)

23

Conclusions: Impact of high long-term elasticity

• Long-term contracting commits producer to lower

spot prices

• Consumers always benefit from this strategic effect

• Lower price levels also increase long-term demand

• This creates benefits for producers

• With high market concentrations and significantly higher long-term than short-term demand elasticity

producers can even profit from long-term contracts

24

5. Benefit of LT contracts: Bilateral components

• Short term trading costs vs. LT contracting costs?

• Address hold up problem if assets are dedicated

25

Drawback of LT contract:

• Creates additional opportunity for collusive behaviour

• If all demand/production covered entry difficult

– Hence initial objection during liberalisation

– Adjustment relative to LT position creates trade

– Balance with benefit for investment of entrant

26

… and what I still don’t understand

• Why not follow other sectors without LT contracting

– refinery, aluminium, oil production, airlines

– Would they be cheaper without LT contracting?

– Is it more difficult to sign LT contracts ?

– Do they receive other government support?

• Is counter party risk too big with fixed price contracts?

27

Institutional constraints on LT contracts

• If retail company buys on long-term contract

– At times of low spot prices customers switch away

– Retail company not credible counter party

• Option 1: LT retail contracts for domestic customers

– Does it further reduce competition?

– Does it create additional transaction costs?

– Do customers care/internalise strategic effect?

• Option 2: Franchise for domestic customers

• Option 3: Only industrial customers buy LT

– Volume too small for strategic effects?

28

Summary

• Current debate on LT contracts

– Concerns raised by sector enquiry

– Does cosy cartel prevent shift from oil-price link?

• Benefits of long-term contracts

– Hedge price risk

– Give right investment incentives

– Reveal information

– Mitigate market power

• LT contracting inconsistent with retail competition?