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German energy giant RWE (OTCPK:RWEOY) has been hurt badly by the yawning gap between spot gas prices and the prices it pays some of its suppliers, which are based on a formula tied to oil prices. The firm has made some progress modifying those contracts with its suppliers, notably Norway’s Statoil (NYSE:STO):

RWE has managed with three of its suppliers to either end some long-term contracts – which in total account for half of the RWE’s gas purchases and run as long as 2036 – or to index them to the price of freely traded gas on European exchanges, it said on Thursday.

But one big supplier holds out. No points for figuring out which one:

Negotiations with Russian state-owned gas monopoly Gazprom, the world’s largest natural gas producer, are continuing, RWE Finance Chief Rolf Pohlig indicated.

“It’s about a lot of money in an area where we have different opinions. That’s certainly more confrontational,” he said.

Russia is playing “hardball” said Frank Umbach, writing for the Geopolitical Information Service.

“Norway has shown a lot of flexibility so as not to lose important market share in Europe. But Russia considered itself to be in a stronger position and insisted on its long-term contracts,” he said.

The Norwegians are being more reasonable and flexible than the Russians. Go figure.

But the 25% ($100/mcm) price gap between the oil-linked price and current spot prices is putting pressure on Gazprom (OTCPK:OGZPY). It has made noises about adjusting contract prices:

A $100 gap between the forward price of gas in Europe and the current price of some Russian contract gas points to a possible deal with German consumers, who are seeking relief from high contract prices, Russia’s gas export chief said on Tuesday, Interfax reported.

Gazprom Export Chief Executive Alexander Medvedev, speaking in Lubmin, Germany, following the launch of the first phase of the new Nord Stream pipeline, which will ultimately carry 55 billion cubic metres per year to Germany from Russia along the floor of the Baltic Sea, said gas cost $500 per thousand cubic metres under some contracts this quarter.

Forward prices are now at around $400, he said. “This is a good basis for finding a good resolution with our German friends,” Medvedev was quoted as saying.

It is becoming increasingly clear that the oil-linked mechanism is becoming obsolete. Gazprom’s arguments about the necessity of the mechanism are risible, especially in light of increasing liquidity in spot markets at European hubs. Indeed, there is a positive feedback mechanism here. Wider use of spot pricing mechanisms by Statoil and other suppliers increases the liquidity of trading at European hubs, which makes spot prices from these markets even more reliable as the basis for supply contract prices. This process occurred after deregulation of gas markets in the U.S., and soon resulted in the evolution of liquid, deep, and transparent spot and forward markets at a variety of points. Utilities now routinely buy gas at prices indexed to spot gas prices at these points.

And it is not just gas. This process is also proceeding rapidly in iron ore, another commodity that historically has been bought and sold under annual negotiated contract prices. But the development of some modest spot trading soon revealed substantial disconnects between contract and spot prices during the financial crisis of 2008-2009, which drove more activity to the spot market, which undermined the forward pricing system. As a consequence, the industry moved to quarterly pricing, but that system is now under stress as well:

But this system is now under pressure as spot iron ore prices, at 15-month lows of $128 a tonne, are well below the quarterly price of $175, providing an incentive to steel mills to default on their contracts and buy instead on the spot market.

“This quarterly system, which has been in since late 2009, now looks to be failing,” says Rob Clifford, mining analyst at Deutsche Bank in London.

Another industry figure quoted in the article says that the movement to spot pricing is “accelerating.” This is an illustration of the positive feedback effect at work. The more spot trading there is, the less viable negotiated pricing becomes: the process feeds on itself with tremendous speed.

The Chinese were a big force pushing the iron ore industry towards shorter-term pricing mechanisms, and they are evidently taking this lesson to the gas market:

Russian energy giant Gazprom expects to rely heavily on liquefied natural gas (LNG) exports to Asia as talks with China on pipeline gas supply have stalled, the company’s head said on Sunday.

Gazprom has been mired in painstaking discussions with China about Russian pipeline gas supply since 2006 but the talks appeared to hit a dead-end over pricing terms.

Gazprom has insisted on the oil-linked mechanism for sales to China, but the Chinese have said no dice. Hence the “stalled” contract talks. Keep this in mind every time Putin or Sechin or anybody from Gazprom say that a deal with China is all but final: that is so much bull. I know: shocking, isn’t it? I bet you are so disillusioned.

The threat to move to LNG sales to Asia is just another Gazprom/Russian vapor-contract threat intended to put pressure on the Chinese–just as they use threats to sell to China to put pressure on the Europeans. LNG is costlier, and definitely not Gazprom’s comparative advantage. The gas that Gazprom would sell to China is much more efficiently sent to them via pipeline than to other Asian locations via LNG: and don’t think that the Chinese don’t know this. Moreover, Gazprom would face much more intense competition in the LNG market from not just Qatar (mentioned in the article), but the U.S. and soon Canada which has some geographic advantages in serving Pacific markets and which is facing declining demand for its gas in the US due to the shale boom. This is a transparent bluff. It will be called.

So who is Gazprom going to use as its next bogeyman buyer if it can’t use the Chinese to frighten the Europeans and other Asian markets to scare the Chinese? Martians?

Probably not, given what just happened with Russia’s Mars mission.

In sum, cracks in Gazprom’s pricing structure are becoming more apparent by the day. It continues its frenzied attempts to paper over these cracks, but these attempts are quite clearly futile and rather pathetic if you think about the economics. The increase in world gas supplies and the integration of the world gas market with LNG are fundamentally undermining Gazprom’s competitive position, and rendering its pricing mechanism obsolete. The positive feedback mechanism, in which the improvement of spot market liquidity drives more activity to the spot market and spot-based pricing mechanisms, improving spot liquidity even further, means that all of Gazprom’s frenzy will be for nought.

Which all means that last week’s much ballyhooed opening of the Nordstream pipeline does not represent the harbinger of increasing Gazprom–and Russian–power in the European energy market. Instead, it is a day-late-and-several-billion-dollar-short (about $9 billion, to be exact) monument to the past. Yes, Gazprom will likely sell gas through that pipeline for years to come, but it will have to do so at prices determined in increasingly liquid and competitive spot markets

Sucks to be Gazprom. But it will be fun to watch!

Source: Spot Liquidity: Gazprom's Frenzy Will All Come To Naught