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    CEE Gas Markets: Integration Needed

Summary

Short-term contracts give more room for diversification, for new suppliers, but for the market to work there has to be a certain critical mass.

by: DL

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Natural Gas News, News By Country, Bulgaria, Pipelines, South Stream Pipeline, Featured Articles

CEE Gas Markets: Integration Needed

And just how might the South Stream pipeline project change things for countries in Central and Eastern Europe (CEE), like Bulgaria, in terms of diversification?

To answer such a question, Mr. Grzegorz Pytel, Advisor to the European Commission, Sobieski Institute, gave a presentation entitled "Impact of Diversification Upon Consumer Prices" at the event South Stream: Evolution of a Pipeline in Sofia, Bulgaria.

While he admitted it was impossible to discuss quantitative number, he said he would go through the factors to consider when looking at diversification - a "very generic term" - and consumer prices.

One of the ways of putting a metric on diversification, he said, involved taking stock of the risks, the first of which was security risk.

Mr. Pytel commented: "If we've got supplies from one source, if that source gets disrupted we may get cut off."

The second risk, he said, was price risk, which was a risk to the competitiveness of a country's economy. "Supply can be monopolized in the market, and if it is it may dictate the price, hence it may impede competitiveness."

Another aspect was the outlook in terms of diversification: "If we look at it statically now, it may be quite misleading because sometimes the current situation could already entail problems for the future, so we have to look at diversification and at benefits of diversification in a certain time window."

One import aspect of diversification in CEE, said Mr. Pytel, was capacity.

"By capacity, I mean virtual, physical capacities, because it's no good to start talking about diversification and signing all sorts of contacts from many suppliers if the routes of supply are very limited, if the infrastructure to deliver gas can be limited to one source or one route, and if that one route gets disrupted then however many suppliers we may have, they will all get disrupted along the way."

Trading, he added, was an intangible in this equation, but very important. "Typically, in many countries outside CEE, people are used to trading with many partners, whereas those industries emanating from monopolized, state industries don't have a culture of this, so even if they're given all the orders they wouldn't know how to include diversification into operations because they wouldn't know how to dynamically trade with others," he explained.

"My point is, diversification implies a lot of trading, and a lot of trading implies know-how and using that know-how efficiently."

One way of measuring diversification, according to him, was the markets, in a liberalized milieu.

Mr. Pytel said he held that the market was as liberal as the least liberal part of its value chain. "So in order to reach a full liberal market all of the elements of the chain must be free."

Thus, diversification, he said, might not work.

"Practically speaking, monopolies are big companies, they have a lot of investment, capital, they can invest long term, and make long-term decisions as long as they control the market, because they are assured that whatever happens on the market they will dictate the price in order to recoup the investment," he explained.

When monopolies got squeezed by increased competition, typically from smaller companies, it meant taking away a lot of profit in the short term, according to him.

"Consumer markets drop, monopolies follow and a really strong regulatory framework is difficult unless there was an earlier experience. The issue of short-term investment starts ruling the place.

In UK telecoms, he noted, the regulator had kept prices of BT very high. "In the short term they could have slashed the prices down to zero in order to push the competition out, but forcing prices down would also affect long-term investment," he recalled.

Here, he said, was the first warning sign.

"If monopolies develop big markets, and then they are squeezed out by competition which is achieved through diversification, then we may have a problem with long-term investment, especially if it moves to a competitive market on a short-term basis - once the crisis hits some years down the line there will be no company to take a risk into a long-term investment."

In terms of whether diversification would be filtered down to consumers vis a vis the price of gas, he said: "We all want to achieve that. Basically, under the European spot market we see that the prices have dropped dramatically and the contract markets are staying high."

He noted that E.ON had even questioned the grounds for revoking long-term gas contracts with Gazprom. Mr. Pytel commented: "Short-term contracts give more room for diversification, for new suppliers, but for the market to work there has to be a certain critical mass.

"If you look at the numbers for CEE, the big problem is the scale: it's quite small. Poland, for example, is less than 15bcm, while Hungary is about 12bcm. If we need good suppliers, they must have a viable market share."

He opined that by looking at the geography in the CEE, it was possible to conclude that the coveted Nabucco project had been started from a wrong premise, of being a supply route from the Caspian, Central Asia and the Middle East to CEE, when instead such a project should be seen as market integration infrastructure.

"So it doesn't matter whether we've got a supplier in the Caspian or Middle East; we need such a pipeline in order to integrate the markets in our region, because once we've got that then we can operate on all these markets. Then we can start talking about proper diversification that would reflect upon consumer prices," he said.

Diversification at the state level in CEE would never reach an economy of scale, he contended.

"Three, four or five suppliers on the Lithuanian market," he explained, "of 4bcm/annum cannot be viable; even in Poland, 3-4 suppliers for 15bcm won't be viable either. So we need to achieve is integration of these markets. Rather than having diversification on individual markets in each state, they can trade on all of them and hence the totality of the market is 68bcm. Five to eight suppliers on an integrated market would be viable, and because they would achieve an economy of scale, there's the possibility for consumer prices to go down through competition as these diversified supplies would achieve economy of scale."

The other thing that regulators must ensure, according to Mr. Pytel, is that all these competitors are sure of a long-term investment in a supply chain from upstream.

He explained: "If they use the current capacity and don't make sure there's a viable investment for the future, yes there can be a short-term effect on consumer prices due to immediate competition, and all the small companies will rake in big profits within a few years of operation. However, in the longer term it is likely that the price of gas would go up because there will be a lot of longer-term investment and a shortage of supply on the markets, and if there's a shortage of supply it doesn't matter how many diversified trading companies are there; some will go bust, but if demand exceeds supply, prices will go up."

In summary, he said long-term investors' short-term interests must be taken into account.

"Short-term competition and driving prices down cannot come at the price of a longer-term investment. Here a bit of oversight would be needed," commented Mr. Pytel.

His last point was contrasting economy of scale versus competition. "Economy of scale allows for the achievement of unit costs, however, this is what monopoly is all about, which drives prices back up.

"So, it's all a question of balance," he explained. "Yes, competition should be there, however each of these companies must be viable to trade and to invest in the longer term."

Regarding consumers' versus producers' interests, he said: "If in the short term we drive the price down and forget about producers' interest, which is to make enough profit to invest in the long term so that we as consumers may benefit in the prices going down in the short term, where in the longer term the price may actually start going up, and then it could be a serious problem."

Integrating the markets in the region, according to Pytel, was crucial.

"Because each of our markets here locally is not big enough in my view in terms of gas demand to take care of itself, whereas the entire market of about 70bcm is big enough in order to be competitive. This would involve some collaborative thinking and some forward planning, because I don't really think the markets will be able to take care of this by themselves."