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    Oil Indexation and the Falling Oil Price: The Beginning of the End for Indexation in Europe?



Hub pricing may in fact prove more efficient and more favourable, even to suppliers than pricing through indexation to oil.

by: Alan Riley

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Oil Indexation and the Falling Oil Price: The Beginning of the End for Indexation in Europe?

Can the defence of gas indexation to the oil price be maintained in the light of the continued fall in the oil price (Brent recently at $80)? The traditional supporters of the oil price link, such as Gazprom, Sonatrach, Statoil as well as many of the major utilities are likely to find it increasingly difficult to sustain their case for indexation if the oil price continues to fall. Already approximately half of European gas prices are secured from hub and not contracting pricing linked to oil prices. Will the other half of European gas prices go the same way?

At first sight the collapse in oil prices since early summer 2014 should help to protect the linking of gas prices to oil. The falling cost of natural gas as a result of the oil price links should make customers less restive and accepting of indexation. The net effect looks like it should restrict the growth of natural gas trading hubs and the move away to indexation.

This however, is likely to only be the case if the fall in oil prices is marginal and is not sustained. A sustained significant fall in the oil price is likely to make it very difficult to sustain indexation. This time ironically the case for opposing indexation will not come from the customers but the suppliers. It would be a repeat of the late 1990s arguments where even Gazprom sought to argue that indexation was dispensable.

Most suppliers will restrain themselves from making the case against indexation for as long as possible. However, a significant and sustained fall in the oil price would both cause so much economic damage to gas suppliers that there would be intense pressure to seek price revision on European markets on traded not indexation basis.

This is reinforced by the potential for hub prices to end up, through the drying up in domestic production; failure to develop shale gas and higher Asian related LNG prices, higher than European indexed prices. It is not beyond the bounds of possibilities if oil prices remain low, and hub prices are higher that some of the major suppliers may themselves seek a price review to take account of the oil price collapse and the difference between indexed and hub pricing. 

Gas suppliers will however be very wary of doing anything to challenge indexation. The danger they face is that if they challenge indexation they will never be able to credibly go back to the old pricing method. The market is already around 50% linked to hub based pricing. A major retreat by suppliers to hub pricing would finish off European indexation. Furthermore, it would be very difficult contractually to seek to enforce a pricing mechanism that could be so easily abandoned.

The other major difficulty is the antitrust and regulatory angle. If under tremendous commercial pressure gas suppliers abandon indexation for hub pricing  European regulators are likely to make it difficult for suppliers to return to indexation later on.  Regulators will argue that indexation cannot be used as a ‘fair weather’ pricing mechanism for suppliers only when the price is high. Once they switch to hub pricing they will really have to stick with hub pricing for the upside and  downside of the markets.

The antitrust regulators in particular are likely to take a dim view of dominant energy companies switching from one pricing mechanism to another. Using EU competition law, regulators can argue that super-dominant companies have a special responsibility on the market and cannot just jump pricing mechanisms when the price moves against them. If this view is correct it suggests that dominant energy companies would be well advised to seek a price review from an arbitration panel before they switched to hub pricing-to provide themselves with some additional legal defence. However, again, once they had switched, antitrust law would be likely to make it very difficult to switch back again. Jumping once following a price review obtained by a dominant supplier might be deemed acceptable by the European Commission. It is very difficult to see how a second jump say back to oil pricing, as the oil price goes back up, would ever get DG Competition's consent even if there was second price review decision.

For the defenders of the old pricing order it may be that the indexation will survive if the oil price is not sustained, the price decrease is marginal and hub prices are not significantly higher. However, what appears to be taking place is a structural alternation in global energy markets with increasing shale oil production combined with slowing Chinese growth creating significant spare capacity which may last for some time. If this is the case it is difficult to see how the European tradition of indexation can be easily sustained.

Ironically the final end of indexation in Europe may be brought about by a collapse in the oil price, not its rise. Hub pricing may in fact prove more efficient and more favourable, even to suppliers than pricing through indexation to oil.

Professor Alan Riley, City Law School, City University, Grays Inn, London.