Do Recent Rulings Herald The Divorce Of Oil And Natural Gas Prices, And Who Will Benefit?

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1 Credit FAQ: Do Recent Rulings Herald The Divorce Of Oil And Natural Gas Prices, And Who Will Benefit? Primary Credit Analyst: Karim Nassif, Dubai (971) ; Secondary Contacts: Tuomas E Ekholm, CFA, Frankfurt (49) ; Tuomas_Ekholm@standardandpoors.com Elena Anankina, CFA, Moscow (7) ; elena_anankina@standardandpoors.com Mark Habib, New York (1) ; mark_habib@standardandpoors.com Research Contributors: Sapna Jagtiani, Dubai (971) ; Sapna_Jagtiani@standardandpoors.com Ekaterina Kulikova, Moscow (7) ; ekaterina_kulikova@standardandpoors.com Table Of Contents Frequently Asked Questions FEBRUARY 4,

2 Credit FAQ: Do Recent Rulings Herald The Divorce Of Oil And Natural Gas Prices, And Who Will Benefit? Recent arbitration cases and commercial agreements have highlighted controversies in the formulation of gas contract pricing, leading market commentators to point to the possibility of oil prices and gas contract prices being gradually decoupled. Notable cases include those between gas suppliers like Qatar's Ras Laffan Liquefied Natural Gas Co. Ltd. 2 & 3 (collectively known as RasGas), Russia's Gazprom OAO, Norway's Statoil ASA, and the Netherlands' GasTerra B.V. and gas importers like Italy's Edison SpA, Germany's E.ON SE, and Spain's Gas Natural SDG S.A. Some of them have led to compensation being paid by the suppliers. Standard & Poor's Ratings Services answers below the most frequently asked questions about the arbitration and what it may mean for the credit quality of our rated gas suppliers and importers. We also address the dynamics that are driving the decoupling of oil and gas supply contract prices and what this could mean for gas supply contracts and gas markets in general in future. Frequently Asked Questions What have the recent arbitration awards and commercial agreements been about? Gazprom and other European gas market suppliers' contract prices have historically been linked to oil products. Traditional European long-term gas import contracts include price review clauses, which allow base prices and indexation formulas to be reset every three years based on market changes. In the current context of high oil prices and oversupply of gas in the European market, oil-indexed gas import prices have been well above European spot prices and parity levels for alternative fuels such as coal. With oil-indexed import contracts permanently "out of the money" importers have been forced to incur losses in their trading segments to be able to place contracted import volumes in the marketplace. This has pushed Central and Western European importers to file arbitration cases and renegotiate long-term supply contracts with base price revisions outside the normal contract review cycle. It has also led to changes in pricing formula in the form of the introduction of a spot component, and some retroactive payments to importers to recover past losses, higher flexibility in volume, and higher destination flexibility, thus increasing the ability to divert volumes, notably for liquefied natural gas (LNG). Details on base price discounts and changes in pricing formulas are not generally disclosed. The European Commission has started an antitrust investigation against Gazprom. We understand that customers in the Commonwealth of Independent States (CIS), notably Ukraine, are also trying to renegotiate their contracts. What have been the key legal developments in the past year? They all concern gas supplier RasGas. On Sept. 11, 2012, the court of arbitration of the International Chamber of Commerce ruled against RasGas in a dispute with Italian utility, Edison, over their long-term LNG Sales and Purchase Agreement (SPA) contract. The LNG SPA sets out the pricing formula and quantity of LNG to be purchased over the term of the SPA by Edison, subject to FEBRUARY 4,

3 RasGas making the LNG available. The RasGas LNG contracts will typically involve a mixture of crude oil and gas based indices that govern the final price. The relative exposure to crude versus gas based indices will depend on the particular contract. The court ruled against RasGas in the dispute relating to their SPA contract with Edison, which ended with RasGas paying about 450 million in compensation. RasGas is still in arbitration with Distrigas over oil indexation of gas prices in their SPA contract. RasGas entered into arbitration with Spanish utility Endesa S.A. in July 2012 over oil indexation of gas prices in their SPA contracts. What is driving the decoupling of U.S., and now increasingly European, natural gas and crude oil prices? The dramatic increase in unconventional production techniques in the last five years, especially shale. Natural gas and crude oil prices have effectively already decoupled in the U.S. market, resulting in the price ratio of a barrel of crude oil to a million metric British thermal unit (mmbtu) of natural gas rising to over 25:1 on a sustained basis, well in excess of 6:1, the ratio based on pricing energy content at parity. Technology advancements and widespread adoption of horizontal drilling and hydraulic fracturing have lowered development costs and increased production efficiency, flooding the U.S. market with natural gas and natural gas liquids (NGLs). This has helped to drive renewed competitiveness in several industries, like petrochemical production, refining, and other natural gas-fueled manufacturing sectors that rely on these feedstocks. Until the development of large-scale liquefaction that would make natural gas exports viable, U.S. production will remain stranded in North America. This has already led to a sharp decline in Henry Hub prices over the past 12 months (see chart 1). Prices hit a 10-year low in the second quarter of 2012, and have fallen sharply since their 2008 peak over $10 per mmbtu. The decoupling in the U.S. as a result of shale also has consequences for the decoupling taking place in Europe: U.S. LNG import facilities are sitting virtually idle with suppliers rerouting capacity to more lucrative markets like Asia and Europe. LNG that would have been destined for the U.S., from the Middle East and elsewhere, is increasingly being diverted to other markets such as Europe. In addition, following the shale gas growth phenonmenon, the U.S. has found itself with excess coal. Some of this cheap goal is finding a home in Europe. Europe, given the current macroeconomic climate, is happy tapping into the additional coal resources from North America as a short term and cost advantageous way of fueling its power plants. These developments are expounded by the relatively loose implementation of carbon-pricing policy in Europe. Additional supplies of LNG and imported coal from the U.S. have therefore helped tip the supply-demand dynamics in Europe in favor of supply, which is also putting pressure on Europe gas hub prices. Gas demand in the EU fell by 10% between 2010 and 2011, and a further fall is expected for 2012, along with increased pressure in Having witnessed the decline in North American gas prices, buyers of LNG in Europe are looking for substantial FEBRUARY 4,

4 changes in their SPA LNG contracts, and this has prompted importers of pipeline gas from Russia and Algeria in Europe, who have traditionally signed contracts indexed to oil prices to try to renegotiate their contracts. Henry Hub is increasingly being used as a benchmark on which to price gas contracts in Europe. For example, Spain's Gas Natural Fenosa has introduced Henry Hub-based indexation for its Sabene Pass project. This follows developments elsewhere around the globe where Henry Hub is increasingly being introduced to benchmark gas contract prices. In addition to the effect of U.S shale on pricing in Europe, decoupling in Europe has been promulgated through regulatory reform over the past decade. For example, Europe's businesses have gone through considerable structural change as regulatory pressures have grown, mainly because of the determination of policy makers to create a single competitive internal market. Contractual tensions have led to financial losses among companies forced to buy imported gas under oil-indexed contracts and to sell it on at lower hub-based prices. What short- to medium-term effects does Standard & Poor's think the recent trends in decoupling will have on the ratings on EMEA gas suppliers and importers? Little effect for suppliers and a positive effect for importers because they've managed to significantly cut risk in their portfolios. For importers our view is that the recent changes in contract structures toward a higher share of hub-based pricing elements instead of oil indexation, following the decoupling of the market, is likely to be a credit supportive as it lowers the likelihood that an importer will run into a structural deficit in the midstream gas business. At the same time we acknowledge that gas wholesale is likely to be a relatively low-margin activity for the importers going forward. We would expect the effects on gas producers' RasGas' and Gazprom's credit quality to be limited because their ratings already factor in a degree of price volatility and are not tied to currently high oil prices. Our ratings are currently based on a midterm price scenario of Brent at $80 per barrel (bbl), which is about 25% below the current Brent crude price, and factor in that the conditions we see today in the market in relation to the decoupling of oil and gas persisting over the short to medium term. For example, supplier Gazprom's EBITDA would be about $40 billion over the short to medium term if the decoupling persisted, significantly lower than 2011's record levels of $66 billion, but still sufficient to support adjusted debt to EBITDA of about 1.5x, in our view. This is still comfortable for our assessment of the company's stand-alone credit profile at 'bbb-'. Gazprom might need to make compensation payments to its customers of up to $7 billion, $4.4 billion of which would have already been paid in the first half of Compared with gross revenues from sales to Europe of $29.7 billion and $28.8 billion over the same period, and bearing in mind the group's low leverage, this amount in our view is comfortable at the existing stand-alone credit profile over the short to medium term. Supplier RasGas' debt service coverage ratios would be expected to remain comfortably above 3x under this scenario, given the compellingly low break-evens in the transaction. For example, Brent would have to drop to $12.7/bbl and Henry Hub would to $1.62/bbl for break even under the financing. We also note that deliveries to Edison, Endesa, and Distrigas are continuing with no interruptions and that the combined amount sold to all three represented less than 20% of RasGas' total cargo sales for The arbitration award was high but not material, in our view, in the context FEBRUARY 4,

5 of RasGas' overall financial performance in To take two importers as examples, we would expect the ruling against RasGas to have a 2012 financial impact of 450 million for Edison's contract with RasGas, and 250 million for Edison's contract with ENI. About half relates to previous years. These are the first gas contracts for Edison being ruled on by a Court of Arbitration, previously we have only seen out of court renegotiations. This legal precedent provides a positive signal, in our opinion, for Edison and others ability to recoup midstream gas losses. The arbitration rulings secure, in our view, a significant share of Edison's cash flows. Although the magnitude and timing of the arbitration proceeds to Edison are uncertain, they support our view that the improvement in Edison's earnings and credit metrics in 2012 is sustainable in the medium term across the arbitration cycle. E.ON has publicly stated that it has completed a round of renegotiations with all of its gas suppliers, including Gazprom. We do not expect any ratings implications in the short to medium term as a result of these negotiations. What medium- to long-term effects would continued decoupling have on the ratings on EMEA gas suppliers and importers? For suppliers the rating impact would depend on eventual gas prices rather than whether or not they were linked to oil. We also derive our view over the medium to long term based on a price scenario of Brent at $80 bbl, which is about 25% below the current Brent crude price. For importers our medium to long term view is similar to that over the short to medium term. Namely, that the changes as a result of continued decoupling are likely to be credit supportive in that they help remove the structural deficit in the midstream gas business. In practice total effective de-coupling across the market will be closely monitored as this will ultimately determine the impact on credit quality. Thus, speedy change in gas supply contracts towards hub-based prices such that this matches the pace at which liberalization towards hub based pricing on the wholesale side is occurring will be key, in our view, in limiting continued exposure by importers to the structural deficit and in supporting their credit quality over this time horizon. As an example, decoupling of oil and gas prices over the medium to long term, at levels witnessed today, would be unlikely to lead us to take any rating action on the ratings on RasGas over the same time horizon. Based on our analysis undertaken of RasGas' financing, it would take a 65% or more decline in revenues across RasGas' businesses for the project to reach break-even with a debt service coverage ratio of 1x. For Gazprom, our expectation of an "extremely high" likelihood of government support should provide resilience for the rating. Under our methodology for rating government-related entities, assuming that Russia's sovereign rating and Gazprom's critical role for the Russian economy and very strong links with the government remain unchanged, the rating would remain at 'BBB' even if the stand-alone credit profile fell to 'bb-', which we view as very unlikely. An important additional element in the analysis of the impact for an importer over the longer term is the degree to which there is risk sharing under the long-term contract. For example, the typical long-term gas supply contract involves the supplier taking the price risk and the importer only exposed to volume risk. We expect this to continue to provide some protection in the form of potential recovery of past losses for these importers in the event that decoupling results in adverse movements in hub-based pricing and ultimately wholesale prices for importers in their FEBRUARY 4,

6 domestic markets. However, as a business model this does not look sustainable for the importers. We note also that while there continues to be forward momentum in the market toward continued decoupling, there are nonetheless some opposing forces that may limit the degree of that decoupling over the short, medium, and long term. These include challenges in exporting LNG from the U.S. to Europe, the uncertain environmental impact of shale technology, the security of supply offered by gas, political priorities to support clean fuel in Europe, and significant power needs in emerging markets like Southeast Asia, Saudi Arabia, and the UAE, all of which are basing their plants on gas as the principle fuel. Chart 1 FEBRUARY 4,

7 Chart 2 FEBRUARY 4,

8 Chart 3 Additional Contacts: Nicolas Riviere, Paris (33) ; nicolas_riviere@standardandpoors.com Simon Redmond, London (44) ; simon_redmond@standardandpoors.com Vittoria Ferraris, Milan (39) ; vittoria_ferraris@standardandpoors.com Tommy J Trask, Dubai (971) ; Tommy_Trask@standardandpoors.com FEBRUARY 4,

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