The current decoupling of oil and gas prices, where prices of the two commodities move in different directions, negatively affects Gazprom s export

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1 The current decoupling of oil and gas prices, where prices of the two commodities move in different directions, negatively affects Gazprom s export sales by driving up oil-indexed gas prices and leading to lower gas offtakes. This disparity, however, does not mean that oil indexation in long-term (LT) gas contracts has become outdated, as some would have us believe. The main reason behind the oil and gas price disparity that has lasted for over two years now is the financialisation of the energy markets, which has a strong influence on energy prices. I will argue that this financialisation of the energy markets makes oil-indexation more important for the gas industry now, than it ever has before. In other words, systemic distortions in the energy pricing market which have originated from the financial markets cannot be counterbalanced by any means other than oil indexation. Let me remind you of the fact that the necessity to price your commodity via a third commodity stems from the fact that the market for your commodity is not perfect enough to function properly and produce a quality price signal. This was certainly the case in the early years of the gas industry when gas production required enormous investments and the market mechanisms were in their infancy and not in a position to guarantee a security of supply and demand. As the gas industry has matured it seems to have become conventional wisdom that the rationale for oil indexation in Europe no longer holds and that the move to spot prices has become a fait accompli. Allow me to take this opportunity to argue that the rationale for oil-indexation does indeed still hold, more than ever before and it is now no longer the issue of market immaturity rather a case of overmaturity of the commodity markets that can no longer be ignored. The effects of financialisation on pricing in the energy markets should be thoroughly analysed so that the impact thereof is sufficiently understood. 1

2 A decade ago commodity markets were a relatively quiet backwater of the global financial and commodity markets, where the main participants were almost exclusively producers and consumers. According to Barclays Capital, the combined value of commodity index swaps, exchange-traded commodity products and commodity medium term notes was just $6 billion at the turn of the millennium in December This picture changed as financial investors seeking hedges against inflation, rushed into the market with hundreds of billions of dollars. In Q2 of 2008 these assets surged to $270 bn as the commodity boom peaked. Although commodity investors reduced their appetite in the face of the global crisis, they have subsequently returned with volumes reaching a new fresh peak of $350bn in the second half of The financialisation of the energy market would not create any problems if the funds were spread more or less evenly across the various energy commodities. However, this has not been, and is not the case. There were darlings of the financial investors as well as cinderellas and as a result of this, demand for the so-called darlings ceased to be primarily driven by core-market fundamentals. This is what has actually happened in the case of oil, where close to half of the above mentioned $350bn is currently held in a form of long-term crude oil positions.

3 There are two schools of thought as to the assessment of the impact on prices by market financialisation: The International Energy Agency represents one school of thought which claims that the financialisation of commodities does not drive up market prices. The only force that affects commodity prices, this school of thought argues, is a mix of actual supply and demand factors, where speculators simply amplify the tendencies set up by the market fundamentals and do so only within a short period of time. I adhere to another school of thought that subscribes to the view that paper trading in commodities is a force that gives its own momentum to pricing structures. Commodity prices are determined not only by the fundamentals but by the investments of market participants who are not directly connected with the goods in which they trade. Financial investors, in fact, regard these goods as an instrument of inflation risk evasion. The choice of a commodity as a financial paper asset does not increase its physical demand but it does increase its price. This approach does not conflict with the mainstream economic theory that states that the more paper traders invest in a commodity, the higher its churn ratio, the better is the quality of its price. When a critical mass of paper investors emerges, the quality of price improves due to the fact it also starts to capture the vibrations coming from the currency markets. In other words, the over sensitive commodity price reflects not only its own market fundamentals but also the deficiencies of the price measurement instrument and by and large, a fading trust in paper currencies. When investors are using the black gold as a safe haven for hedging their currency risks we have the following scenario: The higher the inflationary expectation, the higher the price of crude and vice-versa. I would like to point your attention to a comparison of the inflation expectations

4 Quantitative easing announced by the Federal Reserve in November 2010 pushed inflationary expectations up and the difference in yields between Tips, or inflation protected 10-year US Treasury bonds and regular bonds, now sits at about 2 per cent, climbing from a low of 1.5 per cent last August. Data from the Commodity Futures Trading Commission, the US Regulator, indicates that investors in the US have put record sums of money in long-term crude oil positions. It is very hard not to see the correlation between inflationary expectations and the actual price of oil. The IEA -who in 2008 were telling the whole world that the growth in the price of oil to $147 per barrel was the result of perceived future demand in China and India -have denied that paper trading was impacting on the price of crude, other than any volatility this might have created in the market. Oil consumption in the world in 2010, according to OPEC s preliminary data increased only marginally, yearon-year, by 1.9 per cent. Oil markets, however, are well supplied and the markets fundamentals cannot explain a 17 per cent growth of Brent prices last year. Therefore, the argument that perceived Asian demand could be one reason for this rise does not sound convincing. What would be the reason, otherwise, that the current price of gas does not correlate with the IEA s prediction that we will be entering a golden era of gas, set to commence in 2020?

5 In contrast to oil, natural gas is treated as the Cinderella of the financial markets. Although the volumes of natural gas exports are only 4 times lower in US$ value than the sales of oil, the financial markets have disregarded natural gas as an attractive hedging instrument. Measured by volumes traded, oil supersedes natural gas 55 times over. As a result of this weak interest by financial investors, the gas price receives support largely from the fundamentals of its own market, which is due to the fact that the gas price is not supported by the financial markets. 5

6 In the wake of the financial crisis, gas lost its attractiveness to financial investors and whereas, prior to the financial crisis, the ratio of oil to the price of gas hovered within a very narrow bandwidth. Since 2008, however, the ratio of the price of oil to gas has diverged significantly and as extreme as 3 to 1. The question is: How to restore the economically reasonable price correlation of oil and gas, acceptable to the whole industry? There are three options to reach this aim: Option 1 Traders out of the energy commodities temple Option 2 Traders into the natural gas temple Option 3 A preservation of oil indexation.

7 Now, Traders out of the energy commodities temple is no more than a figure of speech. It is not possible to stop the financialisation of the energy markets and it will remain inevitable unless we have a stable global currency, something which will not be resolved any time soon. What we can do, however, is to adjust the price of oil in our contracts and use this price as a benchmark, albeit removing its speculative component. Indeed, estimates on the impact of speculation or hedging on crude prices range from a premium of 15 per cent on the conservative side to as high as 50 per cent. Option 1 is therefore clearly not an option. What we see is not only the continuation of the oil-gas price disparity but a broadening of the range of commodities which have become the darlings of investors, seeking to hedge against currency fluctuations. And now we can also see that metals also represent an attractive alternative. When majority of other commodities are racing higher in the midst of very contrary fundamentals, the illogical market behavior could be explained: They were earmarked by financial investors and received their support and blessing. Gas producers would have to buy investment goods at artificially blown-up prices, whilst watching their own prices being depressed either as a result of the Cinderella syndrome or due to voluntary price adjustments.

8 The second option looks more feasible than the first option. In order to attract financial investment, the first thing we need to do is to stop disseminating bearish information on gas; after all, there is no reason for the industry to look worse than it is in reality. The fundamentals of the industry would improve and there are good messages that we could deliver now, as according to our preliminary estimates, gas consumption in Europe in 2010 hit all time highs. It will take time, however, for the financial markets to appreciate natural gas as an instrument for currency hedging. There is a reason that natural gas futures haven t taken off as inflation hedge. Specific commodities chosen as inflation hedge have to feature a standardised spot price structure in global markets. Natural gas doesn t fit this description, with its differing degrees of price seasonality in different locations and many different pricing structures. It also tends to represent more localized markets as the vast majority of gas is still transported by pipeline. The continued emergence of mobile LNG has led to some greater correlation of markets but not to the extent than enables gas to catch up with the broader commodity price trend. There are good chances that it may not happen in the future. As commodity investment is becoming physical amid paper commodity market regulations, gas will hardly become the darling of exchange-traded physical funds. Storage and insurance costs for gas are much higher than for oil and metals.

9 Let me repeat it once more, we are not ignoring market changes. There are systemic inefficiencies in the functioning of the global energy market and these inefficiencies are only getting worse, adversely affecting the industry. Spot market pricing is not a solution. The solution as we see it is as follows: oil indexation as a means of mitigating the consequences of systemic market inefficiencies. My message is not that gas indexation is bad -as a matter of fact, Gazprom has found a space for gas indexation in its LT contracts. Under the existing circumstances, however, gas indexation cannot play a leading role in global gas pricing irrespective of the efficiencies of the spot markets. If gas indexation were used, the gas industry would be forced to develop under a boom and bust scenario as normal investment cycles in the industry would become interrupted. 9

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11 The US liberalized gas market based on Henry hub pricing model is a true showcase of a perfect supply-demand balancing mechanism. However, in the absence of interest from financial investors, this market is not capable of supporting margins for gas producers that were in place before the crisis. For more than two years an average wellhead price in the US has been more or less equal to the Henry hub price, thus leaving many producers without sufficient cashflows that can provide support for their long-term investments.

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