Gas price formulas and the Big Mac Index

Oil price links are finally coming to an end in Europe. They have eked an existence as Zombies of the energy world as the fundamental mechanism destroying them was not American shale but free markets.

Back in 2005, I was involved in a long-term gas supply project and already then an important question loomed largely. What underlying price indicator would we use for our “to be negotiated” gas contract?

The particular contract is unimportant but what stayed with me relatively early in my gas days was the fundamental opposition between oil and oil product-derived gas formulas on one side and gas market price indicators that the market determines on the other.

Back in 2005, there was only one single gas hub indicator that could realistically serve as underlying – NBP. Today – seven years later – the European landscape looks very different with a plethora of new hubs that are getting more and more liquid. No simple pricing points anymore – they rapidly become service centers to the gas economy and hence real reference points of repute.

Back in 2005, it was clear to me that oil product-linked formulas were a thing of the past and would rapidly disappear. The reason for that was simple.

The petrified relationship between the buyer and the seller represented by those formulas could only subsist in a monopolized market. Once monopolies were gone, buyers would be subjected to competitive pressures which in turn would turn them away from the fossilized agreements they had. The question would soon be – do I want to survive and hence pressure my seller into something more realistic or do I want to go bankrupt?

Gas market liberalization killed oil-priced formulas. As already stated in a number of posts – anything in energy takes a long time to unfold. The monopolized gas markets before liberalization were not created in one day. They were built up over many decades with extremely inflated administrations managing them. The ex-monopolies, of course, put up a fierce fight and would do anything legally possible to preserve a situation of eternal bliss. Breaking up such a thing will always be slow and awkward.

But there is no escaping this important truth. Once you take the lid of the monopoly away, market forces will sledgehammer the existing parties into shape.

It’s really surprising today that still many are afraid US US-produced LNG would infect Europe with market-based pricing mechanisms and hence end the oil link when in fact the oil link is stone-dead already. If Europe would not have liberalized, no amount of imported LNG could have been able to break the oil price link.

Ten steps back: the oil price link (or the oil products link) was created to give a product a price. There was no market for this product as (let’s remember) natural gas was a trashy byproduct of oil production and not a valuable commodity. Also, the gas markets were locked down in national monopolies. And if there is no true market, there can be no independent price formation. However, the parties to the contract wanted the price to be outside the influence of the respective other party. It still had to be determinable so they created the fiction of competing energy.

How much gas competes with other forms of primary energy is a bloody battlefield and I don’t want to cut into this cake now. Enough is to be said that the underlying assumption of competition between the different energy forms is more mythology than fact due to the economic pain of switching systems.

What the parties wanted was a pricing mechanism they could live with which did not give them too much of a headache. The Big Mac index as determined by the Economist newspaper would fit the bill. At the very least it reflects living standards and so the relative wealth of a society and the economic health of a market. In the end, it’s nothing but a marker used for determining a price. Oil and its derivatives never served a different role.

But – you will say – the Big Mac Index is a composite index and not a traded one. True. But so is Japanese Customs Cleared (JCC), the most important oil marker for LNG contracts and a whole host of smaller ones. Being a traded index is no prerequisite to be used as a pricing determination mechanism. The whole construct is artificial, to begin with so why bother using a traded index in the first place?

To all those afraid of contagion by US-produced LNG: don’t. The US market could not influence European or any other pricing mechanisms a little bit as long as the monopoly lid was intact. Fundamental forces of the free markets blow that up much more efficiently. The logical conclusion is that the oil price link will be a feature of LNG for quite a while except of course if the JKT countries embark on a change. But that would again be a process that would take a decade to bite. You don’t want to hold your breath for that – would you?