ENTERPRISE AND INDUSTRY DIRECTORATE-GENERAL

AD HOC GROUP: « COMPETITIVESS OF AND ACCESS TO COST EFFECTIVE ENERGY INPUTS TO ENERGY INTENSIVE INDUSTRIES »

BRUSSELS, 31 MARCH 2006 JEAN VERMEIRE

CONSULTANT

EUROPEAN COMMISSION

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General Observations on contractual gas supply issues

• CUSTOMER CHOICE is paramount in liberalised gas market.

Includes freedom to seek contractual and pricing structure best adapted to own requirements from widest possible selection of suppliers.

• Rising price trends and price volatility induce industrial customers to develop more sophisticated buying strategies and risk management skills

• Some guiding principles:– Gas buying should support core business by striving to protect

production margins rather than to beat the gas market

– Capital intensive industrials for whom gas is substantial part of production cost are taking risks by not contracting over sufficiently long forward period to protect business margins or return on investment.

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• Two specific elements in focus:– contract duration– price indexationThey are related ! - the longer the contract term the more

critical is the indexation - the longer the contract term the

more price flexibility and price risk management features can be offered

Industrial customers want large degree of freedom in their choice of gas supplier and of supply conditions. Preventing an incumbent to respond to requests for longer contract duration removes competitive price pressure on new entrants, to the detriment of the industrial customer.

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CUSTOMER CHOICE ON CONTRACT DURATION

What determines the industrial customer’s choice in contract duration?- price expectations- flexibility to adapt to changed market conditions- need for predictable prices- security of supply- internal procurement or planning cycle- flexibility to adapt to changes in consumption

When or why do industrial customers want longer duration?

- Growing concerns for security of supply, because of increasing import dependency

of Europe and related upward price pressure

- Need for predictable outlook on pricing, particularly when (1) gas constitutes a

large portion of production costs and/or (2) conditions of gas supply are

crucial in new investment decisions

- Establishment of a framework agreement with supplier(s), offering price risk

management options (eg. caps, floors, fixed for floating, change of indexation

factor, etc…..)

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CUSTOMER CHOICE ON PRICE INDEXATION

• Segregating contract price in its component parts allows for separate focus on commodity price

Objectives in choosing most suitable indexation for the commodity

• To protect production margin indexation with end-product

value (if feasible)

• To ensure cost competitiveness use index factors prevailing in

industrial sector

• Stability over budget horizon fixed pricing or fixed for floating

options

• Risk management hedgeable indexation factors

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CUSTOMER CHOICE ON PRICE INDEXATION

A PRAGMATIC VIEW on the gas-oil link:

• Even without contractual gas-to-oil indexation does the impact of competing (oil) products still influence the gas price.

• In the liberalised and deep liquid US gas market where gas is predominantly contracted on a gas index, gas prices still correlate with oil prices (see following chart)

• Is it a choice between « correlation » or « indexation » ?

• Gas index may temporarily decouple from oil, – Downwards: if there is a « gas bubble » in the market (USA, UK - 1990’s)– Upwards: if there is a tight supply situation (USA, UK – 2000’s)

• What provides better protection to the consumer in next 5 years:

Correlation or indexation with oil ??

• Other considerations:– world oil market more difficult to influence than less liquid regional gas

market– oil indexation better safeguard for competitiveness on world-scale

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Oil-linked view of gas pricesUS natural gas prices correlated with crude

The Boston consulting Group