Oil to gas price correlation reaches peak in 2015

Jake Horslen

18-Jan-2016

The impact of oil prices on European gas curve contracts peaked in 2015, despite waning oil-indexation in long-term gas supply contracts.

According to an annual survey examining price formation by the International Gas Union (IGU), ‘gas-on-gas competition’ – where prices are determined by supply and demand – held a 61% share in Europe in 2014.

This was up from 53% in 2013 and from 15% in 2005 – the year of the first IGU survey. ‘Oil price escalation’ – where prices are linked to competing fuels, typically crude oil – accounted for a 31% share in 2014, down from 42% the previous year and 78% in 2005.

The presence of oil-indexed supply appears to have had little impact on the correlation between the two commodities in the past two years (see box out).

The key reason European spot gas prices may correlate with oil futures concerns how traders adapt their activity based on movements in oil.

The physical reason behind any correlation is the arbitrage that recipients of oil-indexed gas contracts must manage – between purchasing gas at an oil product-linked cost and selling it at a hub or at a hub-indexed price to a consumer.


Arbitrage opportunities

Recipients of oil-indexed gas can optimise the offtake of contractual volumes, within the flexibility of a long-term deal.

Their decision to do so is often based on the price difference between the oil-linked contract and prevailing European hub prices.

This physical arbitrage opportunity is one factor enabling a correlation to develop and is the key driving force behind the oil and gas relationship.

In a bearish oil market, the recipient of an oil-indexed supply contract may anticipate a lower contractual price several months ahead and would look to nominate lower gas offtake at the current higher price, with a view to nominating greater volumes further ahead when the oil-linked purchase price is expected to be lower.

There is even more incentive to do so if gas hub prices on the forward curve are sufficiently high to allow the company to sell the gas they receive under an oil formula for a profit in the spot market.

Hedging retail sales

One European trader saw an increasing need for companies to hedge their oil-indexed gas contracts at European hubs, for reasons other than optimisation.

Some of the larger energy companies now face a greater risk when it comes to managing the purchase and sale of the commodity to retail customers, which was also a big factor driving the correlation between the commodities, according to the trader.

“My point of view is that there is more correlation because companies have a greater need to hedge portfolio positions,” he said. “In France and Italy, household tariffs are strongly linked to spot gas prices and long-term oil-indexed contracts do not reflect and fit with these sell formulae.

“Companies now need to use [gas hub] trading more and more to hedge and reduce the spread between the new [retail] formulas and the oil-indexed import contracts,” he added.

The same is also true for sales to large industrial gas consumers in Europe, the trader said.

A second trader agreed that this change in dynamic may have boosted some companies need to hedge the receipt of oil-indexed gas supply.

“When you buy oil-indexed and sell hub-indexed the mismatch means you need to trade around the formulas much more because all movements affect your margins. The disconnect is pretty dangerous,” he said.

Outlook

In the long term, one trader said he expected to see the correlation decrease due to developments specific to gas.

He suggested that if mid-stream companies are able to renegotiate the terms of large purchases and imports to fit more closely with the manner in which they agree their supply contracts, this will reduce the need to hedge based on oil.

Increasingly diverse supply – with predominantly hub-linked US LNG exports due to ramp up – should also hit the oil/gas link, since more companies hedging needs will be unrelated to oil exposure.

“In future, LNG will be more and more important on the supply side and more diverse supply should reduce [oil-exposure] risk and reduce the correlation as a result,” a trader said.

For now, spot oil/gas price correlation looks likely to persist in the short term, as market participants continue to adjust to the new environment of low oil prices, although the relationship may have peaked in 2015.

Beyond next year, the strength of the correlation will largely depend on what happens to the value of outright oil futures, with further sharp moves or newly defined trends likely to support a relationship between prices.

So long as energy companies have to adapt strategies at European gas hubs in light of changing oil prices, a correlation will more than likely remain. jake.horslen@icis.com

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