Gazprom, Europe, and long-term take-or-pay contracts

Michael Giberson

Shifting world natural gas supply conditions have put the squeeze on long-term gas supply contracts between Russian gas giant Gazprom and its European customers.  A summary from the Wall Street Journal:

European energy companies, faced with weakening demand and plentiful lower-cost fuel supplies, have bought far less natural gas from Russia’s OAO Gazprom this year than they are obliged to under long-term contracts — setting the scene for a potentially damaging showdown with Moscow.

A person close to Gazprom’s export arm said purchases by the company’s largest European customers had fallen short of the minimum specified in their “take-or-pay” contracts by about 10 billion cubic meters, or about 7%.

The undelivered gas is valued at roughly $2.5 billion, and the person said Gazprom will insist its European customers pay for it. The issue was of “great concern” to Gazprom, he said.

The WSJ article points out the the Gazprom contract prices are linked to oil prices, which has amplified the problem as world spot petroleum prices have increased substantially more than gas prices over the last year.

The Financial Times elaborates on the connection between U.S. shale gas technology, world gas prices, and the Gazprom contracts:

Three years ago, the US energy department was forecasting the US would become a big net gas importer. Companies specialising in liquefied natural gas rushed to exploit the opportunity.

But engineering advances have led to a boom in extracting previously unobtainable gas locked in shale rock, of which the US has lots. Production of such “unconventional” gas is now growing so fast that the energy department forecasts imports will fall as a share of US gas supply. The flow of new gas helped US spot gas prices plunge 80 per cent between early 2008 and this summer.

Faced with a US glut, LNG producers have redirected shipments to Europe which – combined with recession-related demand falls – has sent European spot prices falling too.

That is bad news for producers such as Gazprom. The Russian giant has long sold gas on “take or pay” contracts lasting as long as 25 or 30 years that link prices to oil.

The FT article reported, “Some customers are also seeking to renegotiate long-term contracts. Gazprom says it expects customers to take contracted volumes in full, hinting it might otherwise fine them.”  The WSJ article concluded: “Take-or-pay contracts are a vestige of the early days of the gas industry when liquid spot markets didn’t exist and producers needed long-term deals with stable prices to underpin vast investments in new gas fields.”

The “vestige of the early days of the gas industry” remark is, in essence, a theory about the origin of take-or-pay contracting.  More sustained theorizing on the topic has been done by economists, as Craig Pirrong explained about a month ago at Streetwise Professor: “Nobody Takes, Nobody Pays“:

Once upon a time take-or-pays were common in the US too.  An excellent paper by Scott Masten and Keith Crocker in the AER in 1985 argued on classical transactions cost economics grounds that these contracts were to protect site specific investments in gas wells.  In those days, gas was purchased by pipelines that both transported the gas, and served as merchants: they bought the gas at the wellhead and sold it to industrial users and municipal utilities.  Given the natural monopoly aspects of gas transportation, this “bundling” of merchant and transport functions created a potential for holdup.  Once a well was in the ground, the (usually one) pipeline capable of shipping the gas could opportunistically demand a lower price, particularly when demand was low.  Masten and Crocker showed that take-or-pay was like a pre-packaged expectations damages clause that gave the parties an incentive to perform when the buyer would otherwise have an incentive to breach.

Seismic shifts in the gas business resulting from the perverse effect of price controls; the energy price shock of the 1970s; and the subsequent deregulation of gas prices by Reagan in the 1980s; combined to wreak havoc with these contracts in the 1980s.  Many pipelines had entered into huge take-or-pays in the 1970s when there were widespread fears of gas shortages and energy prices skyrocketed.  When prices plummeted, these contracts were extremely burdensome to the buyers, who sought any way to escape their obligations.  Moreover, the disparity between contract prices and market prices provided incentives for end users to try to buy gas directly from producers, and somehow secure the ability to transport the gas.

In the end, the entire structure of natural gas regulation collapsed.  Starting in 1986, [FERC] “unbundled” the merchant and transportation functions of pipelines.  Essentially, pipelines became regulated common carriers….Soon thereafter, a vibrant gas market developed.  In place of negotiated contracts between big buyers and big sellers, there developed a whole array of markets, including daily markets, monthly markets, longer-term markets, futures markets, and swap markets.  Long term, take-or-pay contracts went the way of the dodo because every seller could contract directly with many buyers (who could get access to transportation), reducing the potential for holdup and opportunistic breach.

In brief, take-or-pay was largely an artifact of the integration of the pipeline transportation and marketing of gas.  Once pipelines became open access common carriers, these contracts became unnecessary, and buyers and sellers relied on more market-like arrangements.

Which raises the question of whether such dramatic reshaping of the Eurasian gas trade is in the offing.  “No,” said Pirrong:

Nothing like that is in prospect in contracting for pipeline-transported gas in Eurasia. This is primarily true because the mother of all bundled gas companies – Gazprom – sits at the center of everything. Indeed, Gazprom wants to extend its integrated activities into downstream marketing.

Pirrong then explains reasons to expect Gazprom will remain an integrated gas merchant for the region.  In brief, easier for various parties to siphon off the economic surplus created from a large, opaque, integrated company.  There are other ways that the Russian government could extract the surplus, but these methods would induce an unwanted transparency to at least parts of the Gazprom operation and limit the discretion of those benefiting from the current system.

The prognosis? Pirrong concludes, “the Eurasian pipeline gas market will continue to be burdened by high transactions costs and inefficient contracting practices.  Contractual breaches and supply cutoffs will be chronic, especially when gas values move a lot one way or another.”


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