Monopoly game

January 13, 2014
Published in corporate Gazprom Magazine Issue 12

Who’s afraid of gas market liberalization

A draft Government’s Decree prepared by the Federal Tariff Service agitated the Russian gas market. The document permits Gazprom to sell gas with a discount of up to 20 per cent of the regulated price to customers consuming more than 100 million cubic meters of gas a year. There were diverse reactions to this initiative among the market participants and experts who expressed most contradictory opinions. However, they were unanimous in considering this suggested state measure solely as a tactical one caused by the current economic situation. Few people saw the draft Decree as another crucial stage towards establishing a full-fledged civilized gas market in Russia.

A question of when an adequate gas market will emerge in Russia will soon move into the category of rhetorical ones, since attempts to form market relations in the gas sector have been made for a decade and a half, but the desired result is still far away. The relevance of this issue was brought home by the participants of the round table dubbed the Legislative Support to Improving the Gas Market in the Russian Federation held by the State Duma Committee for Energy as well as the Gas of Russia 2013 forum. Both events (held in mid-November) called for developing a long-term target-oriented model of the gas market in Russia.

Goals are clear tasks are determined

Perhaps, such document should really be created if we only take time to remember that the basic issues concerning the market improvement have repeatedly been voiced, including in official documents (Government’s Decrees, for instance). The sought-after target model should embrace and harmonize all the activities planned instead of reinventing the wheel or putting forward some fundamentally new concept. There can be no other gas market except for the one based on three key elements, three pillars, so to speak. The first element – deregulation of the wholesale price, i.e. the transitioning to market-based pricing (state regulation applies only to monopoly activities – transmission networks and underground gas storages). The second element is creating a trading system involving a parallel trade in financial derivatives and physical gas volumes using stock exchanges and trading systems, as provided by the Federal Law on Organized Trading. The third component is creating a transmission capacity market providing access to the Unified Gas Supply System on terms of fair competition for all gas market players.

The Russian Government and the gas market players have long come to the consensus regarding the necessity of these three conditions, but it is not yet possible to translate it to reality (under a favorable scenario this model could have come into effect a couple of years ago). All the times there are constraints and various bottlenecks that do not allow to make an adequate gas market a reality. The number of obstacles gradually decreases and there are the last ones left to eliminate (on state decision-making level) before we start to launch all the three mechanisms. However, such decision-making is hindered by the activity of the anti-Gazprom lobby, which for many years have been trying to impose a point of view that it is Gazprom that impedes full-fledged market relations based on a fair competition in an attempt to maintain its monopoly in the gas sector. Facts and figures, however, clearly belie this ideological approach.

To begin with, it was Gazprom that issued a number of initiatives aimed at developing the gas market. Special attention should be paid to the launch of spot trading in physical gas volumes at Gazprom Mezhregiongaz electronic trading platform in 2006. The platform was commended by all the market participants (gas producers and consumers) without any exception. Since 2009 the electronic trading ceased due to the lack of necessary Government’s decisions needed to authorize its continuation. Therefore, it’s not Gazprom’s fault that its electronic spot trading program has remained unclaimed for several years.

The share of independent gas producers in the Russian market and their output tripled from 2000 to 2012.

Monopoly for debts and losses

The next issue: the share of independent gas producers in the Russian market and their output tripled from 2000 to 2012. Gazprom still retains over 70 per cent of gas supplies to Russian consumers and monopolism seems evident. But it looks somewhat strange. Let us, for example, consider the following figures. In the structure of gas consumption by categories of Russian consumers the share of population makes up 11 per cent, but in Gazprom’s supply to the domestic market individual terminal users account for 20 per cent. Public utility services use 8 per cent of the total volume of consumed gas, but in respect of Gazprom’s supplies this figure is again two times bigger, which means that Gazprom supplies gas to over 90 per cent of socially significant consumers in Russia (independent producers work with them only in several regions). Here Gazprom really is a monopolist, but it is only a pain in the neck. It is common knowledge that gas price for the population is 20 per cent lower than for industrial purposes, while the costs of distribution services are significantly higher (that’s why in all countries gas costs more for the population). As for the utilities sector, it is known for its low financial discipline (by the way, this problem also exists concerning the population) and it accumulated debts to Gazprom in the amount of hundreds billions of rubles.

At the same time, in the premium segment of the blue fuel supply – Russian power stations and industrial enterprises – independent producers (following the results of 10 months of 2013) staked out a claim for over 40 per cent of marketable gas and are not going to stop at this. And it is not to mention the geographic inequality caused by the presence of regional cross-subsidization in Russia (which means that gas prices for Russian constituents are formed disregarding the objective costs arising from the blue fuel transportation from the main gas fields). It has been mentioned not once that independent producers prefer short distances, i.e. locations not too far from major gas fields (75 per cent of their supplies cover four Russian constituents), which secures the highest margin for them.

Therefore, it should be understood that most of the independent producers’ achievements in the gas supply sector are primarily conditioned by Gazprom’s (which annually increases the independent producers’ access volume to the unified gas supply system) and the Government’s loyalty towards them (initially the Government provided the independent producers with an opportunity to sell gas at deregulated prices as well as the reduced tax rate, etc.) which made the independent producers feel quite comfortable in the Russian ‘defective’ market. They are also kindly treated by the media (both Russian and international) and the majority of the expert community, which attributes the success of the independent producers to their higher efficiency as compared with Gazprom. Under such conditions, further development of the gas market is a very secondary matter for independent producers as they are quite satisfied with their status quo. Independent producers are currently more interested in maximizing their profit through raising the share of supplies to major Russian consumers as well as gaining access to foreign markets.

There’s no wonder that independent producers didn’t approve the idea of letting Gazprom sell gas at prices lower than those of the Federal Tariff Service (FTS). It would seem there was nothing to worry about for the efficient independent producers, as the possibility to show flexibility (for which they are much praised) provided to Gazprom would only place it in equal competitive conditions with the independent producers. But it is not the main advantage here. Specified by underdeveloped competition, the Russian gas market comprises only several major gas producers, with one of them dominating the others and the supply substantially exceeding the demand. The Government actually pursues the policy of market liberalization by letting Gazprom sell gas at prices lower than FTS prices. The consumers will profit most, getting a wider choice of suppliers at acceptable conditions and at the same time securing themselves from the price collusion of several major gas producers. The independent producers certainly understand that, but their commercial interests prevail over the general long-term interest of all the gas market players, that is, creating civilized rules of the market game.

Looking further ahead, adoption of this resolution will eliminate the problem of cross-subsidization for a large group of regions in the north and east of European Russia as well as Western Siberia. Gas prices there will depend on objective parameters (production+transportation+profit), after which the Government regulation of gas wholesale prices (except for supply to consumers) will become a complete anachronism. In western and southern areas, however, the gas prices will remain artificially low, which means that Gazprom will still dominate there – not because it likes it, but because the independent producers still won’t be interested in those areas. It will turn out that in the east we’ll have a relatively competitive market, whereas in the west and south the old distribution system will persist. Such a preternatural situation will become an added incentive to finally solving the problem of regional gas cross-subsidies which the Government has been approaching for many years, with no luck though.

Matter of price

Abandoning the Government regulation of gas prices in a whole group of regions will inevitably aggravate the issue of objective and transparent price formation under the market conditions already, that will rule out any manipulations and unfair competition. The efficient solution to this problem is possible through a system of well-coordinated gas trading which includes both spot trade of physical gas volumes and financial derivatives trade. Well-coordinated trading in spot mode enables consumers not only to timely purchase additional gas volumes, which are in demand in a case of unexpected changes of weather or market environment, but also provide a price indication for buyers and sellers who work under direct long-term contracts. As for the financial derivatives trade, it creates conditions for hedging contracts to supply physical gas volumes stipulated in direct contracts. Thus, well-coordinated gas trading acts in two ways: trading systems as an instrument of market gas trade and gas exchanges as an instrument of price formation and hedging.

All in all, if the structure of gas supply contracts is regarded from the point of view of delivery dates, the most rational model of gas trade should be as follows. Long-term contracts (one to five years); annual contracts; seasonal contracts; spot contracts (supply within a month, week, next day, current day). By now, such a model is already operating in a number of countries.

In the global practice long-term and annual contracts are the subject of bilateral relations. Price formulas for them are determined by experts of companies entering into agreements that use different indices, focusing primarily on the cost of petroleum products, as well as on forward and futures contracts of trading systems. In addition, consulting companies are involved, which determine the optimal price for both parties relying on their own surveys and calculations.

Russia is a different matter. In this country long-term and annual gas supply contracts are currently signed by independent producers mainly at a discount to the regional government-controlled prices. Such contracts are obviously convenient for independent producers, since the annual indexation of government-controlled prices automatically leads to an increase in the cost of gas sold by independent producers. As a result, it generates monopolization of the most profitable markets and preserves the system of government price regulation, as it allows independent producers to get a good profit without making efforts to compete. As was already noted, the idea of allowing Gazprom also use the discount to the regulated price adds competitiveness to this scheme by making the price a little bit more market-based, but it is clear that this stage is only a preliminary one. In the long term all four groups of contracts must be adjusted in accordance with the model described above.

Theoretically, the entire gas community (suppliers and large consumers) seem to welcome the idea of creating a full-fledged civilized gas market, but in practice Gazprom is the only consistent supporter of this idea.

Non-market anarchy

None of the market participants denies it, but the launch of well-coordinated gas trade is hindered by an obstacle which has existed for several years already (just like the abolition of government regulation of gas prices), although the corresponding document came into force last spring (Resolution No. 323 of the Russian Federation Government). The problem rests on two factors. The first one, so to speak, is theoretical – a discussion between agencies responsible for launching well-coordinated gas trade – about the organizational forms and principles of the trading system for gas sale/purchase, which we shall not discuss here. The second factor is the physical unavailability of the market for spot trade caused by the action of the Russian Government Decree No. 311 of May 10, 2010, which gave gas consumers the right to offtake gas within the range from 110 to 80 per cent of the contracted volumes. This caused a situation where a tenth of the total blue fuel consumed in Russia is offtaken with deviations from the established limits (give or take). In such a state of affairs, consumers don’t need spot or futures trading. They are hedged by the government-regulated price (the more so, for the next year it is fixed) and the problem of gas shortage is solved through legitimate supplies of additional gas amounts.

The Energy Ministry is fully aware of this adverse situation, therefore a proposal was issued a year ago to abolish Decree No. 311, however, the problem wasn’t solved. We may suppose that this was due to the lobbyism of large gas consumers who are quite happy with such anarchy.

A paradoxical situation arises. Theoretically, the entire gas community (distributors and large consumers) stands for the construction of a mature civilized gas market, but in practice Gazprom is the only consistent supporter of this idea. It happens because Gazprom, while operating in the domestic market under considerably less comfortable conditions than other gas producers and having, in addition to this, a large number of social obligations, must inevitably follow the path of optimizing the costs associated with gas sales to domestic consumers. It would be quite complicated to solve this problem without creating a normal market based on those three pillars. Only new forms of natural gas trading based on market principles will enable to adopt more effective interaction mechanisms and methods among the gas market participants (electronic and Internet technologies, for instance) and to make them more cost-conscious regarding the blue fuel.

Unfortunately, other gas market participants seem to be much less worried about these questions. Their life is good as it is. Therefore, independent producers actively try to get access to external export markets and are ready to sell gas in the market of Singapore, which suddenly turned out to be nicer than their homeland. But large consumers put their efforts into obtaining the most favorable prices and gas supply conditions. These efforts are quite logical and appropriate from a commercial point of view, but they lead to the conservation of today’s undeveloped gas market, and this may result in unpleasant consequences later – further increase in the energy intensity of the Russian industry and, as a consequence, deterioration of its competitiveness. It may also provoke a growth of energy imbalance in the absence of inter-fuel competition (domestic coal industry is already suffering from excessively high gas share in the Russian economy), lower investments in gas transmission capacities as well as retention of shady business transactions and schemes in resource trading. Moreover, the idea of setting up an auction trade of natural gas and its financial derivatives in international markets, which has been long cherished by the Russian Government, will be delayed for an indefinite period. This kind of trade will allow Russia, the largest energy superpower, selling its blue fuel for the national currency, influencing gas prices in international markets and expanding gas sales to foreign customers through spot trading in addition to long-term contracts.

The abovementioned negative factors will become particularly noticeable after the ongoing crisis is over and gas consumption in the country and worldwide starts to grow. The only positive thing here is that these risks are clear to government authorities dealing with regulation of the Russian gas market. This gives us hope that, despite the opposition of stakeholders, all the obstacles standing in the way of a mature gas market, will be overcome.

Nikolai Khrenkov