House of Commons - Trade and Industry

Select Committee on Trade and Industry Twelfth Report

8 The future of gas prices

110. Commenting on 1 February 2005 on the three price spikes that had occurred within the previous 18 months, the Minister said: "I do not think the problem of volatility is that big."[285] Three weeks later, a period of very cold weather brought a fourth price spike in the gas wholesale market. The highest price during the spike of October-November 2003 was 34 pence a therm in the day-ahead gas market; in the summer of 2004 the highest price was 35.5 pence a therm in the day-ahead market; on Thursday 3 March the day-ahead price reached over £1.10 a therm.[286] The market is clearly volatile, and the volatility appears to be increasing in both frequency and the severity of the price spikes. Ofgem, the DTI and some of our other witnesses thought such spikes a normal market response signalling a need for more supplies.[287] However, as NGT noted, there is a mismatch between the market signals and the length of time it takes to arrange the financing for and to build the major infrastructure projects needed to increase gas supply.[288]

111. When we were taking oral evidence in connection with this inquiry, the DTI and Ofgem seemed fairly sanguine that, after this winter, the gas supply situation would ease and that excessive price spikes would moderate.[289] They described the investment being made in infrastructure projects to obtain gas from new sources, including new pipelines from the Netherlands and from the Norwegian fields, an upgrading of the Interconnector, and the construction of LNG import facilities at the Isle of Grain and Milford Haven.[290] NGT noted that, although it estimated that supplies from the UKCS would fall by 14 million cubic metres a day in the next year, the new import facilities expected to come into operation during the same period increased capacity by 44 million cubic metres.[291] In addition, as already mentioned, companies are finally investing in the provision of more gas storage facilities.[292]

112. We have no doubt that the UK will shortly have significant extra import capacity, but we cannot predict when construction of this capacity will be completed. We note that, between UKOOA's submission of its original Memorandum to us in late November 2004 and the production of its Supplementary Memorandum in mid February 2005, the target dates for completion of three facilities had been put back, and there had been a reduction in the expected capacity of two facilities (including Phase 1 of the Isle of Grain LNG facility, which is likely to be the first to come into operation).[293] This is in the nature of large infrastructure projects. However, this does prolong the uncertainty to which the wholesale gas market is prey. Government departments should ensure they are well placed to facilitate these developments where they have a regulatory or planning function.

113. Some commentators have raised doubts about the reliability of imports from some of the less politically stable parts of the world, such as Russia and Algeria. Several of our witnesses commented that these fears were misplaced: E.ON noted that its parent company had entered into a number of long-term projects for developing Russian gas fields; Russia has been a very reliable exporter, not least because the income from gas exports is very significant for the Russian economy.[294] NGT was also of the view that, because most of the costs of supplying LNG were incurred in extracting the gas and in preparing it for export through liquefaction, then LNG exporters had a big incentive to maintain the flow of gas in order to recoup their costs. However, though gas would continue to flow, the price of that gas would depend on competition for those supplies from other importing nations, particularly the USA, Japan and South East Asia.[295] E.ON also foresaw a continuing increase in demand for gas for electricity generation in both the UK and Continental Europe.[296]

114. Several witnesses were of the view that, given the timing of the new sources of supply, the supply/demand balance would remain tight for the next 18 months to two years; that the UK might then be over-supplied with gas, leading to a fall in price (according to one analyst, from the average winter 2004-05 price[297] of about 30 pence a therm to as little as 13 pence a therm) and (as the UK became increasingly dependent on imports) convergence with prices in Continental Europe; and then, over the longer term, as demand rose, more expensive gas reserves had to be exploited and extra infrastructure built, prices in both the UK and on the Continent would rise.[298]

115. However, in the short term, our witnesses were agreed that volatility was likely to continue—and, indeed, as we have seen recently, it has. In January, our witnesses were reporting that forward prices for the first quarter of 2005 were higher than they were a year ago for the first quarter of 2004: forward prices for the first quarter of 2005 were 40 pence a therm in January 2004, forward prices for the first quarter of 2006 were 48 pence a therm in January 2005.[299] As of 1 February 2005, gas on the spot market was trading at about 30 pence a therm, but the forward price for the first quarter of 2006 was 45-46 pence a therm. On the other hand, the price for a one year contract starting on 1 October 2005 was 34 pence a therm.[300] The EIUG said that the forward price for next winter was at least 50 percent higher than the price for the same period in the Continental forward market.[301] This body thought that the market was again factoring into the forward price an expectation that next winter would be unusually cold.[302] SSE said that the price was significantly above that at which it would be economic to invest in new import infrastructure: it estimated the 'new entrant' cost of LNG as 20 pence a therm, plus or minus five pence, and a similar amount for new pipelines; while the forward price curve for the next two years showed a price of about 40 pence as the annual average.[303] Despite the general expectation that the market would continue to act erratically, none of our witnesses favoured the re-introduction of regulation into the market; all said that they wanted the market to work properly.[304]

116. We cannot take the Panglossian view of the gas wholesale market that the DTI and Ofgem appear to hold. There are failures in the market which arise from significant problems with physical supply, the lack of information about supply available to participants, the difficulties caused by operating a liberalised market (the UK) alongside a relatively unliberalised market (Continental Europe), and the dearth of traders willing to sell gas into the forward market. These problems are serious enough for us to conclude that the autumn 2004 price spike, and the recent spike in late February, will be repeated over the next two years. We urge Ofgem and the DTI to keep a close watch to ensure that the market is responding to all the proposed developments likely to make it function efficiently (extra infrastructure and storage capacity, the provision of more information, and so on). If there continue to be well-founded concerns over the operation of the market after these changes have taken effect, then we conclude that the market must be considered to be failing.

117. Although all the problems with the market could, and probably will, be solved eventually, customers—and especially I&C customers—will face serious disadvantages in the meantime. The DTI is placing heavy reliance on customers changing their buying practices: avoiding the October bunching, and purchasing gas on short-term markets when forward prices seem excessive. We think that this is going to be difficult for companies, especially the SMEs whose interests the DTI has pledged itself to take particularly into account.

285 Q 534 Back

286 Ofgem report, paras 1.33 and 1.44, and Argus European Natural Gas Back

287 See, for example, Qq 105 (BP), 513 and 537 (DTI) Back

288 Qq 361 and 362 Back

289 Qq 505 (Ofgem) and 536 (DTI), see also Qq 105 (BP) and 228 (Shell) Back

290 These are usefully listed, together with their capacities and the target dates for their completion, in an annex to UKOOA's Supplementary Memorandum (App 30). Back

291 Q 353 Back

292 Qq 331-332 (E.ON) Back

293 Compare the annexes to the two Memoranda (printed as App 20 and App 30) Back

294 Q 341 Back

295 App 33, paras 2-3 Back

296 App 14, paras 18 and 19 and appended tables Back