Memorandum submitted by Dominic Whittome
CONTRACT PRICE
FIXING
Since August last year, forward gas prices in
the wholesale market have risen by over 70%. This is in spite
of an abundance of gas in Northern Europe. The increase has had
little to do with "security of supply" because forward
North Sea gas reserves estimates have not altered in this short
period. Yet wholesale prices of long-dated gas deliveries
are continuing to rise as major gas producers continue to fix
their long-term contract prices to oil. This contractual fix has
driven forward prices to levels much higher than would otherwise
have been the case. Consequently, North Sea gas and UK electricity
prices have being driven higher by the price of OPEC crude.
In recent years, gas producers and importers
appear to have aligned their wholesale supply policies.
Forward price rises in the wholesale market have been exaggerated
as a result. A full examination of company trading policies
will reveal signs of co-ordinated behaviour in the wholesale
market. Gas producers have acted collectively in gradually curtailing
their forward trading activities. Instead, producers have marketed
an increasing and disproportionate percentage of their principal
gas volumes on secret, off-market, long-term contracts.
Many, though not necessarily all, of these long-term
contracts involve contractual indexation to crude oil and petroleum
products. But, whether the gas price in these long-term contracts
is indexed to oil or not, the dominance of off-market trading
undermines the influence of open trading in wholesale market.
This adverse effect on forward pricing competition
transgresses into power generation, where output electricity prices
are driven by input gas prices. The effect then feeds down to
the commercial and retail markets for both gas and electricity.
SECRET CONTRACTS
The long-term contracts in question are negotiated
bi-laterally between large users, utilities and international
producers. They effectively seal the gas out of the forward
market for contract terms ranging generally from 10 to 20 years.
Today over 80% of the gas initially sold into
the UK and 90% on the Continent is contracted under long-term,
off-market contracts. Not only does this action withhold forward
price and volume information from market participants but the
predominance of long-term contracts also "crowds out"
forward gas trading that would otherwise take place; where the
"trading multiplier" make the market impact considerable.
A proper investigation should expose the fact
that, over the past seven or eight years, gas majors and importers
have been selling an ever reducing fraction of their long-dated
gas volumes, ie dated one year forward or longer, on the forward
market and selling a correspondingly higher fraction on long-term
contracts.
The disproportionately high volume sold off-market
is a major problem from the point of view of efficiency. Consistently
higher-than-optimal prices may not be the result of decisions
made by individual traders but by the gas producing companies
who—wittingly or unwittingly—having synchronising
their policy decisions.
COPYCAT STRATEGY
The convergence of wholesaling policies has
had the effect of greatly constraining liquidity in the
long-dated wholesale market. The dearth of forward trading in
large volumes has reduced wholesale price transparency (where
posted long-dated prices are indicative, estimated or non-existent).
It has also increased market volatility, which in turn has significantly
increased the price premium, ie on top of the already exaggerated
forward prices, which the producing supplier can levy on gas consumers
who need to fix their price one year forward or more. Consequently,
some gas buyers will purchase a swap from a merchant bank, although
that is a further unnecessary cost they then incur.
The inquiry must identify what the individual
wholesaling policies of major gas producers are; assess the extent
to which these company polices coincide; and ascertain whether
these policies have been converging. In short, are we witnessing
copycat behaviour in the supply policies of the producers. In
the background, we have seen in a 180% increase in forward-year
power prices (from £21/MWh to £59/MWh) and a 400% increase
in wholesale gas prices (from 13 p/th to 65 p/th) since the start
of 2000.
CORPORATE MOTIVES
Duplicative gas supply policies, which promote
off-market contracts as the principal (or only) platform for selling
forward have the effect of supporting long-dated prices
posted in the wholesale market. Higher wholesale gas prices not
only boost the immediate profits of producers, they also serve
to safeguard the contractual integrity of their long-term
contracts. Restricting the liquidity in forward trading reduces
the danger of any wide price discrepancy evolving between long-dated
wholesale prices and long-term contract prices. Allowing these
prices to get out-of-kilter would trigger calls from consumers
and possibly regulators for some contracts to be re-negotiated,
which producers should want to avoid at all costs.
TACIT COLLUSION
If we not concern ourselves—at least for
now—about "price fixing" between individual gas
traders, we should be concerned about any alignment of producer
policies. Above all, the inquiry should explore the unwillingness
of producers to sell a significant proportion of their gas openly,
on the long-dated, forward market. In most cases, this proportion
could be below a third and in some cases below 5%, quite possibly
zero in one or two cases.
In the final analysis we may see a textbook
example of tacit collusion whereby producers are not fixing prices
directly but simply acting rationally; recognising in common
the commercial interest in copying the other's behaviour, which
replicates the effect of a price-fixing cartel.
This de facto producer boycott of the
forward market when it comes to selling gas on a long-dated basis
will partially explain why wholesale gas prices have soared to
the unprecedented levels that we see today, far above the levels
that would otherwise be achieved in an efficiently-operating market,
where actual gas supply and demand fundamentals will determine
the forward price.
ELECTRICITY MARKET
IMPACTS
A proper inquiry should find evidence of producers
reverting to long-term contracts for practically all their forward
selling, trading only residual gas volumes on the wholesale market
to support these long-term contracts' flexibility commitments
to the buyer. The consequential constraint on liquidity in the
forward gas market has also affected electricity trading, where
liquidity collapsed over the past two years. Only a miniscule
percentage of power volumes are now traded more than six months
forward on the UK Power Exchange as a result.
Despite Britain's head start over its EU peers
in terms of energy market liberalisation, forward liquidity in
the Nordic and German power markets has already overtaken the
UK's and other European countries are closing in. Even in gas,
industry insiders see the Dutch Title Transfer Facility replacing
our own National Balancing Point (NBP) as the principal trading
hub in North West Europe.
This meltdown in liquidity in our gas and especially
power markets has coincided with weaker price transparency, soaring
volatility and record "risk premiums" (ie over short-term
delivery prices) in the forward market.
VICIOUS CIRCLE
IN THE
WHOLESALE MARKET
Constraints in forward trading have had multiple
impacts on traded prices. First, reducing the availability of
long-dated gas supplies posted for sale on the forward market
puts buyers into a position where they have to compete (what appear
to be) "scarce supplies". This tightens the market
generally and leads to higher prices than would otherwise
be the case. Second, higher volatility and weak price signals
make new entrants (eg large consumers, independent generators
and energy merchants) wary of posted prices which deters them
from entering the market. This reduces forward trading further
and the liquidity problem becomes self-reinforcing. (Mergers between
producers and exit of US merchants added to the problem of market
concentration). Third, with the market is more volatile and allegedly
"riskier" to trade in, the incumbent producers are then
able to charge a higher "risk premium" to buyers, although
producer policies contributed to this situation. A similar pattern
may be prevalent in the power market, but as gas prices affect
electricity and not vice-versa, the root problem with producers
of gas needs tackling first.
PROFITS IN
PERSPECTIVE
Today we see a widening gap between the pre-taxes
supply cost of gas delivered into the UK (at 15 p/th ±30%)
and the wholesale price (at 65 p/th), which suggests a nominal
and pre-tax profit margin of around 50 pence per therm.
To put the producers' profits into perspective,
we can make a back-of-an-envelope calculation by simply estimating
the total profits of producers who just supply gas as far as the
wholesale market viz. the beach terminal and no further. We can
exclude the cost of flexible volume or "swing gas" for
which producers will charge a premium. Assuming the UK consumes
on average 130 million th per day in a year, the nominal profit
shared by the handful of producers = 130, 000,000 th/d x 365 days
x 50 p/th = £ 24 billion gross.
This rough estimate shows just how high the
stakes are and the sensitivity of producers to any change in the
status quo. This same is probably true of any Exchequer in light
of the high tax take involved. At the moment however, supra-normal
profits for the club of producers who export gas to the UK is
assured; nearly all the equipment is in place and is operating,
as are the long-term contractual arrangements which provide the
income stream outlined above. Producers have no commercial incentive
to advocate changes or foster the development of a wholesale market
that may facilitate price discovery and expose any discrepancy
with long-term contract prices. So this market is unlikely to
correct itself without a proper investigation that would show
that a problem exists.
CONCLUSION
The most recent charge in the wholesale market
has seen gas and power prices rise by 300% and 200% respectively
versus five years ago. Long-term supply & demand fundamentals
alone should not explain increases of this magnitude. Two main
factors are responsible for this anomaly. First, the fixing of
gas prices to oil in most long-term gas contracts agreements and
second the adverse effect on liquidity in the forward market caused
by long-term contracts generally, by they oil-indexed or not.
These two anti-competitive practices might be
resolved jointly, by obliging producers to release pre-contracted
gas into the open market, albeit at the expense of gas tied up
under legacy long-term contracts. In addition, wider measures
to promote free-market trading of gas on an over-the-counter basis
could be introduced, so more gas is sold on standard, re-tradable
contracts. Such remedies, which a Competition Commission investigation
should be equipped to identify, will be key to resolving the problems
which still exist in the wholesale gas and power markets, some
15 years after privatisation.
It is odd perhaps to see so much attention placed
on the retail gas market, where profit margins per therm are comparatively
small (possibly negative in the case of some utilities) and where
prices are ultimately dictated by the wholesale market. Further,
the question of competition within the wholesale market itself
is not included in the terms of reference of the Ofgem inquiry
although it is to be covered by the BERR inquiry.
Whatever motive, design or co-incidence explains
the policies of gas producers towards the wholesale market, seemingly
synchronised behaviour is having the effect of a price support
operation. Because of the complexity of the long-term contracts
in question and the cartel-type impact on competition, the multi-national
producers concerned should be referred to the Competition Commission.
A start can then be made to identify why we are seeing exaggerated
gas and electricity prices posted in the wholesale market.
The Competition Commission is the appropriate
body to act, having been set up specifically to deal with such
cartel questions under the Enterprise Act. Due to numerous energy
mergers and acquisitions in recent years, the final number of
gas producers in question may be comparatively small. However,
all the companies concerned will have UK gas shipper licences
and many will also be UK domiciled. In either case, English law
applies to them just like any other entities selling goods and
services within the UK.
Whatever producer practices are distorting market
competition, householders and industry are in urgent need of answers.
A fully independent investigation by the Competition Commission
will deliver this and it may well throw light on some early market
remedies as well.
April 2008
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