Malfunctioning Pricing

Hybrid in Europe Needs a

Fix

November 6, 2014

Berlin

Gas Price Structuring and Market

Liquidity Forum

Sergei Komlev Contract Structuring and Price Formation

Directorate

Gazprom Export LLC

© ZMB 2

Gazprom Export estimate for imported gas 2013

No System Change: Oil Prices is Still the Main Determinant of Gas Prices in Europe (ACER)

39.5%

17.0%

14.5%

1.7%

3.2%

17,0%

4.8%

2.3%

Gazprom oil-indexed

Norway oil-indexed

Algeria oil-indexed

Libya oil-indexed

Qatar oil-indexed

Norway hub-indexed

Qatar hub-indexed

Gazprom hub-indexed

72.7%

27.3%

*Excluding Baltic and CIS countries and including Turkey

ACER November 2013 Market

Monitoring Report states: “In

the EU approximately 60% of

gas supplies are still linked to

oil (p.180).

European Parliament’s

Directorate General for Internal

Policies special study “The

Impact of the Oil Price on EU

Energy Prices”(Feb 2014, P.19)

concluded: “While the EU might

try to accelerate the process of

decoupling oil and gas prices, it

seems that this objective will

not be achieved in a foreseeable

future. The majority of exporters

seems reluctant to make that

move”.

© ZMB 3

Natural Gas Prices in Europe move in Tandem

Sources: BAFA, Bloomberg, World Bank

0

100

200

300

400

500

600

Sep

-07

Nov

-07

Jan-

08

Mar

-08

May

-08

Jul-0

8

Sep

-08

Nov

-08

Jan-

09

Mar

-09

May

-09

Jul-0

9

Sep

-09

Nov

-09

Jan-

10

Mar

-10

May

-10

Jul-1

0

Sep

-10

Nov

-10

Jan-

11

Mar

-11

May

-11

Jul-1

1

Sep

-11

Nov

-11

Jan-

12

Mar

-12

May

-12

Jul-1

2

Sep

-12

Nov

-12

Jan-

13

Mar

-13

May

-13

Jul-1

3

Sep

-13

Nov

-13

Jan-

14

Mar

-14

Natural gas in Europe (World Bank)

BAFA

TTF Day-Ahead (Bloomberg)

NBP Day-Ahead (Bloomberg)

$/mcm

© ZMB 4

100

150

200

250

300

350

400

450

500

Jan-

08

Mar

-08

May

-08

Jul-0

8

Sep

-08

Nov

-08

Jan-

09

Mar

-09

May

-09

Jul-0

9

Sep

-09

Nov

-09

Jan-

10

Mar

-10

May

-10

Jul-1

0

Sep

-10

Nov

-10

Jan-

11

Mar

-11

May

-11

Jul-1

1

Sep

-11

Nov

-11

Jan-

12

Mar

-12

May

-12

Jul-1

2

Sep

-12

Nov

-12

Jan-

13

Mar

-13

May

-13

Jul-1

3

Sep

-13

Nov

-13

Jan-

14

Mar

-14

BAFA TTF, month-ahead

US

D/M

cm

Hub Prices Tend to be Lower Due to Contract Price Embedded

Premium for Security of Supply and Flexibility

Hub prices will generally fall below

contract prices because gas delivered

under long-term contracts offers greater

supply security and delivery flexibility

Sources: BAFA, Bloomberg

Hub prices are not independent: they are in

fact derivatives of the contract prices that set

a baseline trend for their behavior. Supply

and demand only mutate their changes

© ZMB 5

0

100

200

300

400

500

600 MCM/d

Gazprom is the major provider of supply flexibility to Europe as seasonal swing in Russian gas daily deliveries doubled

Source: International Energy Agency database

1998-2005 80-100MCM/d seasonal swing

2005-2013 150-220MCM/d seasonal swing

Midstream Flexibility is a Highly Valuable Product

© ZMB 6

Hub-Price Behavior in Hybrid Pricing Model

200

250

300

350

400

450

500

Liquid Hubs (Europe)

Oil-indexed LTC

Liquid Hubs

$/mcm

350

400

450

500

550

600

650

Illquid Hubs (Asia)

Oil-indexed LTC

Illiquid Hubs

$/mcm

© ZMB 7

Gas Hubs Liquidity and Churn

* Source: LEBA, International Energy Agency

0

5

10

15

20

25

30

0

50

100

150

200

250

300

350

UK NBP Nethelands TTF Germany NCG and Gaspool

France PEG Austria VTP Italy PSV Belgium Zeebrugge

bcm

Volume of trading Consumption in the hub zone Churn ratio (right axis)

© ZMB 8

Spot LNG Is not a Source for European Hubs Liquidity

Sources: GIIGNL, Gazprom Export calculations

6,7 12,9

23,0

11,7 12,1 17,4

2.2

6.4

4.1 2.4 2.9

13.0

26.9

40.6

16.7 9.5

2.1

71,6

46,3

53,9

50,5 56,3

65,8

0

20

40

60

80

100

120

140

2008 2009 2010 2011 2012 2013

Asia

Europe

Middle East

Americas

bcm

© ZMB 9

Use of LTCs as Financial Instrument Leads to Structural Oversupply

Volumes sold on forward

curves (1) vs. actual

demand (2)

Episode 1. Contract gas sold on a forward curve

Episode 2. Trading, portfolio optimization and gas buyback

Episode 3. Renegotiations and/or arbitration procedures

Advantages: • price hedging Disadvantages: • negative margins when contract prices (a) are higher than hub (b)

Advantages: • possibility to turn negative margins into positive • volumetric risks mitigation (ToP) by buying back volumes on hub equal to the actual demand by the clients Disadvantages: absent on the overcontracted market

Advantages: • although end-users pay hub+ price, hubs are promoted as the true market price indicator Disadvantages: • complicated and lengthy procedure, not all requirements could be met by the seller / court

(1) = (2) a > b by the size of premium for contract price security of supply and flexibility (PS/F)

Negative margins are minimum and could be netted by trading

Sum of the rebates is the smallest

(1) < (2) a < b due to undersupply on the hubs minus PS/F

Utilization of the contract volumes flexibility for price arbitrage between contract and hub gas

Seller can initiate a renegotiation procedure of its own. But on the overcontracted market buyer uses its nomination right to minimize mismatch

(1) > (2) a > b due to oversupply of hub gas plus PS/F

Negative margins could be the highest in this case, but be minimized by trading and contract gas displacement by cheaper hub gas

Strong case to apply for rebates

© ZMB 10

Oil Indexation is not Artifact of the Past: EU Final Energy

Consumption in the Industrial Sector, 2012

Sources: Eurostat, Gazprom Export estimates

14% 14%

22%

36%

29% 35%

36%

37%

39%

30%

30%

29%

29%

40%

36%

47%

28%

30%

27%

44%

34%

35%

32%

37%

48%

46%

31%

36%

21%

39%

40%

44%

43%

26%

100%

13%

12%

9%

5%

11%

9%

10%

14%

12%

4%

11%

12%

29%

12%

14%

4%

27%

4%

7%

12%

27%

0% 7%

15%

9%

7% 9%

11%

4%

2%

17%

13%

4%

21%

6%

16%

9%

22%

8%

4%

11%

18%

23%

4%

21%

8%

4% 6%

15%

8%

12%

22%

12%

9%

72%

32%

44%

44%

42%

41%

40%

39%

35%

35%

35%

34%

33%

33%

32%

31%

30%

30%

29%

29%

29%

25%

24%

22%

21%

21%

8%

5%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

EU

-28

Hun

gary

Luxe

mbo

urg

Spa

in

Rom

ania

Bel

gium

Net

herla

nds

Ger

man

y

UK

Slo

veni

a

Cro

atia

Aus

tria

Slo

vaki

a

Italy

Fra

nce

Irel

and

Cze

ch R

epub

lic

Den

mar

k

Bul

garia

Lith

uani

a

Pol

and

Por

tuga

l

Latv

ia

Est

onia

Gre

ece

Fin

land

Sw

eden

Cyp

rus

Mal

ta

Gas

Oil products

Coal

Electricity & Heat

Renewables

Wastes

© ZMB 11

Oil Indexation is not Artifact of the Past : EU Final Energy

Consumption in the Commercial and Residential Sector, 2012

Sources: Eurostat, Gazprom Export estimates

10%

8%

12%

5% 13

%

9%

32%

11%

16%

10%

22%

11%

13%

36%

27%

17%

29%

27%

15%

24%

12%

17%

13%

39%

31%

33%

30%

43%

33%

27%

43%

37%

33%

28%

41%

44%

30%

48%

44%

37%

61%

44%

53%

52%

39%

57%

45%

59%

82%

66%

54%

81%

6%

10%

25%

5% 7%

15%

3% 6%

11%

2%

5%

29%

4%

26%

23%

7%

19%

16%

35%

20%

16%

10%

12%

9%

5%

21%

24%

9%

34%

5% 4%

16%

33%

17%

34%

64%

58%

51%

48%

48%

38%

35%

35%

34%

32%

29%

24%

23%

21%

18%

17%

12%

10%

10%

10%

7%

7%

6%

4%

2%

1%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

EU

-28

Net

herla

nds

UK

Italy

Slo

vaki

a

Hun

gary

Bel

gium

Cze

ch R

epub

lic

Luxe

mbo

urg

Ger

man

y

Rom

ania

Fra

nce

Cro

atia

Irel

and

Spa

in

Aus

tria

Pol

and

Den

mar

k

Latv

ia

Lith

uani

a

Por

tuga

l

Slo

veni

a

Est

onia

Gre

ece

Bul

garia

Sw

eden

Fin

land

Cyp

rus

Mal

ta

Gas

Oil products

Coal

Electricity & Heat

Renewables

Wastes

© ZMB 12

Types of Market Failure in the Natural Gas industry

Type of Market Failure Negative Outcome Treatment Remedy Efficiency

Lack of mechanisms of

adjusting supply to price

signals leads to a wrong

level of output

Gas as byproduct of oil is

not a self sufficient

commodity

O –I

For decades O-I and long-term

contracts served as efficient

instrument of matching supply

and demand

Instability of prices

undermines long-term

investments

Inability to plan revenues

makes projects difficult to

finance

O-I

and gov.

guarantees

O-I makes projects financeable

while gov. guarantees raise risk

of antitrust actions

Price manipulation by

dominant suppliers High prices for buyers

O-I

and gov.

intervention

O-L is a hedge against price

manipulation. Poor track record

of competition enhancement in

gas market by governments

Externalities in gas

Free markets do not

address security of

supply

O-I and

‘Too big to fail’

policies’

Competition promotion leads to

‘free riding’ while O-I provides

security of supply

© ZMB 13

Oversupply Caused by ‘By-Product’ Status of Natural

Gas (USA)

Source: Gazprom Export LLC

Pric

e

Quantity

P* opt.

P

resulting

from

over-

supply Q* opt. Q over-

supplied

Supply

Demand

Supply

Oil-indexation as

market distortions

fixer

Oversupply

© ZMB 14

Source: Company 10-Ks

Notes:“Full cycle” or “All in” costs are defined herein as the sum of operating costs (on a unit of production basis) plus the cost of

acquiring, exploring for, and developing new reserves (on the basis of an equal unit of new reserves identified). The annual

presentation of costs incurred in property acquisition, exploration and development activities (collectively referred to as “costs

incurred”) is an SEC requirement for publicly listed oil and gas companies. Such an accounting, however, is not required, and is

typically not reported, on a quarterly basis. Thus, this interim update will not discuss 2012 YTD all-in costs.

$ Per Mcme 2005 2006 2007 2008 2009 2010 2011 2012

Operating Costs 91.84 94.05 98.71 127.93 92.07 116.28 141.05 132.30

G&A 11.42 13.85 13.71 15.52 14.18 14.61 14.00 12.59

Interest 11.06 12.20 14.93 11.05 9.78 6.80 7.30 7.33

Current Tax 24.50 25.85 20.42 26.70 0.00 10.22 12.66 (1.14)

Cash Costs (incl Tax) 138.82 145.95 147.78 181.20 116.03 147.91 175.01 151.07

F&D Costs 68.04 100.70 104.22 130.78 40.51 69.35 75.84 74.26

Full Cycle Costs (incl Tax) 206.86 246.64 252.00 311.98 156.53 217.26 250.85 225.34

Realized Gas Prices 248.99 218.27 216.41 279.12 188.17 176.72 158.30 106.90

Wtd. Avg. Oil & Gas Prices 256.77 234.71 236.24 303.13 204.31 212.67 220.87 203.35

Henry Hub Price of Gas 307.13 233.43 248.82 309.85 139.85 154.32 139.31 97.27

Note: Cash Costs and Current Tax in units of production. F&D costs are in units of reserve additions.

139 146 148181

116148

175151

68101 104

131

41

69 76 74

207

247 252

312

157 217

251

225

0

50

100

150

200

250

300

350

2005 2006 2007 2008 2009 2010 2011 2012

$/M

cme

Pro

du

ced

Cash Costs (incl Tax) F&D Costs Full Cycle Costs (incl Tax)

Realized Gas Prices Wtd. Avg. Oil & Gas Prices Henry Hub Price of Gas

US Companies’ Costs Exceeded Revenues on a Unit

Basis for Six Years in a Row

© ZMB 15

Henry Hub Prices and US Gas Rotary Rig Count and are

Strongly Correlated

Sources: Baker Hughes, Bloomberg, Gazprom Export estimates

0

2

4

6

8

10

12

14

16

0

200

400

600

800

1000

1200

1400

1600

1800

Gas Rigs Count

Henry Hub, $/MMBtu

The lowest

natural gas rigs

count in 21

years

Correlation between

Henry Hub prices of

natural gas and gas

rigs count in the US is

+0.83%

© ZMB 16

Henry Hub price does not cover dry gas production costs estimated to be USD 6 per MMBTY on average for

more than five years. Production of dry gas because of the depressed prices is possible only as by-product of

gas liquids of shale oil. This situation is not sustainable and will eventually lead to the Henry Hub price rise

above the USD 6 MMBTU levels. There are already no major increases in shale gas output over the last two

years in the USA and there are predictions that dry gas output may fall unless price adjustments takes place.

USA Dry Gas Industry is the State of Coma Pointing

to Shale Gas Price Anomaly

0

200

400

600

800

1000

1200

1400

1600

Mar

-09

May

-09

Jul-0

9

Sep

-09

Nov

-09

Jan-

10

Mar

-10

May

-10

Jul-1

0

Sep

-10

Nov

-10

Jan-

11

Mar

-11

May

-11

Jul-1

1

Sep

-11

Nov

-11

Jan-

12

Mar

-12

May

-12

Jul-1

2

Sep

-12

Nov

-12

Jan-

13

Mar

-13

May

-13

Jul-1

3

Sep

-13

Nov

-13

Jan-

14

Nu

mb

er o

f ri

gs

Oil

Gas

Sources: Baker Hughes, Gazprom Export estimates

© ZMB 17

Natural Gas Production in USA is Stagnant

Source: EIA

0

10

20

30

40

50

60

70

Conventional natural gas and coalbed methane

Rest of US 'shale'

Utica (OH, PA & WV)

Marcellus (PA & WV)

Haynesville (LA & TX)

Eagle Ford (TX)

Fayetteville (AR)

Barnett (TX)

Woodford (OK)

Bakken (ND)

Antrim (MI, IN, & OH)

49,2

%

Bcm/month

68,9

%

© ZMB 18

Demand Destruction Caused by Heavy Taxation and

Competitive Fuels Subsidizing (Europe)

Source: Gazprom Export LLC

Pric

e

Quantity

P* opt.

P resulting

from

demand

destruction

Q* opt. Q demand

destruction

Demand

Supply

Demand

destruction

Demand

Oil-indexation as

Market Distortions

Fixer

THANK YOU FOR YOUR ATTENTION!