spot trade or long term contracting a strategic perspective
TRANSCRIPT
Spot trade or long term contracting a strategic perspective
Karsten Neuhoff
Based on Work with Christian von Hirschhausen
Cambridge, December 2005
2
Do we need long-term contracts for gas producers?
• EU sector enquiry – are current LT contracts collusive?
– No resell provisions
Source: Sector Inquiry of Commission
3
Do we need long-term contracts for gas producers?
• EU sector enquiry – are current LT contracts collusive?
– No resell provisions
• Should we move to liquid spot trading?
– UK forward prices failed to predict lower production
4
Forward prices failed to anticipate current price spike
0
20
40
60
80
100
120
Mar-03 Oct-03 Apr-04 Nov-04 May-05 Dec-05
NBP
Zeebrugge
TTF
p / therm
Oil price
increase
Transmissionon continent
Work with Anne Neumann
5
Do we need long-term contracts for gas producers?
• EU sector enquiry – are current LT contracts collusive?
– No resell provisions
• Should we move to liquid spot trading?
– UK forward prices failed to predict lower production
– Russia – does Gasprom invest in production/T?
– LNG terminals – but where are ships and gas?
6
…. and will we get all that LNG investment?
Liquefaction Capacities Worldwide
0,0
50,0
100,0
150,0
200,0
250,0
2005 2006 2007 2008 2009 2010
mtp
a
Norway
Australia
Russia
Asia Oceania
Middle East
West Africa
North Africa
Latin America
North America
Source: Sophia Ruester
7
Do we need long-term contracts for gas producers?
• EU sector enquiry – are current LT contracts collusive?
– No resell provisions
• Should we move to liquid spot trading?
– UK forward prices failed to predict lower production
– Russia – does Gasprom invest in production/T?
– LNG terminals – but where are ships and gas?
• Or should we move to transparent fixed price contracts?
– Free resell, not restricting spot market liquidity
– Producers don’t want to abandon successful cartel
– Domestic retail competition constrains counter party
8
The benefits of spot trading
Production
DemandDemanduncertainty
Price
Resourceuncertainty
priceresponse
priceresponse
• Spot trading ensures efficient response to uncertainty
• But exposes all market participant to price volatility
9
combined with the benefits of long-term contracts
Production
Demand
contractprice
priceresponse
priceresponse
Resourceuncertainty
Demanduncertainty
• Fixed price long-term contracts eliminate price volatility
• While retaining efficient re-allocation in spot market
(assuming free resell etc.)
spotprice
10
1. Benefit of LT contract: Hedging price risk
• Price risk difficult to hedge in financial markets
• Investors require higher rate of return on capital
(limited risk appetite, regulatory risk)
• Increases production costs and expected gas price
• Consumers prefer stable energy bill if they do not sell
output on markets linked to gas price
• Replicate LT by overlapping ST contracts ?
11
LT contract priced relative to oil
• Historically 15-20 year take or pay contracts
• With increasing regulatory uncertainty contract length decreased
• Historic oil price link
Source: Sector Inquiry of Commission
12
Future of oil price link?
• Remove oil price link today?
– In power sector main substitute coal
– Reduces revenue volatility for exporting/importing economies
• Retain oil price link?
– If collusion among producers, likely to resist renegotiations
– First moving electricity generator increases risk with fixed gas prices if electricity prices remain
linked to volatile gas price
• Shift towards fixed pricing via S-curve?
13
2. Benefit of LT contract: Securing investment
• Stable revenue streams facilitate financing
• Assume competitive market/spot sales:
– downside risk is excess capacity and low prices
– risk averse producers reduce investment
• Assume competitive market/LT sales
– downside risk is failing to meet contract obligation
– risk averse producers increase investment
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Effect of uncertainty about future production
Assume:
• Fixed investment costs c per unit of capacity
• Technology uncertainty can shift future output +/-15%
• Competitive market invests while profits are positive
• Risk averse investors weight losses (1+r) times profits
Gas producersselling spot
0.30.20.10
8.75
8.5
8.25
8
7.75
Risk aversion of gas producers (r)
Insta
lled g
as
pro
duction c
apacity
Gas producersselling spot
0.30.20.10
15
Contracting changes investment choices
Assume:
• Producers sell 95% of output with long-term contracts
• Then decide on investment in production
• Producers can sell or buy on spot market
Gas producersselling long term
Gas producersselling spot
0.30.20.10
8.75
8.5
8.25
8
7.75
Risk aversion of gas producers (r)
Insta
lled g
as p
rodu
ctio
n c
apa
city
Gas producersselling long term
Gas producersselling spot
0.30.20.10
8.75
8.5
8.25
8
7.75
Risk aversion of gas producers (r)
Insta
lled g
as p
rodu
ctio
n c
apa
city
16
3. Benefit of LT contract: Revelation of information
• If most sales spot, producers signal excess supply
– Prevents entry of competitors
– Reduces investment
– Increases future prices and revenues
• If most sales long term, producers signal short supply
– Demand buys long-term contracts at high prices
• With long-term contracts
– Demand/supply expectation revealed in contracting decision
• Without long-term contracts
– Forward market reveals market expectations
– But recent experience unsatisfactory
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4. Benefit of LT contract: Reducing market power
• Strategic value for sellers
• Additional sales stage reduces MP
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0
1
2
3
4
5
6
7
8
9
10
0 2 4 6 8
Long-term contracts commit producer to lower prices
p
Q
Demand
Neuhoff, K. and von Hirschhausen, C. (2005) ‘Long-term ve. Short-term Contracts; A European perspective on natural gas’, CWPE 0538 (EPRG 05)
•Long-term contracts reduce prices
•In traditional models long-term contracts reduce producer profit
Price without LT
Price with LT
Long-term contracted
19
Demand more elastic short-term than long-term
psp
q
pl
Rational Expectations, Pl = PS
Qe
ps
Qe,long-term
• Fuel choice at time of investment decisive
20
0
1
2
3
4
5
6
7
8
9
10
0 2 4 6 8
Investment/ output choice with rational expectations
p
Q
LT demand
ST demand
no cont
ST demand
contracting
21
Producers‘ profits with(out) long-term contracts
γ*~ 5, corresponding to elasticity estimates by Al Sahlawi (1989) for industrial gas demand and Estrada and Fugleberg (1989)
108642
12.5
10
7.5
Ratio between long-term and short-term elasticity (γ*)
Pro
fit o
f duop
olis
t
Without long-term
contracts
With long-term
contracts
108642
12.5
10
7.5
Without long-term
contracts
With long-term
contracts
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When are producers better of with LT contracts?
54321
30
25
20
15
10
5
0
Number of players
Producers profit from
long -term contracting
54321
30
25
20
15
10
5
0
Number of players
Producers profit from
long -term contracting
Ratio b
etw
een lon
g-t
erm
and
short
-term
ela
sticity (
γ*)
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Conclusions: Impact of high long-term elasticity
• Long-term contracting commits producer to lower
spot prices
• Consumers always benefit from this strategic effect
• Lower price levels also increase long-term demand
• This creates benefits for producers
• With high market concentrations and significantly higher long-term than short-term demand elasticity
producers can even profit from long-term contracts
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5. Benefit of LT contracts: Bilateral components
• Short term trading costs vs. LT contracting costs?
• Address hold up problem if assets are dedicated
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Drawback of LT contract:
• Creates additional opportunity for collusive behaviour
• If all demand/production covered entry difficult
– Hence initial objection during liberalisation
– Adjustment relative to LT position creates trade
– Balance with benefit for investment of entrant
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… and what I still don’t understand
• Why not follow other sectors without LT contracting
– refinery, aluminium, oil production, airlines
– Would they be cheaper without LT contracting?
– Is it more difficult to sign LT contracts ?
– Do they receive other government support?
• Is counter party risk too big with fixed price contracts?
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Institutional constraints on LT contracts
• If retail company buys on long-term contract
– At times of low spot prices customers switch away
– Retail company not credible counter party
• Option 1: LT retail contracts for domestic customers
– Does it further reduce competition?
– Does it create additional transaction costs?
– Do customers care/internalise strategic effect?
• Option 2: Franchise for domestic customers
• Option 3: Only industrial customers buy LT
– Volume too small for strategic effects?
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Summary
• Current debate on LT contracts
– Concerns raised by sector enquiry
– Does cosy cartel prevent shift from oil-price link?
• Benefits of long-term contracts
– Hedge price risk
– Give right investment incentives
– Reveal information
– Mitigate market power
• LT contracting inconsistent with retail competition?