Taking the strain - the impact of the volatile oil price on natural gas prices

In 2008, the price of crude oil increased dramatically. After reaching highs of $146 a barrel the price has recently fallen back to below $80 a barrel. In the interim, it had risen and fallen, recording the highest single day increase and highest single day decrease on record. The increase in the price of oil has had a significant impact on the price of natural gas. In the UK natural gas market, increases in oil prices, oil price volatility and concerns over the pricing of long-term gas sales agreements has resulted in a rapid rise in natural gas prices.

In continental Europe, long-term natural gas sales agreements to suppliers largely retain the traditional link of prices indexed in some measure to oil prices. There is no true independent gas pricing mechanism in continental Europe, nor is there a wholly liquid natural gas market (such as that found at the Henry Hub in the USA). Accordingly, natural gas prices have risen as a result of increases in oil prices, after time lag due to indexation arrangements in gas sales agreements. Although natural gas price rises are viewed by the press as a grave consumer issue, which indeed they are, they are nevertheless a function of the basis on which the supply chain has reacted to oil price volatility.

Companies - both buyers and sellers - entering new natural gas and liquefied natural gas ("LNG") sale and purchase agreements will be acutely aware of the need to agree price terms that are relevant and appropriate in this new oil price environment and the markets in which the gas will be sold. Companies that are already parties to long-term natural gas or LNG supply arrangements that were agreed in the days of lower oil prices will be actively seeking to maximise their position by monitoring any opportunities to revise or reopen the price to their advantage.

Unlike oil, there is not yet any "market price" for natural gas across most of Europe. Both natural gas and LNG are commonly bought and sold in continental European markets through long-term contracts for large volumes. To maintain the relative value of gas over time, the price of natural gas and LNG under long-term contracts has traditionally been set by reference to traded oil (crude), oil product prices (such as fuel oils) and, on occasion, other indices such as electricity pool prices and inflation.

Indexation to oil and oil products is not however a direct dollar for dollar pass-through to the price of natural gas. Rather, the indexation is often weighted according to assumptions, agreed by the parties, about the buyer’s market and the influence of changes in oil prices over time. Since these agreements are invariably long-term, it is accepted that the price can drift from ‘market’ over time. In recognition of this, many gas sales agreements include a periodic price review. The right of the parties to a review does not, however, mean that the indexation or price basis will change automatically on a price review.

Some commentators are beginning to question whether there is any justification for retaining the link between oil and gas pricing. Other commentators argue that oil linked gas prices are preferable as they are more predictable and, in the absence of true wholesale gas-to-gas markets, are the best proxy. The following trends may develop:

• For those negotiating new natural gas or LNG contracts, options to avoid the oil/gas price linkage can include: indexation to inflation, to a local electricity pool and/or to indices that relate directly to the market (such as indices that reflect the costs of production of industrial and commercial consumers). In circumstances where a simple link between natural gas and oil prices might historically have been appropriate, a combination of the mechanisms above might now be better suited to prevailing circumstances.
• For existing contracts, sellers to national or wholesale suppliers, whose pricing mechanisms only reflect changes in oil prices to a limited extent, will inevitably use the first opportunity under the agreement to seek a review of the contract price. Conversely, buyers whose pricing mechanisms currently pass through a significant proportion of any oil price increase to the natural gas/LNG price, which cannot be easily recovered in their markets, will also seek a price review. This is particularly the case where price rises are deeply unpopular with end-consumers or where the buyer is in a long-term contract to take and to pay for significant gas volumes.

Whether the review of the price is contractually justified is another matter altogether. This requires a careful analysis of the price review provisions, including consideration of the relevant price review period, the circumstances giving rise to the right to a review and whether any contractual hurdles to a price review have been overcome.

CMS Cameron McKenna LLP has experience in negotiating and drafting natural gas/LNG sale agreements on behalf of both buyers and sellers, and has experience of price review and price reopener disputes in the UK and internationally.