Led by the EU, Europe has made a concerted push over the years towards greater natural gas market liberalisation, and this has involved a shift from longer-term supply contracts and oil-linked pricing to shorter-term deals and gas hub prices. That has led to a gas crisis this winter as a perfect storm of surging post-corona demand, falling EU gas production, a Russian supply crunch due to its own high domestic demand for gas and high prices for LNG in Asia drawing off the swing supplies have combined to send gas prices in Europe soaring.

But while the continent’s gas consumers have reaped the rewards from reforms to the market for much of the past decade, saving themselves tens of billions of euros in the process, the changes have come back to bite them now. Oil indexation acts as insurance against market volatility and those countries that still use it rather than hub-based pricing have fared much better than those that don't.

Not all European countries have been affected the same way by the current supply crunch. While many in northern and western Europe that fully embraced price liberalisation are now contending with an unprecedented spike in their gas import bills, others in eastern Europe and less aligned with EU energy policy are faring comparatively better.

Europe relies more on hub-based, or gas-on-gas pricing than anywhere else in the world now, which helps explain why it has been hardest hit by the current energy crisis. The International Gas Union (IGU) estimates that gas-on-gas pricing accounts for over 80% of supplies there, and this is largely down to efforts by Brussels. EU authorities view the liberalising of gas prices as a core energy policy and have encouraged gas customers to push their suppliers for less oil indexation and more hub-based pricing. And this strategy has clearly paid off.

The International Energy Agency (IEA) estimates that the EU saved some $70bn in gas import bills over the last decade by moving away from oil indexation and towards hub pricing. This has primarily come at the expense of Gazprom, by far Europe’s largest single gas supplier. The company estimates that the share of oil indexation in its sales dropped from 78% in 2005 to 22% in 2019. An anti-trust investigation several years ago even forced Gazprom to offer more flexible terms in its contracts with European buyers.

The situation has now dramatically reversed. In late October, the IEA estimated that EU countries will be paying around $30bn more for gas in 2021 alone than if they had stuck with oil indexation, giving up almost half the gains reaped in the last decade. The consensus is that high prices will continue into next year, causing the cost to rise even higher and possibly leading to a net deficit as all the gains of the last decade are lost.

Spot prices in European wholesale markets are far higher, with the front-month contract at the Dutch TTF hub surging to nearly $2,000 per 1,000 cubic metres in October. That is an enormous increase when compared with Gazprom’s contacted gas, which the company reported this week it sells on average for only $313.4 in Europe during the third quarter. Gazprom’s prices are typically set according to hub rates over a longer period, as well as being in some cases indexed to oil. But this still represents a growth from only $143 in 2020, when demand was subdued by the pandemic, and the average price in 2019 was a mere $210.6 per 1,000 cubic metres.  

Oil indexation versus hub pricing

The way that gas is priced has been through a small revolution in the last few years. Previously the problem with pricing pipelined gas was there was no market: the deal consisted of the producer that put the gas into the pipeline and the buyer who took it out. With only two parties in the deal there could be no competition and no market to set a competitive price.

The advent of LNG has changed all that, which can be sent on a ship to the highest bidder, creating a market-based price for gas and effectively turning it into a commodity similar to oil, which is almost all transported by ship. Previously the default option was to link gas prices to oil prices in acknowledgement that the price of both is linked. Now gas is becoming a commodity it is increasingly possible to let markets like the Dutch TTF hub set the price of gas.

In practice, as pipelines and politics still play an important role in the gas business and LNG production is still a relatively young business, pricing of gas deals are a mix of both negotiated deals, some oil-price linking and averaging prices on the Dutch TTF hub.

Oil indexation has been used for decades in natural gas supply contracts and essentially involves linking the price in that contract to the average price of oil and sometimes other petroleum products over time. Suppliers have generally favoured oil indexation, as it results in greater price stability, providing the certainty that they need to invest in supply projects sometimes worth billions of dollars.

On the other hand, gas-based pricing, otherwise known as gas-on-gas pricing, is when prices are determined purely based on the interplay between gas demand and supply. There has been a steady shift away from oil indexation and towards hub pricing over the last decade, largely because prices at hubs have been cheaper than under oil-indexed contracts, and an amply supplied market has given buyers more power to demand hub pricing from their suppliers.

Pricing reforms have not moved forward at the same pace across Europe. Those member states more closely aligned with EU policy led the way, but others in the east progressed at a slower pace. And some aspiring EU members have only begun to adapt their energy markets to standards set by Brussels.

While the extent of the shift in Gazprom’s sales from oil indexation to hub pricing in Europe is clear, the company very seldom discloses pricing terms in individual supply contracts, making it difficult to determine to what extent each of its customers in Europe has suffered as a result of the current supply contract. However, it is understood that Gazprom continues to have 100% oil-indexed contracts with companies in Bosnia-Herzegovina, Greece, North Macedonia, Serbia and Turkey, and it is these markets that have consequently seen a much smaller increase in their energy bills since the crisis took hold. Some companies elsewhere in east Europe have partial oil indexation as well.  

Serbia

A notable example of a country that has been shielded from the gas crisis by sticking with oil indexation is Serbia. Serbia’s close political relationship with Russia has no doubt also helped it secure a favourable price for gas.

Serbian President Aleksandar Vucic said on November 25 that his country had secured an “incredible” gas price from Gazprom of only $270 per 1,000 cubic metres over the next six months, following talks in Sochi with his Russian counterpart Vladimir Putin. In contrast, the December delivery contract at TTF was trading at around $1,070 per 1,000 cubic metres on the same day.

Putin “has shown friendship towards Serbia,” the Serbian leader said, who also earlier boasted that Serbs would be able to spend Christmas “in their T-shirts” as energy supplies would be so abundant.  

“We managed to get … for the next six months a gas price of an incredible $270, so that our price does not change; we also got an increase in the amount of gas in those six months and we got flexibility [in monthly delivery], for which I especially begged Putin,” he said.

Serbia gets most of its gas from Russia, save for a small amount it produces domestically. But its supply contract with Gazprom is due to expire at the end of this year and will need extending. Earlier, Russian media reported that Vucic was looking to obtain 3bn cubic metres per year of annual supply from Russia.

While contractual talks are not complete, with further discussions due to take place in Moscow, both countries’ leaders indicated that Serbia could count on getting a decent price for Russian gas next year. The assurance of a low price for six months is important, as Serbia will hold general elections in April and energy bills are likely to take centre-stage in the run-up to voting.

Serbia is in a better position than other countries to secure favourable terms from Gazprom owing to its support for the extension of the Russian company’s TurkStream pipeline into Southeast Europe – a project that Russia has viewed as critical for cutting gas transit via Ukraine. It has also allowed Russia to maintain a dominant position in its oil and gas production, gas transmission, oil refining and petrochemicals sectors. The country has notably resisted EU calls to unbundle its gas transmission infrastructure, even though it is still aspiring to join the bloc by the late 2020s.  

Hungary

Hungary inked a new and very controversial deal with Gazprom in September that diverted gas that used to flow through Ukraine and rerouted it via the newly launched TurkStream pipeline, cutting Ukraine out of the loop.  

The deal, involving EU member Hungary, caused a major diplomatic flare-up, with Kyiv calling in the Hungarian ambassador to Ukraine to complain. Ukraine is afraid of losing a substantial amount of its circa $2bn a year in transit fees if the new Nord Stream 2 gas pipeline comes online, but the Hungarian gas deal is already a step along that road. Kyiv protested that the Hungarian deal amounted to the “use of gas as a weapon” and demanded that the EU and US impose fresh sanctions on Russia as a result. Nothing happened.  

Hungary obviously got a better deal with lower prices from its new deal, but the details are an extremely closely guarded secret. Hungarian authorities insisted that the new deal, which will last up to 15 years, will result in a lower price than the one calculated in the old agreement that expired that month. Analysts speculate what that means in practice is that a greater share of oil indexation was used in the pricing formula.  

Like the Serbian government, the governing Fidesz-KDNP Party Alliance in Budapest is facing parliamentary elections this spring, and is keen to ensure a spike in energy bills does not undermine its popularity.  

Turkey

The biggest change to the gas business in the last year was the advent of TurkStream that went online in January and has not only opened a new large capacity route to from Russia to southern Europe with its 31 bcm nameplate capacity, but has already seen exports from Russia to Turkey up by about 100%, reducing Ukraine’s transit fees by around $1bn thanks to re-routing.  

The various contracts between Gazprom and Turkish gas imports remain oil-indexed, although there had been expectations in recent years that some of these buyers would push for hub-based pricing. In light of current market conditions, however, it is likely they will stick with oil indexation for the foreseeable future.

Russian gas supplies to Turkey slumped in 2019 and early 2020, as a drop in global LNG prices meant Gazprom’s gas was uncompetitive versus super-cooled shipments from overseas. But they have rebounded steeply this year – almost doubling year on year between January 1 and November 15 – as prices at gas hubs have soared.

A number of contracts between Gazprom and Turkish buyers are due to run out soon, but it is likely that pricing terms will more or less be the same as before, although the Turkish side is likely to push for reduced take-or-pay requirements. Complicating these talks is the fact that some private Turkish buyers have amassed a debt of billions of dollars to Gazprom for previously failing to meet take-or-pay obligations.

While current market conditions give Gazprom an advantage, Turkey will be able to leverage its new role as a key transit route in the southern prong of Gazprom’s trident of delivery routes – southern, central and northern – for Russian gas heading to Europe through TurkStream. And Turkey’s state-owned Botas, and others, are likely to seek shorter-term deals and reduced volumes in anticipation of the start-up within several years of the large gas field that Turkey has discovered in the Black Sea.  

Poland

Poland has been especially hard hit by the crisis, as it recently shifted from oil indexation to hub-based pricing in its contract with Gazprom following a battle in court.  

The supply contract of state-owned PGNiG with Gazprom was fully oil-indexed until 2019, when the Polish company won a Stockholm arbitration case against the Russian supplier. Gazprom was required under the ruling to introduce hub-based pricing in the contract and pay $1.5bn to make up for overcharging for gas in the past. Now thanks to the surging prices on the TTF hub it looks like Gazprom will be able to claw a lot of that money back.  

Ironically, in late October PGNiG asked Gazprom for a price cut, which could suggest that it is seeking a return to oil indexation in light of current high market prices.

“We’ve witnessed unprecedented increases in natural gas prices across the European wholesale market recently,” PGNiG CEO Pawel Majewski commented at the time. “This extraordinary situation provides a basis for renegotiating the price terms on which we purchase gas under the Yamal contract. In our opinion, there is room for a reduction of the price of gas supplied to PGNiG.”

Conditions on the gas market have placed considerable financial strain on PGNiG, Poland’s monopoly gas importer. The company’s core earnings slumped 31% year on year in the first nine months of the year, as higher gas import costs eroded the gains it made from gas sales in Europe.  

Moldova

But the most sensational of all Gazprom’s client problems has been in Moldova, where Gazprom radically reduced supplies in September after Chisinau’s gas contract expired before a new one was agreed.  

In the end Gazprom gave Moldova a month’s extension, albeit at reduced volumes, while talks continued, but the government declared an emergency as energy supplies ran low. The contract with Gazprom was eventually amended and will start at the end of this year to include hub-based prices. Moldova also has big debts to Gazprom for unpaid gas, but a discussion on restructuring those has been put off until the New Year.  

After talks on extending its contract collapsed in September, Moldova was forced to buy all of its gas from Gazprom using hub-based pricing, which the impoverished republic could ill afford. The two sides entered a new contract beginning in November which restores partial oil indexation.

Moldova now says it is paying $450 per 1,000 cubic metres for gas, versus $790 in October. The Moldovan press has reported that the new contract takes into account the prices of oil and gas in the preceding nine months, with a 70:30 ratio between oil and gas price indexation.

Even these more favourable terms for supply are proving a struggle for the country, the poorest in Europe. Even after agreeing on a new deal Moldova nearly fell at the first fence and narrowly avoided having its gas supply cut off again on November 26 after scrambling to meet a deadline for payment of supplies in October and the first half of November. Gazprom had demanded payment on November 24 and Moldova didn't have the money. But the Russian gas giant granted the government a two-day extension, and Chisinau came up with the $70mn in the end.  

While some media and politicians have criticised Gazprom for using gas as a geopolitical weapon in Moldova, other observers say Chisinau effectively brought the crisis on itself by stalling in contract talks with Gazprom. It was also Moldova that insisted that its supplies should be priced more according to rates at gas hubs.  

What next?

Certainly, gas buyers whose long-term contracts with Gazprom and other suppliers are near to expiry are likely to go back to the greater use of oil indexation, or indexation to other energy products such as other petroleum fuels and perhaps even electricity. They are also likely to seek longer-dated pricing systems that safeguard against this year’s volatility.

However, whether the crisis will result in diversification away from hub pricing in the longer term is less clear. The EU has defended its efforts to liberalise prices, and buyers are often susceptible to short-termism. Once prices do fall, they may once again revert back to hub pricing for short-term benefit.

A more immediate source of concern for buyers is the upcoming winter. Supply has already been put to the test by low levels of storage following the distortions created by the pandemic, a sharper-than-expected economic recovery over the summer, and continued supply constraints. Meteorologists report that this November has already been the coldest for over five years – even colder than the winter of 2021 that was a big contributing factor to the current gas crisis – and that means prices are likely to stay elevated this season too.

EU gas storage is already depleting quickly from historically low levels, with facilities only at 71% utilisation on November 24, according to Gas Infrastructure Europe, even though the continent is less than two months into the heating season. There were hopes that Gazprom would provide extra gas to ease the supply crunch in November, but this influx of supply has not materialised and the company’s own storage sites in Europe remain near to empty. While many have accused Gazprom of artificially squeezing European supplies as a way of putting pressure on German regulators to fast-track approval of Nord Stream 2, as bne IntelliNews reported, the V-shaped gas market of the last two years means Gazprom is already working at close to its maximum and has limited capacity to increase exports to Europe at all.  

While Gazprom has been accused of intentionally withholding some supply to jack up prices, its supplies to Europe and Turkey minus former Soviet Union countries were up 8.3% year on year between January 1 and November 15. Following cuts to its investment plans in 2020 in response to the pandemic, and given that the sharp rebound in gas demand in Europe largely took the market by surprise, the Russian supplier may not have the gas ready to avert more serious shortages in the coming months.