A more competitive gas market may be bad news for BP as well as Gazprom

BP has been making some interesting points about the outlook for the natural gas market, most recently in a very thoughtful article in Foreign Affairs (requires subscription) by Christof Rühl, the company’s chief economist. It is a theme that BP is likely to highlight in its strategy presentation to investors on Tuesday.

It looks pretty clear that the key trends in the gas market – strong US production of “unconventional” gas, and the shift from long-term contracts to spot market sales – are bad news for Gazprom. Alexander Medvedev, the head of Gazprom’s international business, told the FT last week that the the basis of the company’s business in long-term oil-linked contracts remained unchanged, in spite of a shift to spot market pricing for between 10 and 15 per cent of the volumes sold to European customers.

What has perhaps been less widely appreciated is that, for all the enthusiasm of BP CEO Tony Hayward, the changing nature of the global gas market could also be bad news for BP and other international oil companies.

The term ‘IOC’ is, of course, becoming increasingly anachronistic. Gas accounted for more than a third of BP’s production last year. Shell expects it will be more than a half of its production by 2012. Exxon reported recently that all the net growth in its reserves over the past ten years had come from gas. So weak gas prices will hurt those companies just as they hurt Gazprom.

Mr Rühl draws a very interesting distinction between the three main hydrocarbon markets: coal, gas and oil. Coal, he argues is the most competitive: no-one has even tried to make a “coal Opec” work, and prices have followed demand pretty closely.

Oil is much less competitive, because Opec is pretty effective. But for Opec’s production cuts that began in the second half of 2008, Mr Rühl says, oil could still be below $40, instead of above $70.

Gas, meanwhile, is somewhere between the two. There is no “gas Opec”, in spite of Russia’s dreams of creating one, but gas prices have in many countries been sheltered by Opec’s market power, because of oil-linked prices specified in many long-term contracts.

As those contracts break down, under pressure of the global “gas glut”, that protection for prices is being eroded. Liberalisation in the European Union is also playing a part: while some of the hopes of market reformers have been disappointed, the gas supply market is becoming more competitive as the pipeline infrastructure opens up, so suppliers such as Eon and Eni will be increasingly less able to pass on to their customers whatever price they are charged by Gazprom.

Gazprom hopes that these changes are only temporary. As Medvedev put it to the FT:

“Every three years we have the right to look at prices, and what we have done today is just for a three-year period including 2010. We are sure that in three years the situation will be back on track. There is no danger in the mid- to long-term.”

However, if unconventional gas supplies continue to grow, then oil-linked contracts could be chipped away even further. That might make the long-term profitability of all gas sales less attractive, for BP as much as for Gazprom.

In those conditions, the IOCs will have two important issues to address. One will be to make sure that they can be the lowest-cost suppliers, whether by developing North American gas reserves of their own, as BP, Shell, Exxon and others have moved to do in the past couple of years, or by building other low-cost projects, probably including gas from Iraq. Certainly few projects are likely to be as high-cost as Gazprom’s Shtokman development in the Arctic waters off Russia’s north coast, which has already been delayed and will be doing well to ever make any progress.

The other priority for the industry will be to convince policy-makers that gas is better than coal for power generation: just as secure, and cleaner both in terms of local pollution and CO2 emissions. The coal lobby is active and well funded, but the gas lobby in the US is already stepping up its efforts to make that case.

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