At the time of writing this IssueAlert article, gas energy companies all over Europe are in the process of applying to their national regulators for interim gas price increases. Increases in the high teens are not unusual; with projected cost increases having an impact on consumers and power generators alike. Over the past year fuel prices have risen dramatically, as gas prices have risen by over 130 percent, oil by 85 percent and coal by almost 100 percent. In this regard, it is unavoidable that such increases will have a proportionate impact on electricity prices as well.

Recently Gazprom has warned that European consumers should expect stiff increases in natural gas prices as the soaring cost of oil feeds through into contracts for the sale of Russian gas into Europe. Gazprom predicts the cost of wholesale natural gas will rise by between 15 and 20 percent this year. Gazprom expects even greater increases could follow if the European Commission pushes through measures to break up Europe's gas grid.

Europe currently imports about 58 percent of natural gas needs making European gas somewhat sensitive to increasing international demand. In fact, total energy dependence in Europe in 2006 ran at a whopping 54 percent.

Oil Price Indexation Effects?

Perhaps at the heart of the debate over European gas prices is the practice across much of Europe to use oil or petroleum product price indexing for long-term contracts, essentially tying the price of natural gas, albeit with some lag time, to the price of crude oil or refined products. This practice has been the subject of some debate and contrasts with the United States, where gas-gas indexing is more often used and where there is a more liquid and well-developed spot market with adequate price transparency. There is no room in this article to visit the history of these different pricing mechanisms except to say that regional European gas markets have moved more slowly than the United States to develop liquid spot benchmarks for natural gas. With crude oil prices at such high-levels, this debate has been sparked back to life recently.

One criticism of oil indexation is that it is does not factor in supply and demand and that price does not reflect market equilibrium at any moment. This obviously has a number of consequences, such as potentially meaning rising gas prices even when gas supply is sufficient. However, it is the historical lack of European spot price natural gas benchmarks with sufficient liquidity and transparency that makes for the historical preference for oil indexed contracts. In reality, the movement to gas-on-gas indexation also has downsides as it would likely significantly increase price volatility. Additionally, the rise of LNG is also having an impact on price formation, market development and pricing mechanisms while moving natural gas from a regional to a global commodity market.

To clarify the picture a little, consider the recent past in terms of European and U.S. natural gas prices. Until earlier this year, there was a sharp difference in prices as the NYMEX Henry Hub contract price was falling but European oil-indexed prices was rising. U.S. consumers benefited and were afforded some protection from oil-related price rises reflected in their natural gas prices. But, by early this year, the NYMEX contract price also began to rise quite steeply as speculation about levels of production being sufficient to satisfy future demand combined with competition for LNG with Europe forced prices higher there.

Utilities will argue that they do not profit from rising natural gas rates, but rather, from distribution of the fuel. They pass along whole price increases to customers on a dollar-for-dollar basis. So are the price increases that customers continue to experience a direct result of strong correlations between crude oil and natural gas and, by implication, related to oil-indexation or, are they a result of poor hedging practices on the part of utilities? And can trading divisions within utilities do more to protect their customers from the vagrancies of the wholesale market and the short-term fluctuations in price?

Crude oil prices and natural gas prices are often definitely related. But plenty of short-term differentials do exist. Over the past number of years there have been many examples where gas's massive price spikes have not been followed by oil in terms of magnitude. In addition, the relative size of each market can also explain this asymmetric relationship between oil and gas prices. The estimation of oil prices occurs at a global scale, while the estimation of the price of gas depends on regions. This means that the gas segmented market is considerably smaller than the global oil market. In the case of Europe, the relative size of the gas market compared to the global gas market is significant and it could be argued that the demand requirements for our regional market do not always follow the global market trends. Gas disruptions in local regions tend not to have a global impact in the natural gas world. In short, the price of gas on the European market has as much to do with regional demand requirements as it does with the correlation to global crude oil prices

And what of the trading practices and the complex instruments available to utilities? Can these be better employed to help iron out the regional and global differentials and help off-set the annual trend towards price increases? In the past few months we have seen crude oil prices rise by as much as 50 percent. In the past year, prices have more than doubled. Much of this may well be down to large amounts of money moving into energy commodities and a large proportion may well indeed be down to investors changing their positions to protect themselves in a market with falling prices and a weakening dollar. Of course, this presents challenges to the energy trading practices run by large energy users and producers. But those same price fluctuations and the relative short period over which crude oil prices have escalated, gives utility energy futures trading functions the capability to hedge their natural gas prices against rapid and unpredictable price increases.

Here too there is some debate. Some companies see hedging as speculative trading and therefore outside of their mandate. Hedging demands good risk management practices and it also requires liquid instruments and counterparties to provide those hedging opportunities. By way of comparison, it is well known that Southwest Airlines was able to remain relatively profitable by hedging a significant proportion of its fuel needs while other major US carriers did not and suffered the consequences. Again, it was the consumer - the traveller - who suffered most for this lack of trading and risk management acumen on the part of the airlines.

Summary

In today's commodity markets, which are dynamic and thriving with more and more instruments, players and opportunities, is it incumbent on the utility to place greater emphasis on using sensible, well managed and well thought through price risk management strategies, to reduce the exposure to price for the end consumer? Many utilities see themselves as simply a supplier and distributor. Their trading operations focused on ensuring adequate physical supply and often as an unfortunate necessity for their pipes and wires business.

In part, there may be a hangover from the Merchant collapse when many utilities plans to build trading-centric businesses were cancelled or curtailed abruptly. But things have changed. Markets have changed. Is it time for utilities to place more emphasis again on trading and risk management? Is it time to have the utility use more of what is available to it in commodity markets in order to take a greater level of responsibility in protecting the consumer from price risk?

Should we demand more of the utilities in terms of their trading capabilities and is it acceptable, in the face of ever increasing profit margins that utilities simply pass on wholesale price increases to their customers. In the same way that utilities are required to perform operational functions within an acceptable margin of safety, so too should we expect that their energy futures trading operations perform within an acceptable level and that they demonstrate good risk management and price sensitivity in their performance.