Europe’s gas: careful what you wish for

European energy security was getting a bit dull. Not now. The global gas glut has seen some of Europe’s biggest energy players turning the contractual tables on Gazprom to slowly start breaking up oil indexation on gas prices. Eni, E.On and Gdf-Suez are the leaders in the pack, securing up to 15% of sales to be linked to gas spot prices. In ball park terms, this is around 25% cheaper than oil linked contracts based on current benchmark prices.

Congratulations, Europe’s energy will be a little cheaper thanks to shale gas, coal bed methane and LNG developments, but what political ramifications might this deliver? Answers have not been forthcoming, not least because no one has bothered to pose the questions yet. Here goes:

In the short term, probably not much; Gazprom’s Deputy CEO, Alexander Medvedev has made clear that the changes are only designed to last for three years, by which time he assumes the oil index link will be re-cemented. But what if Medvedev is wrong and we are genuinely entering a new era of ‘gas on gas’ competition? The entire political dynamics of European gas supplies would change: the catch of course is that it’s actually in Europe’s interests to stop this.

For if European demand remains blunted for some time to come, it’s practically inevitable that Russia, Central Asian, North African, and Middle Eastern producers will look to diversify their export routes away from the EU. The Pacific Basin is the logical option. Many in Europe will of course argue so what? If demand is down, demand is down. LNG will give us ample elasticity of supply anyway: stop worrying about ‘security of demand’ for producers - that’s old school.

The problem is that European demand will increase, and it will probably do so quite sharply once economic fundamentals recover and climate policy bites (in blunt terms the latter means less coal, more gas, and a handful of wind farms for aesthetic window dressing). Thus, the politically smart move to secure long term gas supplies is to take a massive bet against the market, and to do so now. Rather than encouraging gas on gas competition, Europe would be well advised to tell producers exactly what they want to hear: oil price indexation for gas firmly remains the order of the day – be it for Russia, Africa, Central Asia or the Middle East.

The rationale would be to tie up long term supply contracts now, to ensure the demand security blips do not turn the lights out in future, or indeed put emissions up should gas taps tighten and coal need to be shoveled. Launching a buyer’s cartel would certainly help in this regard to reduce Europe’s political exposure to producer states, but the real key is to try and pull back from the gas on gas competition brink.

Failure to do so would not only jeopardise upstream investment in the short term (Shtokman and Yamal provide an obvious Russian reference point), but see Moscow redouble its efforts to co-ordinate price with MENA and West African suppliers while tightening its grip in Central Asian reserves. More bluntly, the prospect of gas on gas competition could be the glue needed to start sticking a ‘Gas OPEC’ together - or at the very least, strengthen bilateral price collusion amongst European suppliers that had previously stalled. Maintaining ‘healthy’ spot prices over competing consumers would be the clear priority of the day.

Once we put rising Asian demand, supply side constraints, and unconventional gas proving more expensive to produce than first imagined into the mix, then gas supplies will not be as plentiful as Europe assumes. But if the game has moved on and a ‘global gas’ price starts to look a credible prospect, Europe might not like the response its contractual wrangling engenders: producers setting as high a price as possible through supply side collaboration. This is certainly a reality that Algeria has already woken up to in calling for gas production cuts ahead of GECF meetings in mid April. It’s all very early doors yet, but what might be commercially cheap option for European utilities now, could prove to be very politically costly for all in future.

Matthew Hulbert is Senior Fellow at the Center for Security Studies, ETH Zurich.