As discussed in the previous chapters, the use of market tightness or looseness as the indicator for the periodization of European NG prices has profound flaws. Gas market traders who rely on supply and demand data find out to their chagrin that such forces are not always the best indicators driving NG prices. Amid signs of tightening supply, spot gas prices have often fallen sharply and vice versa. As explained previously, spot prices are reflective of only a small segment of the total NG market and are intricately linked with LTC pricing. Having shown this interrelationship, we are left with the question of the logic of having LTC pricing be oil-linked and further whether that link is rational. This leads us to consider the hidden forces that actually provide the impetus for NG price changes.
This book is not a detective story where the denouncement of the plot comes at the end. That is why I will give my answer to the above mentioned question at the very beginning and then come back to it throughout the text. This driving force is interfuel competition with other carbon fuels, otherwise referred to as NG-on-substitute competition. Oil historically plays the role of the most important competitor to NG.
Since the very beginning of the NG industry in Europe in the 1960s, NG prices were set by adjusting the NG price in relation to competitive oil products that are burned for the same purpose as NG. Since markets for oil products had already been actively working for a long time prior to when the commercial NG market began, price formulas in long-term NG import contracts were set in reference to oil prices. The price of NG was tied to an equal energy equivalent value of its carbon fuel competitors through oilindexed pricing, with a discount, to make switching to NG more financially attractive for customers. This reference pricing mechanism has been referred by the term “oil-indexation” and is also known as “oil-price escalation (OPE),” the term used by the IGU.
Now nearly sixty years later, gas trading hubs have emerged in Europe with gas-on-gas pricing (GOG) as the major pricing alternative to OPE.