Industry Trend Analysis - Coal Displacing Oil As Gas Price Driver - APR 2017

BMI View : European gas hub prices will continue to decouple from oil and more closely reflecting the dynamics of the regional market. Russia stands to gain, where market tightness drives hub prices above pipeline contract prices.

In recent months, European gas hub prices have spiked upwards, decoupling from oil. Traditionally, hub prices have been anchored to oil due to the use of oil-indexation in contract pricing and significant volume flexibility in pipeline supplies to the region. Increasing (decreasing) contract nominations when hub prices rise above (fall below) contract prices has kept the two relatively tightly bound, with oil-indexed contract prices tending to act as the ceiling for hub gas. However, since H216 the UK benchmark NBP has more closely tracked the rise in coal, which spiked upwards in the back end of the year due to rampant Chinese import growth.

Crude, Gas Diverging
NBP (GBp/therm - RHS) & ARA Steam Coal (USD/mt - LHS; LHC) & Brent Crude (USD/bbl - LHS; RHC)
Source: Bloomberg, BMI

The decoupling of oil and gas prices in Europe is part of a more structural trend. Contract pricing, at least in Western Europe, has shifted increasingly towards hub indexation in recent years. Russian contracts remain nominally indexed to oil, but contain various adjustment mechanisms that bind prices to the hubs. As contracts roll off and are renegotiated we expect this decoupling to accelerate, with gas prices increasingly reflective of regional gas market dynamics. Within this, there is likely to remain a stronger correlation between gas and coal, given competition between the two in the power sector. The rise in coal prices has been one of the key factors driving up hub prices, as the higher cost of coal-fired generation has encouraged fuel-switching to gas, driving up demand. This added to a host of other price-supportive factors, including nuclear capacity brought offline in France and low storage levels in the UK due to outages at Rough.

Coal Taking Centre Stage
NBP 10-Week Rolling Correlation To ARA Steam Coal & Brent Crude
Source: Bloomberg, BMI

One offshoot has been the atypical rise in hub prices above pipeline contract prices. This has been bullish for Russian exports, as European buyers increase contract nominations. This chimes with the healthy growth in Russian gas exports seen in 2016: exports to Europe stood at 179bcm for the year, a y-o-y rise of 13%.

Breaking The Gas Ceiling
NBP & Russian-German Border Gas Price, USD/mnBTU
Source: Bloomberg, BMI

While we expect continued Russian export growth in 2017, this is likely to happen at a much reduced rate ( see ' Gazprom To Continue Expansion At Slower Pace ' , January 4). One factor will be a pullback in European hub prices from their recent highs. There are signs of this trend already in play, with benchmark NBP falling almost 20% since its February 3 peak. Milder weather, nuclear restarts and a fall in coal prices will all continue to weigh on gas over the coming months. This is liable to pull hub prices back below contract prices, softening the y-o-y growth in Russian pipeline imports.

Cheaper Coal To Drag Down Gas
Coal And Gas Annual Price Change
f = BMI forecast. Source: Bloomberg, BMI