Globalization of the Gas Market: It has Been Going on Longer Than You Think
The general view among analysts is that gas prices in North America, Europa and Asia diverged in the period 2005-2014. This was always a bit odd, since regional markets were becoming more interconnected in those years through increased LNG trade, increased market related pricing and gas hub development. Now it turns out that, according to new research from Floris Merison at the Energy Delta Institute, the conventional view of price divergence is wrong. Global gas prices converged – as you might expect from market trends.
Almost all reports, articles and presentations on natural gas pricing show a diverging trend, at least in the decade through 2014. This is a typical example of such a graph, published by the International Gas Union (IGU) in 2015:
Figure 1: Example of the regular view of global gas price divergence (source: IGU)
Most graphs of global gas prices up to 2014 show price divergence from 2009: a low Henry Hub Price (US), the NBP price (UK) and German import price in the middle, and the Japan import price on the high side. The major reason for the low prices in the US is usually given as the shale gas revolution. The main reasons given for the high gas prices in Japan are high oil prices and high demand for gas in the power sector due to the shutdown of nuclear power plants after Fukushima (2011).
Nevertheless, this picture of diverging global gas prices is somewhat remarkable, since there also have been many improvements in global gas markets during the last decades. Global gas markets have become more integrated through increased LNG trade, increased market-related pricing and the development of gas hubs. The economic theory of the Law of One Price states that in a perfect market potential arbitrage opportunities between countries are immediately exploited by market participants, leading to convergence to one single price. From this perspective, it would be expected that global gas prices should have converged, due to increasing arbitrage possibilities and further market integration.
Figure 2: Example of increased connectedness in the global gas markets (source: IGU)
The conventional view of global gas price divergence is based on prices in only a few countries, usually the United States, United Kingdom, Germany and Japan. This is rather limited taking into account that there are more than one hundred countries consuming natural gas. In our research we have used a database of gas prices of almost all gas consuming countries. Additionally, we have used a measure of convergence, the coefficient of variation, which is particularly suitable for this dataset. By this approach we wanted to shed more light on the apparent contradiction between economic theory (expecting more price convergence) and the conventional market view of price divergence in the global gas markets.
The IGU has been conducting Wholesale Gas Price Surveys for 7 years in the period 2005 – 2014. For more than 100 countries, assigned to 8 IGU Regions, data are available on:
- annual average gas prices
- gas volumes and shares of gas price formation mechanisms for:
- domestic production
- LNG import
- pipeline import
- total consumption
The measure we use in our research is the so-called coefficient of variation. This is the ratio of the amount of variation in a dataset (the standard deviation) to the mean value. It is a measure for price convergence. A coefficient of variation of 0% means full price convergence. The higher the value, the less convergence. This measure is particularly suited for the dataset we used, with a limited number of prices (7 annual prices) for a large number of countries, which are allocated to different subsets of countries with different average gas prices.
When we look at the data in this way a different picture emerges.
The first and main conclusion of the analysis goes against the regular market view, confirming the expectations based on the Law of One Price:
1) 2005 – 2014 was a period of global gas price convergence
The trend in the coefficient of variation of gas prices of all importing countries with market based prices shows a decline, indicating gas price convergence in the period 2005 -2014. This trend of price convergence is especially clear for a subset of countries with pipeline imports. The standard market view of global gas price divergence in this period, based on gas prices in only a few countries, should therefore be nuanced.
Our analysis also led to a number of other, possibly less remarkable, results.
2) Gas prices of importing countries are more converged
Gas prices within the group of countries with gas imports of at least 10% of gas consumption are more converged than gas prices in the group of countries with less import. From a theoretical perspective, this is as expected. In order for the Law of One Price to potentially apply, it is necessary to be able to trade to exploit arbitrage opportunities: countries should be connected to the global gas market.
3) More gas price convergence with market related gas prices
There is more gas price convergence amongst countries with market-related pricing than non-market-related pricing. (Market-related pricing includes oil indexation as well as gas-on-gas indexation. Regulated prices, used for around 40% of global gas consumption, are referred to as non market-related pricing according to the indexation of the IGU Pricing Workgroup.) This outcome is also to be expected from the theoretical perspective of pricing theory: market-related pricing is a precondition for proper functioning of a market. In a perfect market, prices would be converging to a single price.
4) More gas price convergence amongst countries with oil based gas prices
Gas prices of countries with oil price indexation mechanisms are relatively more converged. This can be explained by the fact that the levels and movements of these gas prices are all related to levels and movements of prices of oil and oil products, such as crude, gasoil and fuel oil.
5) More gas price convergence within regions than on a global level
The coefficients of variation of most regions in most years are below the coefficients of global prices. More price convergence within regions than between regions is not hard to explain: intraregional trade of natural gas is usually easier and less costly than interregional trade. Due to the more limited availability of data in most other regions, the IGU region Europe is the best example of more price convergence within a region, as compared to gas prices on a global level.
This article is based on the report “Global natural gas prices 2005-2014 – Convergence or divergence – An analysis of global gas price convergence using Wholesale Gas Price Surveys of the International Gas Union” by Floris Merison (employed by GasTerra B.V.). The research was conducted as a Master’s Thesis for the Executive Master of Finance and Control for the Energy Industry program of the Energy Delta Institute under supervision of prof. C. J. Jepma, University of Groningen and in cooperation with the Pricing Group of the IGU Strategy Committee. The views in this report are the sole responsibility of the author (not of any of the organizations mentioned).