Germany's decision on nuclear could open Europe's doors to Gazprom

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18 August 2011, Gas, Nuclear, Solar, Wind

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RWE is under threat from expensive long-term gas contracts that are index-linked to high crude oil prices when European spot gas prices trade at a 20-30% discount to the long-term contract price. It does not help that RWE is also badly positioned in the upstream gas market. By April 2011, this issue was such a big problem that RWE initiated arbitration procedures for some of its long-term natural gas supply contracts with Gazprom, claiming the oil indexation was no longer competitive, which of course was (and still is) true.

For now, Gazprom, the main supplier to both RWE and E.ON, insists on enforcing and retaining these long-term contracts to protect its gas revenues in Europe, but not at the risk of shredding gas supplies into Europe. Until now, a drop in European sales at Gazprom was a likely consequence of cheap gas spot prices on the back of lower industrial gas demand and a new found abundance of natural gas production in the US.

For some time now, the thinking has been that long-term oil-linked gas contracts would progressively be replaced by gas contracts that link in part to a basket of related commodity prices, such as non-oil products (coal), gas replacement fuels, power, and wholesale hub prices traded on freely available and increasingly liquid Western European market hubs. Germany's new and seemingly definitive stance on nuclear power was arguably the trigger behind RWE and Gazprom's recent memorandum of understanding (MoU), which will see them work together on new and existing gas and coal power plants in Germany, the UK, and Benelux.

The MoU will also allow RWE to secure a competitive gas supply, undoubtedly on the strict understanding that oil indexation will underpin Russian supplies in long-term take-or-pay contracts. At the same time it will give Gazprom, which has been creeping further downstream for a while, the means to access valuable European production and distribution power assets, as well as presenting it with potentially lucrative swap agreements.

However, RWE's woes are not limited to the gas market or Germany's nuclear exit. The combination of three years of fairly constant power prices and rising coal prices has also squeezed the coal revenue margins of firms with large coal exposure, such as RWE.

The German government's nuclear phase-out is classic small-world thinking, certainly where gas is concerned, and has prompted RWE to rethink its strategy. The company will seek to strengthen its upstream gas position and renewables business in the long term. However, the current game of brinkmanship between RWE, which is intent on salvaging its nuclear position, and Gazprom, which is intent on maintaining its pricing policy and growing exports in the region, is giving the German government a reason to rethink its position.

Alarm bells should be ringing in Brussels. Potentially at stake is the future of independent gas benchmarks, which are of course in Europe's long-term market interests, and Russian control of European production and distribution, which is arguably less so.

Source: Datamonitor

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