Modeling Gas Markets with Endogenous Long-Term Contracts

Abstract

Since its initial development, long-term contracts have been associated with the gas industry in all regions of the world. This was also the case in Europe where natural gas trade was, for a long time, dominated by bilateral long-term agreements between producers and midstreamers. These contracts fixed a minimum volume to be exchanged (take or pay) and indexed the gas price using a price formula that usually referred to oil product prices. These arrangements allowed market risk sharing between the producer (who takes the price risk) and the midstreamer (who takes the volume risk). They also offered risk hedging since oil is considered as a trusted commodity by investors. The fall of the European natural gas demand, combined with the increase of the oil price, favored the emergence of a gas volume bubble that caused significant losses for most of the European midstreamers bound by long-term agreements. As a result, the downstream part of the industry brought forward the idea of indexing contracts on gas spot prices. In this paper, we present an equilibrium model that endogenously captures the contracting behavior of both producer and midstreamer, who strive to hedge their profit-related risk. Players can choose between gas forward and oil-indexed contracts. Using the model, we show that (i) contracting can reduce the trade risk for both producer and midstreamer; (ii) oil-indexed contracts should be signed only when oil and gas spot prices are well correlated, otherwise, these contracts hold less interest for risk mitigation; (iii) contracts are best suited when the upstream cost structure is mainly driven by capital costs; and (iv) a high level of risk aversion from the midstreamer might deprive upstream investments and downstream consumer surplus. The online appendix is available at https://doi.org/10.1287/opre.2017.1599 .