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Wither Long-Term Contracts?

April 20th, 2015 by Anne Neumann, Universität Potsdam and DIW Berlin

Have you ever heard the story of long-term contracts withering away, washed away by the emerging competition in regional, if not global natural gas markets? And have you really believed that in an industry characterized by multi-billion US-$ investments, “perfect competition” should assure long-term supply security? Ten years ago, when I started to work on long-term contracts in the natural gas industry, I believed in these stories too. Until I started to collect data and assembled what is now the largest database on long-term contracts world-wide.

A dynamic, capital-intensive industry …

The natural gas industry spans a broad field of activities, from exploration and production, to transportation at various stages (e.g. high-pressure and low-pressure pipeline transportation, or shipping in the form of liquefied natural gas (LNG)), trading, storage and the final distribution to end customers. The industry emerged with the diffusion of natural gas burning applications in heating, electrification, the transportation sector, and other non-energy activities, including the fertilizer industry. Previously considered as the “younger brother” (or: sister) of the electric power companies, or even the oil industry, the natural gas industry has evolved into a sector of its own following World War II. Natural gas has several characteristics that make it an attractive fuel: it can be used in different sectors and for various applications, it is easy to manage, transport and store, while having the lowest CO2-intensity among all fossil fuels. The International Energy Agency (IEA, 2012) heralded the “golden age of natural gas”; Holz et al. (2015) provide a survey of the literature on the global perspectives of natural gas.

Contractual relationships and the structure of vertical coordination along the value added chain have always played an important role in the sector, shaping both industrial strategy and national policies vis-à-vis the industry until today. In particular, the degree of coordination between highly capital-intensive exploration and production on the one hand, with large-scale consumers and traders on the other, is a critical issue that has attracted a sizeable amount of interest from industrial and institutional economics. In order to understand this specific industry better, we started to collect data on one of the best kept secret in the sector, the long-term contracts (LTCs).

The topic of long-term contracts excites both practitioners and academics, due to the crucial importance that these contracts have played (and continue to play) both in stabilizing the industry and in finding appropriate measures to maintain or increase competition at different levels. From an academic perspective, the sector lends itself naturally to theoretical and empirical analyses of institutional economics and industrial organization. The institutional economics literature interprets long-term contracts as a device to avoid the risk of opportunistic behavior in transactions that involve high sunk investments. Thereby, considerations about the “best” form of organizing an industry go back to the seminal work of Ronald Coase (1937) on the “nature of the firm”, asking for the determinants of “markets” vs. “coordinated hierarchies”, i.e. firms and other forms of vertical coordination. Hubbard and Weiner (1986) developed a theoretical model of contracting, emphasizing the determination of price and minimum-purchase provisions. Masten and Crocker (1991) investigated the choice of alternative price adaptation clauses with the economic trade-off between flexibility and contractual completeness. Whereas the presence of uncertainty should favor renegotiation, the presence of high quasi-rents should support redetermination clauses based on pricing formulas that reduce the frequency of negotiations and therewith the hazard of opportunistic haggling.

… requires complex contractual structures

Our Data Documentation (Neumann, A., S. Ruester and C.v. Hirschhausen (2015): Long-term contracts in the natural gas industry – Literature survey and data of 426 contracts (1965-2014). Data Documentation 77, DIW Berlin) is the fruit of a decade of work, started at the German Institute for Economic Research (DIW Berlin), continued at the Chair of Energy Economics & Public Sector Management at Dresden University of Technology (TU Dresden), and completed – as it stands now – after returning to DIW Berlin. The Data Documentation accompanies a Special Issue of the Review of Environmental and Energy Policy (REEP) on natural gas; see Neumann and von Hirschhausen (2015): Natural Gas: An overview of a lower-carbon transformation fuel. Review of Environmental Economics and Policy, 9(1): 64-84.
The objective of our Data Documentation on “Long-term Contracts in the Natural Gas Industry” is to provide a comprehensive set of long-term natural gas supply contracts – covering both deliveries via pipeline and in the form of LNG – and their characteristics to the research community as well as to stakeholders in industry and policy. This Data Documentation provides a detailed account of a large number of long-term contracts concluded between suppliers and buyers from the early years of this industry in the 1960s through 2015. In addition to the descriptive presentation of the database and the different data sources, we also provide some simple empirical statistics; in particular, we analyze the contract structure, differences between pipeline and LNG contracts, and also some country-specific effects. The Data Documentation should, therefore, be of use for academic research investigating the changing nature of international natural gas trading, as well as for industry analysts and policy makers interested in the underlying contract structures. By making this database publicly available, it is hoped that further in-depth research and conversations about this exciting topic is fostered.

A unique data sort: the DIW Data Documentation on Long-Term Contracts

Our global database covers long-term contracts from the early years of the industry in the 1960s through 2014, connecting producers/sellers with buyers/importers of natural gas. The database covers both pipeline and LNG deliveries. A long-term contract thereby is understood as a contract covering a time period of five years or more. The database includes information on contracting parties (i.e. companies associated to a specific export or import country for the respective contract), annual and total contracted volumes, the year the contract was signed, the start date of deliveries, as well as contract duration. Contracts currently in place or agreed for with the start of delivery during the coming years as well as contracts that already have been terminated are incorporated. Moreover, contracts can be new, first-of-a-kind agreements or renewals of existing and terminated ones. The database has been under construction since 2003, collecting information from various publicly available sources. These include industry reports, press releases, company and project websites, as well as a number of books and regular institutional publications.

Figure 1 summarizes the main findings: 1/ Yes, contract duration tends to become shorter over time, driven by the evolving maturity of the industry. Very long contract durations of 30 or more years – even up to 40 years – are no longer common. In contrast, shorter agreements covering five to ten years increasingly complement the typical 20-25 year contracts. But 2/No long-term contracts have not disappeared – as was suggested in the policy debate on the effects of market retructuring – even in the last decade, well into the restructuring of natural gas industries in North America, Europe, and even some Asian countries. The subsequent Figures provides additional insights into our main theses, 1/ shorter contracts, but 2/ LTCs that are here to stay.

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We can conclude that long-term contracts are an important element of all economic activity and, thus, critical for understanding modern economic structures. The natural gas industry provides particular insights into the functioning and dynamics of long-term contracts and industry structures, in a sector that is globally important. Our Data Documentation provides a survey of the literature on long-term contracts in the natural gas sector, as seen from an institutional and industrial economics perspective; we also add suggestions for further research. The core of the documentation is a detailed database of 426 long-term contracts struck between sellers and buyers between 1965 and 2014. Though not comprehensive, the database covers a large share of contracts, both for pipeline gas and liquefied natural gas (LNG). And it provides, we hope, food for further research on this exciting topic.

Anne Neumann, Universität Potsdam and DIW Berlin

P.S. The full documentation including access to the data can be downloaded here.

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