The history of long-term gas sales teaches us much about their resilience to political crises, argue partners at international law firm Wikborg Rein, Dag Mjaaland and Aadne Haga

Soviet stamp dedicated to the Urengoy-Uzhgorod

Asian gas buyers are no strangers to dealing with political risk. Many of them import liquefied natural gas (LNG) from countries that have seen political unrest in the past, like Indonesia and Yemen. They also systematically diversify their supplies and seek to adapt their historical supply arrangements to new realities, in particular in terms of price.

For example, gas buyers in Asia were able to remove increasingly irrelevant official government selling prices for crude oil from their contracts in the 1980s. Today, the main challenge is to adapt to the increasing irrelevance of oil prices to the gas price in general, not least in the light of the Japanese government’s recent initiative to improve third-party access to gas infrastructure and establish traded gas markets, measures that contributed to breaking the oil link in Europe.

The political crisis in Ukraine, not least Russia’s recent involvement, has highlighted the issue of political risk in gas sales. Russia supplies around one third of Europe’s gas, and around half of that gas passes through Ukrainian territory, so there have been some nervous price movements seen in European gas trading markets. Importers have been rushing to reassure markets and customers that supply interruptions are unlikely.

However, long-term gas sales to Europe have shown surprising resilience against political risk in the past, perhaps due to the particular level of mutual dependence between the parties to long-term gas sales agreements, but also to the benefits of increasingly diversified supplies and competition.

European long-term gas sales have been exposed to political risk since the beginning of cross-border sales in the early 1960s, when the Dutch government took an active role in managing the Groningen gas field. The Dutch government’s changing policies, from conservation to increasing sales, and from the invention of the oil-link to liberalisation, have had a major influence on the European gas market.

Politics and pipelines

Political risk increased with Soviet gas exports to Western Europe beginning in the late 1960s and early 1970s. In the 1980s, the Reagan administration imposed an embargo on the sales of gas compressors to the Soviet Union, and attempted to speed up the development of Norway’s super-giant Troll field to limit Soviet exports.

The collapse of the Eastern Block in 1989 and of the Soviet Union in 1991 created new political risks, as much of the pipelines between Russia’s gas fields and the markets of Western Europe suddenly were in non-aligned and independent States. In 2006 and 2009, disputes between Russia and Ukraine reduced transit volumes to Europe.

Long-term gas sales have, however, proven themselves impressively resilient against political risk. The Reagan administration’s attempts at curtailing Soviet gas sales in the 1980s were unsuccessful. The countries of the former Eastern Block quickly transformed their former barter arrangements for Soviet gas into long-term contracts in line with the concepts in Western Europe during the transitional years of the 1990s.

The Ukrainian transit disruptions in 2006 and 2009 were short-lived and had commercial price disputes at their core. Recent improvements of infrastructure and coordination, as well as increasingly diversified supplies contribute to the European importers’ recent reassurances that supply interruptions due to the Ukrainian crisis are unlikely. The German border price dropped below spot prices in late 2013 as buyers and sellers have realigned their relationships in the light of European gas market liberalisation.

Mutual dependence

In a comment to the current crisis in Ukraine, Fridtjof Nansen Institute Senior Research Fellow Arild Moe notes that the mutual dependence created by gas supplies is a stabilising factor. On the one hand, gas supplies may raise opportunities for games and pressure, but on the other hand strong common interests tie the countries together. The parties’ mutual dependence on each other is also a main underlying characteristic of long-term gas sales agreements. Both parties have to make major investments, and the lapse of an agreement will create major challenges for both parties, who may not be able to find alternative partners on short notice.

This mutual dependence forms the background for the peculiar combination of rigidity and flexibility found in most long-term gas sales agreements, where the buyer has a long-term obligation to pay for large volumes of gas which cannot be terminated, but only at a fair price which adapts to changes in the market.

In our opinion, this strong combination of mutual dependence and flexibility has contributed to the gas industry’s ability to weather the political crises of the past, and will contribute to Asian gas buyers’ efforts to update their supply arrangements to new realities, like today’s waning relevance of oil as a competitor to gas.