There are two distinct markets for gas in Europe operating in different time-frames. Although short-term gas trading is now well-established in the UK and at a number of embryonic gas trading "hubs" on the Continent, around 90% of Europe’s gas supplies are purchased under long-term take-or-pay contracts most of which are still priced using formulas linked to the oil market. This is very different from the United States, where gas commodity prices are now widely used in both short- and long-term contracts and Henry Hub in Louisiana provides a reference point for gas trading throughout the US.
There is no intrinsic reason why the European gas market should not develop into a fully-fledged commodity market. Natural gas displays all the necessary characteristics that encourage the development of commodity trading. Gas prices are highly volatile, especially in the short-term, because demand is not only strongly seasonal but also unpredictable, while supply is relatively inflexible, creating the need for an effective storage market to iron out the imbalances that arise both geographically and between different time periods. However, this will be hard to achieve while long-term contracts linked to oil prices remain the predominant source of gas supplies.
Although gas commodity prices act independently of the oil price in the short-term - reflecting daily, weekly and seasonal balancing needs at the different trading locations - longer-term gas prices remain firmly wedded to oil. This inhibits the development of a fully functioning commodity market in gas. Because the oil-indexed price formulas used in long-term gas contracts include a built-in time lag of between six and nine months, the market is able both to gauge the general trend of gas prices and use the oil market to hedge its longer-term exposure in the gas market. As a result, market liquidity is highly concentrated in the near future and there is only limited arbitrage along the forward curve, creating an unusual and distinctive pattern of price behaviour in the IPE natural gas futures market.
The European Commission believes that "fully developed [gas trading] hubs with transparent gas reference prices will be required to secure the full benefits of competition". The major gas producers and key pipeline system operators in turn argue that such a development could undermine long-term security of supply, since significant investments in new capacity - required to meet growing natural gas demand in Europe - could be jeopardised. As things stand, unless the major gas producers and key pipeline system operators are prepared to switch away from oil-indexed pricing in long-term contracts - which currently seems unlikely - or the Commission is able to persuade national regulators to force gas market incumbents to renegotiate their long-term contracts with suppliers in order to create a more competitive market (as happened in the US and UK), a fully-fledged commodity market for gas in Europe will remain a distant prospect.