Energy-on-energy pricing for a Guyanese spot market

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Bobby Gossai, Jr.
Bobby Gossai, Jr. is currently pursuing the Degree of Doctor of Philosophy in Economics at the University of Aberdeen with a research focus on Fiscal Policies and Regulations for an Emerging Petroleum Producing Country. He completed his MSc (Econ) in Petroleum, Energy Economics and Finance from the same institution, and also holds an MSC in Economics from the University of the West Indies. Mr. Gossai, Jr.’s professional experiences include being the head of the Guyana Oil and Gas Association and senior policy analyst and advisor at the Ministry of Natural Resources and Environment.

If the oil companies could have fought harder against the subversions of their markets by spot pricing, assume that they would have. Nonetheless, despite their principled objections and huge power, there was nothing they could have done to halt the spread of spot market influence, over time. It is Marshall’s margin, and very insidious in its operations (Roeber 1996). When a spot market becomes a credible alternative source of or outlet for material, one of the counterparties in a stable priced term arrangement will always be dissatisfied, for term and spot prices are only ever the same infrequently, and by accident: at any moment, either buyer or seller could have done better in the open market. In this situation, as prices become more turbulent, two things happen:

  • The review of prices in term contracts becomes more frequent.
  • The review takes the form of negotiating expectations about spot prices in the coming period.

Price feedback is the third of the four stages in market development. The result is that term prices converge on spot prices. If they do not, the term supply arrangement itself becomes unstable-as happened in oil in the early 1980s, following the second price shock. Finally, and inevitably, the price clause is rewritten in such a way that spot prices are plugged into current supplies via price formulae. The spot price becomes the price driver-which, for the international trade in crude oil, happened in the mid-1980s and is where the industry rests now. It is often assumed that oil is still reeling from something like a revolution, but in market terms, it was a late developer. Other commodities have been routinely priced out of spot and futures markets for many years. It is already happening in some emerging energy markets.

Five factors will determine the rate of change and the final form of the market:

  • The strength of the spot market and the credibility of price reporting services. Nobody is going to link prices in a term contract to dim prices from a thin market.
  • The relationship between term and spot prices. If spot moves either side of term, there is asymmetry of interest between the counterparties and both have an interest in negotiating themselves out of the contract. However, if one has a systematic advantage, as in some contracts, and if the contracts are watertight, why should the beneficiary relinquish his advantage? It cuts the other way too, with companies enjoying the benefits of high-priced take or pay. There is room for negotiation.
  • The rate at which existing contracts decline.
  • The rate at which new contracts are negotiated.
  • The nature of contract terms, particularly the provision for a price review.

There is too much stress in the marketplace for there not to be benefits for both sides in negotiating their way out of inappropriate contracts.

Critical Paths

Markets can be left to evolve organically, or the direction of change can be influenced by skillful interventions. The local market could evolve, with and without intervention.

  1. Start with where the market is now, with a “Bilateral Information Market”. This is an explicit description of a market in which individuals maintain an information network through which they learn about prices, what’s on offer, what’s needed, who’s in play and other gossips. The trade is heterogeneous and sparse, and the market is almost completely opaque, although becoming less so. Such a market is inefficient, but it can be adequate for the needs of certain low-volume commodities. (For example, speciality chemicals and rare earth metals are satisfactorily traded in this way.) Nevertheless, as the pressures on the market grow, as will certainly happen with the energy market, there is a need for more systematically available information and for standard trading instruments.
  2. Hence the growth of price reports-which is already happening without the companies’ needing to act, as a result of reporters’ commercial initiatives. Other forms of price reporting (such as panel pricing, or statistically based pricing systems) would require company initiatives which, if the oil is any precedent, will not be taken.
  3. Standard contracts need to emerge. This is the crucial first step in the development of any halfway efficient market and has to be the result of a conscious company decision. Further development of the market is not possible without such a trading instrument, which allows counterparties to trade in shorthand-everything taken for granted except the names, quantities and prices. In the Brent market (a close parallel) different “standard” contracts coexisted for several years, causing much confusion, but highly profitable for the sharper traders. It was not until the near failure of the market in 1986 that the effort was made to produce standard Brent contract. There are not yet any signs that the gas industry learned from that experience. Several spot gas contracts are in existence, and ‘master terms” are beginning to emerge. On the Brent model, they would bob around together until the weakest break-up, sink and a crisis forces some joint industry action: a wasteful process. However, the Brent failures took place in the daisy chains that resulted from multiple forward trading of contracts. The energy market is a long way from this development. Even if there were an appetite for forward trading, the present time span of trading-typically, involving deals done for delivery within a short period-does not leave room for it.
  4. The development and wide acceptance of a standard trading instrument open the possibility of starting up a forward paper market. This could be like Brent, a “professionals’ market”: informal and lightly regulated, for the most part, resilient enough but with fundamental flaws and, as a result, fragile. It will happen spontaneously in the energy market as the capability for forward trading becomes attractive for covering price and supply risks. (The market that was set up by the Intercontinental Exchange is aimed at this development.) Forward trading was the form explicitly favoured by the oil companies in spite of its intrinsic weaknesses, and it may have some appeal to energy companies today for the same reasons.
  5. The companies could decide to set up a clearinghouse to stand in as counterparty in all contracts, offset positions, take margins and guarantee performance. This was in many ways the obvious way for the Brent market to go but the companies most influential in the market decided that it would suit their purposes better to leave the market as it was. The companies’ reasons, as far as they have been made public, were rational but short-term. This has put a limit on Brent’s capacity to adapt; at a guess, it is past the end of its vigorous life.
  6. Futures are not an alternative to a cleared market per se, but they can be competitive with it for liquidity. The Intercontinental Exchange’s Brent contract might have had a harder time in establishing its position if a cleared market had existed. Yet, if forward markets are seen as a sort of unripe futures, the growth of a modem futures market is the next logical next step and will be for gas. It is also possible to set up a futures market without the intervening steps, as happens in other commodity markets, on the base of a well-established, liquid and transparent spot market.

These comments on a complex situation are necessarily brief. The point has been to highlight the role of the companies in deciding what sort of market they want. (Markets are not usually set up, they grow.) Nonetheless, there are places where companies can intervene, if they have given thought to the sort of market they want.

It is important to look at the present state of the market to see where undirected growth can lead to confusion, manipulation, and wild price fluctuations-all avoidable if the companies had taken the trouble to ask what they wanted and then acted to secure it. Instead, as happened with Brent, short-term, expedient and self-seeking motives (and inertia) rule the day. Three consequences will follow:

  • Companies fold their arms and say, what did you expect? They will be confirmed in their gloomiest expectations and feel justified in staying away-although the best way of securing the health of a market is to use it intelligently.
  • Over-regulation will follow, with dire effects on market function. An unholy coalition of regulators and engineers will introduce complex rules into the void as market surrogates, with the certain outcome that the balancing regime will be cumbersome and inefficient and will invite gaming strategies by the savvier players. There is no doubt that regulation is always a profit opportunity.
  • The way is opened for the few companies that do want to influence events and have the technical depth and management to do so, to shape the market to suit their own purposes. It happened in Brent, and it could happen with other energy markets.

The industry has not as yet missed its chances of creating a spot market that will suit the needs of the majority of players. The result will be, as predicted, pretty chaotic. This is a pity, as an efficient, transparent and liquid spot market will do the work of regulation far better than the regulator can.

When and where will there be a spot market? Are the conditions for its formation likely to be present? This is not a question that has to be asked about Guyana, where the necessary changes in supply structure will likely take place. Signs of change are visible on a number of widely separated fronts: as a result of the new and energy sector and anticipated competition between major suppliers.

There are likely to be radical changes in Guyana’s energy market, analogous to the changes that have occurred in other countries, but it will probably take longer. Supplies of energy priced out of the short-term Guyanese market will become available and the price effects that follow will have the power to subvert existing structures.

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