Gazprom’s budget constraints drive sales

This is the second in a series of blogs using data from Argus Data and Downloads, which are available to Argus Direct subscribers here.

Yesterday’s blog analysed the recent increase in Russian producer Gazprom’s exports to Europe, despite weaker prices. But it is not only Gazprom that has an unorthodox supply curve — you and I do too.

There are some similarities to the backward bending labour supply curve. People at first try to work more as wages go up, but once income reaches a certain level they will start cutting hours to free up leisure time.

Gazprom’s case is somewhat different, and partly stems from having large investment plans including three huge export pipelines — Nord Stream, Turkish Stream and Power of Siberia.

Let’s assume that a firm has a normal upward sloping supply curve, but also a budget constraint to ensure that it can fund its investments. In this case, the price multiplied by quantity must equal investment and we get the following graph.

The budget constraint will always slope down, which could result in the firm having to increase sales in response to a drop in price.

To get to this point we need to make a few assumptions. It requires the firm to have the flexibility to adjust output, but little or no power to affect prices.

This is mostly the case with Gazprom. The firm’s sales to its marketing and trading arm in the UK — which provide some of its flexibility on sales volumes — are a small proportion of its portfolio and account for considerably less than 5pc of Europe’s supply.

And European gas prices are largely determined by factors outside the gas market —such as coal — particularly during periods when there is ample supply.

Commodity curves

Commodity demand and supply curves are steep, as BP chief economist Spencer Dale has pointed out. But gas demand curves are often kinked, being mostly steep but with a price elastic section where it becomes competitive with coal.

There are actually two price-elastic sections in western Europe, with the UK having a higher fuel-switching price than the continent because of its carbon tax.

Northwest European gas prices have mostly held at levels that bring gas into competition with coal on the continent, which is the larger elastic part of the demand curve. But when it was cold in January and stocks were below average, NBP prompt prices went to the UK fuel-switching price to encourage burning more coal and less gas.

This has allowed Gazprom to deliver more gas to Europe without crashing TTF prompt prices because the power sector has been able to take the extra gas and displace coal.

The Russian firm could lift prices were it to deliver less than nominated to its buyers, but this would require either breaching deals or paying fines and may be detrimental to its income. The elastic part of the demand curve effectively leaves Gazprom as a price taker, within a range around fuel-switching prices.

As Gazprom has little power to set prices, its decisions on Russian exports could become largely dependent on how much it needs to sell to meet its budget constraint — effectively a downward sloping supply curve.

Exchange rates and revenues

There are other factors that come into this, including oil prices and exchange rates.

The rouble often moves with oil prices, which props up Gazprom’s export prices when denominated in its domestic currency. The highest quarterly average TTF everyday prices from the third quarter of 2012 to the first quarter of 2017 were 121pc above the lowest, but the gap was just 71pc when denominated in roubles.

Exchange rate movements can make supply curves much steeper for firms selling in foreign currencies. A depreciation can help maintain a country or a company’s income in its domestic currency even if dollar-denominated receipts fall. This could aid Colombian coal producers over US ones, or countries that rely on their oil exports.

Gazprom has been able to increase its rouble-denominated revenues even when prices slip in euros and dollars.

Lower oil prices could also encourage higher gas exports by countries other than Russia, such as Algeria.

Production cuts by Opec and non-Opec crude exporters this year have allowed Algeria to increase its gas output for sale by using less for enhanced oil recovery. And state-owned Sonatrach has increased its gas exports to Italy after agreeing smaller contractual reductions with Italian buyers in October 2016-September 2017 than in previous gas years.

Budget constraints could also play a role here. A country that receives most of its tax revenues from oil and gas sales would get less if a crude production cut did little to lift prices. This would cause a shift in the budget constraint for a gas producer as the country would need more gas revenues to offset lower oil income.

In this event, the country may have to sell more gas at the same or lower prices to balance its budget.

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