Royal Dutch Shell Group .com

The Scotsman: Burning a hole in our pockets: “WHEN Shell’s new chairman, Jeroen van der Veer, unveils a near 60% jump in third quarter profits on Thursday, City traders will barely bat an eyelid. With oil prices sitting above $50 a barrel, it’s not difficult for an oil company to make money - even if it has had the most traumatic year in its history.” ( 


By Iain Dey

Posted 25 Oct 04


WHEN Shell’s new chairman, Jeroen van der Veer, unveils a near 60% jump in third quarter profits on Thursday, City traders will barely bat an eyelid. With oil prices sitting above $50 a barrel, it’s not difficult for an oil company to make money - even if it has had the most traumatic year in its history.


But while it is the spectacular crude price and its likely impact on the economy that will be given most of the credit for Shell’s performance - as it will with BP’s similarly impressive figures due out two days earlier - surging gas prices are also propping up their profits.


Although crude has been cruising higher for the past few years, gas prices, at times, have been clocking up jet-propelled rises. UK gas prices stood at 12p a therm at the beginning of 2000 but now stand in excess of 55p a therm - and have been as high as 75p recently. Last October, wholesale prices suddenly spiked 80% higher within days. Over the past six months gas has gained a further 30% - prompting almost all the suppliers to pass at least some of this additional cost on to homes and businesses across the country.


According to a report last week from energy consultants Ilex - produced on behalf of BP, Shell and the other member companies of the UK Offshore Operators Association - there is no realistic prospect of gas prices falling between now and 2010. What’s more, if the power companies are to cover these rising costs, Ilex believes household bills are likely to rise by a further 10% to 15% next spring.


Ken Lawson runs a nine-bedroom bed and breakfast in Anstruther, Fife. After totting up the impact of the price hikes which have already been imposed on him by his gas supplier, ScottishPower, and his electricity supplier, Centrica, he is expecting his energy bills to jump by around 40% over the next 12 months.


"Based on last year’s consumption, I’ve worked out that the bills are likely to be somewhere between £1,500 and £2,000 more," he says.


"And there’s no way we can put up our prices to accommodate all of that increase. People just wouldn’t come through the door. It’s basically just something else that reduces your net profits.


"I’ve tried shopping around, but there’s not that much difference between the companies any more. They’re getting a bit like the banks. I tried for reductions, but they just weren’t interested. I could have maybe saved £25, but it’s not worth the hassle of changing supplier. Better the devil you know really."


While there are highly visible factors that have been sending world prices through the roof - such as the war in Iraq - it is a much more complex set of circumstances fanning the flames of the gas price.


There have been allegations of the oil majors manipulating the gas market to boost their profits, but the Financial Services Authority has found no case to answer.


Energy regulator Ofgem is currently investigating contractual arrangements which allowed a handful of firms to hold back 5% of the UK’s gas supplies from the market last year at a time when prices were already surging higher. Now a fresh conspiracy theory has emerged which suggests that the galloping gas prices have been caused in part by the collapse of Enron.


In the early days of North Sea development, gas was nothing more than a waste product burned off on flares on the platform. It was too complicated to get the gas back to shore due to the difficulties in maintaining pressure in the pipeline so the North Sea pioneers focused simply on getting the oil out of the ground.


Whatever the cause, with 40% of the UK’s electricity generated by gas-fired power stations, high gas prices affect more than just the cost of boiling an egg.


When gas was first harnessed for commercial use, the deals struck were all based on long-term contracts. Hence, there was no need for an open market to trade gas contracts as there was no freely available gas to trade. And to avoid further complication, all prices were indexed against the crude price.


Once deregulation hit the industry and British Gas was broken up, competition was brought in and a market for gas contracts emerged. In time this led to the UK gas price drifting away from the crude price and adjusting according to its own spikes of supply and demand. In short, wholesale prices go down in summer when the nation requires less heating and the pipelines and storage terminals are full then rise in winter when the opposite happens.


But because there is such a strong psychological link between oil and gas, traders still tend to push gas prices up when oil rises. In this context, it’s worth noting that the wholesale price for coal has also soared, even though there are no substantial worries about supplies running low.


Since 1998 the UK’s gas market has been tied into the infrastructure in continental Europe through a pipeline known as the Interconnector. By and large, continental gas markets are still controlled by long-term contracts linked directly to the price of oil with much less gas traded openly. This has reflected back on the UK market, partially re-establishing the link between crude and gas prices that previously existed.


But the Interconnector should be having a more profound impact on prices. Theoretically creating a pan-European market should create a more competitive arena where none of the major oil and gas companies can afford to price themselves too high.


In reality it is allowing the firms to chase the highest prices available in Europe - irrespective of what the UK’s needs are.


An Ofgem report published earlier this month showed that when UK prices were rising in October 2003, gas was flowing out of the UK into Europe, exacerbating the problem. In other words, when the UK needed more gas, supply was being pumped from the North Sea to continental Europe through the Interconnector pipeline. Despite suggestions that this was part of a plan to push prices higher, the regulator found a much more straightforward - but equally alarming - reason to support this. Basically, it was even colder in much of central Europe and the storage terminals were empty.


So while the market created by the Interconnector was working for the firms, it didn’t work for UK consumers. There is a stream of additional pipelines planned between the UK and continental Europe which are all due to open over the next few years. Ofgem hopes this will liberalise the market further in favour of the consumer. But the evidence to date does not suggest that will necessarily be the case.


Looking at the movement in gas prices over the past few years it is clear to see that the seasonal spikes became steeper once the Interconnector opened in late 1998. But since November 2001, Ilex believes another factor has been interfering.


Enron was the world’s largest energy trading company. It may have made money from various off-the-books vehicles that obfuscated its true finances, but Enron’s legitimate means of making money was by betting on energy prices.


Put yourself in the shoes of an Enron trader then imagine what you would do if you could see that the forward gas contract for January was sitting at record highs. What goes up must come down. The chances are that you may well ‘go short’ - sell the contracts you currently hold in the expectation that prices can’t go any higher and you’ll be able to buy back the same supplies later for less money.


This is essentially how commodity and currency traders make their money. With no Enron and no one willing to take Enron’s place in this risky business, traders have not been ‘going short’. This has created a market that only wants to buy and doesn’t sell.


Ilex director David Cox says: "A lot of people were happy to see the back of Enron although they did perform a role in the market. If there had been someone going short in the market recently there would never have been those big spikes as there would have been someone to keep that in check - someone selling, putting downward pressure on prices."


Of course, there is one simple factor that has been propping prices in recent months: fear.


North Sea gas supplies are gradually dwindling, with much of the infrastructure now at a ripe old age. Many traders are concerned that if, say, the St Fergus gas terminal near Peterhead hits technical problems, there simply won’t be enough gas to meet the national demand.


Furthermore, there are genuine fears that this winter could be particularly cold. Weather forecasters say we should experience a particularly bad winter every 20 years. The last one was in 1979 - 25 years ago.


Ilex does not believe in the doomsday scenario which would see power blackouts across the country, but the weather is a factor. But once again, the absence of an Enron-type character in the market has left nothing to check the rise. Traders are only concerned with making sure that their companies will have enough gas, which has left them all buying into the worst case scenario through fear of being caught out. With a market only interested in buying, there’s only one way for prices to go - up.


Of course, the fact that wholesale prices are increasing need not be of particular concern unless the energy providers - the likes of ScottishPower and Scottish & Southern Energy (SSE) - decide to pass these costs on to consumers.


Competition in the retail power and gas markets is tough. Nonetheless, when the gas price rises began to hit at the end of the summer, Centrica, the company behind the British Gas and Scottish Gas brands, pushed gas prices 19% higher and electricity prices 15.9% higher.


ScottishPower raised gas prices 17.9% and electricity prices 14.8%, while SSE implemented a more modest 4.9% rise in gas prices and 1.8% increase in electricity charges.


SSE’s exposure to gas prices is slightly less than some of its peers due to its hydro electric projects. But it hopes to win more market share by passing less of the costs on to consumers, possibly encouraging more people to switch.


Interestingly, Ofgem says that with the first round of price hikes over, consumers can save more money by switching supplier than ever before because of the differing strategies in passing on costs. But overall, prices are still increasing.


SSE has promised not to hike prices again this year. This makes it difficult for any of the other providers not to do the same. But if Ilex is right, the situation will come to a point early next spring where the supply companies have no option but to raise prices again.


Note that Ilex is speaking on behalf of the oil majors. When the BPs and Shells of this world say that gas prices are likely to rise, there’s a fair chance they will.

Click here to return to Royal Dutch Shell Group .com