You will wonder what Gresham’s law has to do with the gasmarket. Well, the basic principle underlying the ‘law’ has everything to do with today’s gas market. The fundamental observation made by Gresham is that if there are two different prices on one market - e.g. an official one based on convention or rule, and a price determined by market forces - then arbitrage will crowd out those commodities that are priced higher leaving the lower priced commodities circulate in the market. The same phenomenon also explained why during some periods either silver or gold coins left circulation once the official exchange rate deviated (too much) from the corresponding market-based rate. Many comparable examples can be found on other markets.

The simple but fundamental economic insight that on one market one cannot maintain two different prices at the same time is amongst the most powerful economic laws and has universal
application.

In the gasmarkets the emergence of gas exchanges has introduced market conditions bearing some resemblance with Gresham’s case of differently priced commodities in one market: gas traded against spot market conditions on the one hand, and gas priced on the basis of long-term contracting terms (a.o. linked to oil and other primary energy prices) on the other hand. If the same commodity is offered against different conditions, Gresham’s law will apply sooner or later, especially as price differentials increase, the market gets perfect and market conditions transparant.

So, if spot prices for gas are much higher than contract-based prices, traders will stretch their buying capacity of contracted gas as much as they can in order to being able to resell gas surplusses on the spot market against higher prices. This is precisely what, for instance, happened in the Netherlands during 2007, when Gasterra unexpectedly had to declare itself ‘sold out’, much to the embarassement of some traditional clients.

The opposite, however, will happen when spot prices are (much) lower than contracted prices, because then buyers try to get rid of their contractual obligations to buy (‘take or pay’), and will use every opportunity they can get or enforce to renegotiate contract terms in order to be able to buy the cheaper gas on the spot market.

The latter case applies nowadays, partly due to the fact that - quite unexpectedly for many? - the share of unconventional, mainly shale gas in US gas production increased from some 30% in 2000 to about 50% nowadays (probably reaching some 60% by 2030). This rapid development at the supply side, together with much weaker than expected demand (due to the, again rather unexpected, deep credit crisis) has, for instance, expanded unutilised US LNG liquefaction and pipeline transport capacity to over 50 bcm (to possibly further expand, according to the World Energy Outlook 2009, to some 200 bcm by 2015!). No wonder LNG and spot gas prices have come down considerably.

Although US shale gas development is still rather immature and therefore resource estimates rather uncertain, it is not unlikely that the US gas supply curve has shifted ‘to the right’ for a fairly long period in the future, by - according to the MIT ICF Hydrocarbon Supply Model - at least 500 Tcf (against $5/MMBtu prices). This may well exercise downward pressure on LNG and spot market gas prices for at least a number of years to come.

Keeping in mind Gresham’s law, it is hard to argue why such a development would not sooner or later have a long-term impact on contracted gas prices.

Catrinus J.Jepma

President of Energy Delta Institute