Gas prices in Asia now stand 50 percent higher than those in Europe and three times those in the U.S. A wave of enthusiasm for market-led, hub-indexed pricing models for natural gas has been sweeping eastward from the U.S. since the 1990s, as more traditional oil indexation becomes unfashionable. Now, it is taking hold in the Asia-Pacific region.

However, it may be the lure of current low prices that are selling hubs to Asian policymakers, rather than an inherent preference for a more volatile pricing model that Asia's geography complicates.

The case for oil indexation

Gas prices have traditionally been set using global oil prices as a reference point. In Japan, the JCC — nicknamed the "Japanese Crude Cocktail" which represents the average price of crudes imported into the country, sits at the base of the gas pricing equation.

This made sense in the 1970s, when gas was still seen as a "poor neighbor" to oil, before we entered the so-called "Golden Age of Gas." The logic was that gas was a substitute fuel to oil in power generation, which justified a strong relationship between the two. But as gas has gained prominence in power generation, and oil-fired power generation has declined, that relationship has started to look weaker.

The market alternative

Both oil and gas are fossil fuels and primarily used for power generation, but each has different characteristics. Natural gas is more expensive and technologically challenging to store in large quantities and transport between regions than oil, and will consequently tread a less smooth path to global commodification.

The most persuasive alternative to oil indexation in finding a price for gas is hub indexation. This is where natural gas is traded over and over again between buyers and sellers at a conveniently located marketplace or "hub."

Prices are set regionally according to supply and demand, either at a physical location a junction between gas pipelines or at a virtual one. By allowing market forces of supply and demand to determine the value of gas, proponents of hubs argue that this model better balances the needs of producers and consumers.

Tracking the development of natural gas hubs

Unsurprisingly, the trend to decouple oil and gas prices in favor of market signals began in the U.S. with the development of the Henry Hub, a confluence of more than 12 interstate pipelines in Louisiana. The Americans were followed closely by the U.K., which came up with its own National Balancing Point (NBP) in the 1990s on the back of aggressive deregulation of markets in the 1980s. It is important to remember that both of these countries had significant oil production at the time of making this transition.

Continental Europe, and particularly Southern Europe, was slower on the uptake. According to the IEA in 2012, 72 percent of gas in Northwestern Europe was hub-based, with only 37 percent in Central Europe and 12 percent in the Mediterranean.

But the EU has put serious efforts behind a push to integrate and liberalize energy markets since 2000, particularly following the adoption of its "Third Energy Package" in 2009, which among other things opens the continent's pipelines up to third-party access, as happens in the U.S. There has been clear momentum away from oil indexation and toward hub pricing, based on gas prices discovered at the most active NBP, TTF (Netherlands) and Zeebrugge (Belgium) regional hubs.

This has been much to the vexation of traditional suppliers like Gazprom and Statoil, which have been doing a nice business in long-term contracts indexed to oil prices. Now they are under pressure to act on the price review clauses in their contracts as customers demand a better deal, and have in several cases bowed to that pressure.

Emerging Asian gas hubs

Asia-Pacific, where demand is set to rocket over the next decade, is clearly the next big game for proponents of natural gas hubs. China needs to fuel its booming industries while weaning itself off heavily polluting coal, post-Fukushima Japan needs to fill the hole left by its nuclear power generation capacity in order to keep its trade deficit under control, and India has stringent environmental targets to meet.

For all of them, an increased reliance on natural gas makes sense.

On a global level, several fundamentals have changed since 2008, which have widened the regional price gap for gas and encouraged demands for hub pricing. Demand in key European markets has fallen as economies have stalled, and simultaneously the U.S. shale boom resulted in a "global gas glut." LNG supplies originally destined for U.S. markets were turned back and dumped on European markets, causing market gas prices to plummet below those stipulated in contracts.

In addition, Russia and Qatar have traditionally dominated global gas markets last year they were responsible for more than one-fifth of global gas production between them. But the broadening base of natural gas suppliers in recent years has threatened their dominance and given greater power to customers to demand changes to the pricing in their contracts.

A "third wave" of suppliers from more than 25 nations, including East African and Asian countries, and of course the U.S., where the first LNG export terminals could come online as early as 2015.

With only modest domestic sources of natural gas currently in production, Asia imports the majority of its gas from LNG. 75 percent of that gas comes from from Qatar. In Japan, which sources most of its LNG from Australia, Qatar and Malaysia, long-term contracts will be up for renewal over the next four to five years, and many are beginning to clamor for change.

Obstacles

Geographically, Asia presents its own problems. In Europe, pro-competition policy and regulation was aimed at allowing gas to flow freely through the region, by allowing third-party access to the pipelines that criss-cross the integrated region. While there is a growing network of terminal and pipelines, Asian geography complicates regional integration by pipeline, raising concerns over the level of liquidity necessary to develop an effective hub.

There is much unresolved debate as to where a regional gas-trading hub would be best located. IEA chief Fatih Birol has suggested Singapore, which is already an oil-trading hub and is geographically central. Japan is seen as too isolated and China too new to the game.

But is market-priced gas necessarily desirable? Although some have branded oil indexation as "old world thinking" and inappropriate for today's market realities, long term oil-indexed contracts appeal because they are tried and tested and allow all parties to manage their risk. As gas becomes fully commodified, both suppliers and consumers are exposing themselves to far greater risk. Ultimately, market prices can go up as well as down.

As tempting as it seems given the current gap between oil and gas prices in Asia, it would be reckless to entirely abandon oil indexation in gas contracts. Suppliers need some guarantee of a floor price to make investments upstream economically attractive and meet growing demand.

Gas exporters worldwide are beginning to take note of the shifts in natural gas dynamics globally, and that they must change with them. But their customers must understand that hub-priced gas may not look like such a good bargain forever.