Europe’s natural-gas producers are set to do well in the postderegulation era, but wholesalers, transmission companies, and retailers will see their margins squeezed as regulation and fierce competition bring lower end-user prices. This conclusion contrasts with traditional analyses and with the experience of deregulation in many other energy markets in Europe and the United States. Deregulation usually redistributes wealth from upstream players to distributors in the middle (by way of lower producer prices) and to consumers (in the form of reduced retail prices).

McKinsey’s divergent slant on deregulation emerged from a model developed to analyze the structure, dynamics, and price movements of the European gas market. The model is an important tool for assessing the huge investments being considered in Europe’s highly complex gas industry.¹

The model assumes rapid deregulation, based on a directive that the European Union implemented last autumn, over the next five years. It takes into account the capacities and costs of 500 current and possible gas sources as well as the quarterly demand curves for industrial, power generation, and household customers in 20 regions. In addition, the model specifies the cost and capacity of pipelines and storage throughout Europe.

Unusually, the McKinsey model allows the simulation of scenarios that take into account most of the factors relevant to assessing a business opportunity. These include political factors such as national production caps imposed to conserve resources, regulatory factors such as energy taxes and the varying speed of liberalization in different markets, and commercial factors such as the prospect that gas producers will adjust production levels so that prices match long-term reinvestment costs.

Together, these factors suggest that the average price obtained by a supplier selling gas to wholesalers on a spot market, for example, will remain remarkably robust. This is good news for big European producers like Statoil, Royal Dutch/Shell, ExxonMobil, BP, OAO Gazprom, and Sonatrach.

But deregulation will lead to more volatile prices right through the value chain. Because gas prices are linked to oil through long-term contracts, those prices show little seasonal variation, although twice as much gas is consumed in winter as in summer. But the oil-price link is likely to be phased out with the development of a liquid spot market for gas—a market that could provide a reference price for gas contracts. Seasonal price differences (driven by the cost of storage capacity) of three to four eurocents per cubic meter are likely (Exhibit 1).

Although potential supply far exceeds current European demand—which would suggest falling prices in a deregulated environment—a strong rise in demand is projected (Exhibit 2). Natural gas is the fuel of choice for new and cleaner power plants, and its use is growing rapidly. The International Energy Agency (IEA) estimates that gas will overtake coal and nuclear power as the main fuel in European power generation by 2020.

Much of the new supply will have to come from high-cost sources such as liquefied natural gas (LNG) and non-European sources such as Russia and Algeria, where huge investments in infrastructure are needed for the gas to reach Europe (Exhibit 3). The depletion of existing low-cost Western European fields will accelerate the shift toward more expensive gas in three to five years.

By 2005, the base-case scenario predicts the establishment of a single core European gas market comprising Belgium, France, Germany, the Netherlands, northern Italy, and some Eastern European countries, all linked by a pipeline network. Transmission capacity will be abundant, and prices will tend to move in parallel with spreads set by transmission tariffs. As large gas customers select suppliers under the EU directive, and new gas suppliers get access to transmission networks through third-party agreements, midstream competition between new entrants and former monopolies such as Gasunie, Gaz de France (GdF), and Ruhrgas will become fierce.

Eroded margins will hit incumbents, though their customers—the power generators, the big industrials, and the local distribution companies—will benefit from lower prices. The German midstream industry alone could suffer overall revenue losses of €3.8 billion ($3.4 billion) if deregulation leads to the midstream margins seen in Britain when the gas market was deregulated, in the 1990s (Exhibit 4). As distribution to small enterprises and households opens to competition, margins will also fall in the retail part of the value chain.

In newly deregulated satellite markets—such as Spain, southern Italy, and the Nordic countries, which have been unlinked from the core market because of their limited pipeline capacity—midstream competition may initially be less fierce because it will be harder for new players to enter the field.