Coal that’s being priced out of the US market by cheap natural gas is being burned instead in Europe, where it’s cheaper than natural gas with prices traditionally linked to oil.

The resulting pressure is beginning to break down those links, and the differential between natural gas prices in the US and Europe could diminish significantly before any US liquefied natural gas (LNG) can be exported.

That was the picture painted by economists for the US Energy Information Administration’s (EIA) International Natural Gas Workshop in Washington recently.

Wholesale natural gas in the US Gulf Coast has been running in the $2-4 per million Btu range, while European prices have been in the $9-10/mmBtu range as crude oil prices remain elevated. US producers have eyed the European market as potentially profitable if they can get federal permits to export their surplus gas there as LNG, and the first exports may come in 2015.

“US coal exports are hurting European gas more than future LNG,” said Thierry Bros, Senior Analyst, European Oil & Gas, Societe Generale.

US coal exports to Europe increased 29% in the 12 months through March 2012, EIA data show. The increased use of US coal comes because Germany shut so many nuclear plants post-Fukushima, and because European carbon allowances are “too cheap,” said Bros.

While Germany hopes to replace its nuclear capacity with renewables eventually, the shutdown decision means more fossil fuels burned now, and imported coal has been cheaper than oil-linked gas, especially with carbon allowances selling in the $6-7 range.

Proponents of Europe’s carbon cap-and-trade system had expected allowances to cost more like $40 now, but allowances are in surplus due to political decisions and to recession-led reductions in electricity use.

Europe is supplied by a combination of North Sea gas, where fields are in decline; pipeline gas from Russia; and LNG from Africa and the Middle East. Natural gas has long been priced on a basket of refined products, which usually rise or fall with the price of crude oil.

Customers Call for Greater Hub Indexation

Recent high crude prices have pushed natural gas prices unusually high, and major distributors who can’t pass on the prices are losing significant money, said Howard Rogers, Senior Research Fellow, Oxford Institute for Energy Studies.

That’s led to customer rebellion, just as the recession has sapped gas and electricity demand.

“Germany is the combat zone,”said James Jensen of Jensen Associates, with powerful utilities E.On and RWE wrestling down gas contracts with Russia’s Gazprom. “Russia is trying to hold the line on the oil linkage,” Jensen said, but is having to accept some concessions, as is Norway’s Statoil which markets North Sea gas.

Jensen said northern Europe is moving to competitive hub pricing, and southern Europe may follow.

Bros said 58% of natural gas was still oil-indexed in OECD Europe in 2011, but he expects that by 2014, less than 50% will be, increasing pressure to shift all trading to indexation on hub market prices.

“Confidence in the hubs is improving,” said Rogers, pointing to growing liquidity at the UK’s National Balancing Point and the Dutch TTF hubs.

A major unknown for potential US LNG exports is Russia’s response, said Rogers. Even with a change in pricing basis, Russia will remain dominant, supplying a quarter of Europe’s gas.

Russia could choose to dump gas in Europe and undercut the LNG market, depressing prices when US supplies arrive, said Rogers, or it could cut back deliveries and try to prop up its price.

Bros warned that gas consumption in the last couple of years has been consistently below previous usage, with Gazprom holding 11 billion cubic meters of gas that customers contracted for but on which they couldn’t take delivery.

Bros said demand looks likely to stay low, since the big growth in natural gas use in the past decade, and the biggest contractions now, are in Greece, Portugal, Spain and Italy, the nations worst hit by the ongoing economic crisis.

This is the second article in a three-part Breaking Energy series on the potential impacts US LNG exports could have on domestic and international natural gas market dynamics.