Algebra 101: Russia and China unlikely to solve gas equation in St Petersburg

By bne IntelliNews June 10, 2011

Tim Gosling in Moscow -

It seems a simple equation: one of the world's biggest energy producers sitting next door to one of the world's hungriest energy consumers - but Russia still sells a relatively tiny amount of oil and gas to China. The pair is set to have another go at agreeing a gas deal in June, but there's little evidence to suggest they'll make one plus one equal two this time either.

Both Chinese and Russian officials have said that they expect to see an agreement on gas supplies by the time Chinese President Hu Jintao meets President Dmitry Medvedev at the St Petersburg International Economic Forum. Some announcement will certainly be made, but don't expect to hear they're ready to start building pipelines to carry gas into China. For that to happen, they need to agree a price, and they still look stuck on that.

Negotiations on how much Russian gas should cost the Chinese have been going on for more than a decade. The last push came in September, when President Dmitry Medvedev led a delegation to Beijing and claimed the pair moved $60 closer in their pricing demands. There's little evidence to suggest that gap has closed any further in the meantime.

Show me the money

Still, filling in some of the blanks in the terms on the deal has accelerated somewhat as the St Petersberg summit approaches, adding colour to the memorandum of understanding signed in 2006 and the 2009 framework agreement, which targeted the first delivery of piped gas to China by 2015 - a date officials still say they're sticking to.

Russia's deputy prime minister and energy tsar Igor Sechin announced on May 31 that the pair have agreed terms for 68 billion cubic meters (bcm) of gas to cross the border annually for the next 30 years, with 30 bcm carried by the Altai pipeline from western Siberia into northwest China, and the remainder to travel down the Pacific coast. The annual volume is over 75% of the 88.7 bcm China consumed in 2009, according to BP's Statistical Review of World Energy.

Two days later, Gazprom CEO Alexei Miller spoke of, "certain progress" and noted that the Russian company would likely contribute 30% to the cost of building the infrastructure to carry the gas to China, whilst borrowing at least 70%.

"In reality," say Citi analysts, "all major points of the contract have been agreed ... but the key question of price remains." Even on that they point out, the pair has agreed to tie the price to the Japanese crude cocktail, which is the benchmark for much of Asia's LNG trade.

All of which would be fine and dandy - except there's no indication as to what level, relative to that marker, the price will be set - leaving them back at square one.

Reading tea leaves

All of which leaves observers reading tea-leaves. A cancelled trip by a Chinese delegation in late May could suggest that a final deal is in the offing - with the final parameters and big announcement kicked upstairs to the top dogs - although Beijing said it was due to a dispute over payments for oil deliveries.

"It's a relationship between two bureaucratic and unwieldy structures," says energy security analyst Ariel Cohen. "People are afraid of making decisions. It's now become political really, and the pressure is on because of this high-level summit. Does Russia want to offer a compromise and have the achievement of finalizing the deal?"

That may be tempting, but they can't afford to give away too big a concession on price. In the meantime tempers have begun to fray. Beijing has publicly criticized Moscow for what it sees as weakness in the face of Nato's action in Libya, while the pair came close to clashing in court in May in an oil quarrel.

Much was made of the pipeline that began carrying crude to China in January - the first piece of energy infrastructure that physically ties the two economies together. But an argument over price and outstanding debt that surfaced only three months into joint operations took much of the gloss off the achievement, and hardly encourages trust in talks over further infrastructure links.

The tide has turned

Alexei Kokin of Uralsib suggests investors and analysts would welcome some good news on Gazprom, beset as it has been by tax hikes and tariff caps in recent weeks. "Something game-changing would be great," he laughs, "but we're unlikely to get it."

The analyst says Gazprom executives have told him they "expect an agreement in St Petersburg, but not what kind of agreement. We don't know how final it will be, nor how binding, nor the allocation of capex for the infrastructure between the two, and of course most importantly - the pricing."

According to Cohen, the pricing gap in the talks is still around $100 per 1,000 cubic metres, which, as he points out, is "huge!" One suspects that it was Russia offering most of the compromise at last year's summit in Beijing - which took place amidst a global gas glut - to achieve Medvedev's $60 reduction (Cohen claims "China's demands have been unreasonable"), but the boot is now on the other foot.

"The Chinese have been extremely hardball in negotiations with every potential supplier," Cohen continues. "They have a buyers point of view which positions China as a poor country, and since Russia has said it wants to diversify its customer base, they have felt they have the upper hand."

With around 150 bcm per year heading west, Russian gas exports are almost completely dependent on Europe. "The Chinese market has the potential to be crucial for Gazprom going forward," says Pavel Sorokin at Alfa Bank.

However, with the balance of power on global gas markets having swung dramatically since the start of the year, and Chinese demand spiking, officials in Beijing have been speaking much more enthusiastically about sealing a deal in recent weeks.

The IEA said in November that global gas demand may surge by up to 44% in the next 35 years, with Chinese consumption set to expand by 6% annually. The Asian giant's natural gas imports more than doubled in the first quarter of 2011 according to the Beijing-based National Development and Reform Commission.

Russia is understandably in more bullish mood as the tables have begun to turn. A Gazprom spokesman insisted on June 6 that the company will not agree to lower profits on gas piped to China via the Altai route - which could also be sold in Europe. "Until we get the price that suits us," Sergei Kupriyanov stated, "the time frame (for an agreement) is not critical."

"I think the Japanese disaster was the final piece of the puzzle, added to events in Libya etc." says Kokin. "Gazprom feels that the tide has turned and it's not now in a hurry. They sense there's simply no way that China can make do without Russian gas by finding the volumes elsewhere. They've failed in Australia, and the likes of Indonesia and Qatar just can't offer enough."

Turning the screw

The Russian company has been cranking up the pressure in recent weeks with invitations to Japan to join the major gas projects in East Siberia and on the Pacific coast that would feed China under any deal. However, although the Fukushima nuclear disaster will inevitably raise Japan's demand for gas, it's unlikely to find a spare $10bn or more to help build the infrastructure to pipe gas from the massive Kovykta and Chayanda fields 3,500km away in Siberia.

China, on the other hand, can simply dip into its massive sovereign reserves, as it did to find the $25bn it lent Russian state companies in 2009 to build the infrastructure for oil imports.

It's likely another area of the debate delaying the whole deal - after all, to price delivery of a commodity you need to know how it will be transported. "On top of the netback, Gazprom will want to take the capex costs into consideration in the price of the deal," Kokin suggests. "China will likely also offer to actually build the eastern part of the infrastructure. That would keep Gazprom happy - but I'm not sure the Kremlin would like it. They were fairly unhappy with some of the work performed by Chinese companies on the Espo [oil] pipeline, and they have their own ideas about who should do what in East Siberia."

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