Nicholas Watson, Ben Aris, Tim Gosling and Rob Whitford -
The growing confrontation between Russia and the West ranges across many fronts, none more significant than in an area of rural northwest Bulgaria, where in October workers began welding pipes that will feed a natural gas compressor station near the settlement of Rasovo. However, work here on the Bulgarian section of Russia's giant South Stream gas pipeline project has now stopped – a victim of the EU's decision to punish Russia for its annexation of the Ukrainian province of Crimea, as well as its growing frustration with the Kremlin's meddling in the east of that country.
Yet in keeping with the to-and-fro of this controversial energy project and the longstanding Russian policy toward Europe of divide and rule, just three weeks after the EU told Bulgaria to halt work on the pipeline, Russian President Vladimir Putin on June 24 popped up in Vienna to oversee the signing of an agreement between the Russian state gas exporter Gazprom and Austrian state energy firm OMV to begin work on an Austrian section of South Stream, which will terminate at the Baumgarten gas hub, 70 kilometres south of the Viennese capital.
The crisis in Ukraine has galvanized both sides over South Stream, especially now that the Russians have raised the stakes by yet again cutting off gas supplies to Ukraine in June after Kyiv failed to pay off its huge overdue gas bill.
For the West, South Stream – which will eventually carry up to 63bn cubic metres of Russian gas a year (cm/y) under the Black Sea, then westward via Bulgaria and Serbia, then up through Hungary and into the heart of Europe – is regarded as a major security threat. It will entrench European states' reliance on Russian gas for decades, argues Brussels, while also neutering any remaining influence Kyiv has over its giant neighbour because it will effectively end Ukraine's status as the main transit nation for Russian gas into Europe.
For Russia, it is exactly those reasons that make this pipeline so appealing. Together with its Nord Stream pipeline, which carries 55bn cm/y under the Baltic Sea into Germany, the two pipelines form a kind of pincer movement on the EU gas markets. The military allusion is not misplaced; this is war by other means.
Hard habit to break
Europe's biggest problem, as our cover so vividly portrays, is that it is addicted to Russian gas. Europe relies on Russian gas for about 30% of its annual needs, some 40% of which is transited through Ukraine. In 2013, Russia increased gas exports to European markets to a record 162.7bn cubic metres (cm), up 16% from 2012 and exceeding the previous record of 160bn cm set in 2008.
And many argue that will probably rise further, even as Europe raises its efforts to secure alternative supplies to wean itself off Russian gas. Europe is looking to develop its own reserves of unconventional gas like shale gas, while importing more liquefied natural gas (LNG) from producers in the Middle East and Africa, as well as start LNG imports from the US (in March the US Energy Department conditionally approved its seventh LNG export terminal). Europe is also looking to the start of new gas supplies direct from Azerbaijan from 2015, which won't cross Russian soil. Some 10bn cm/y will come to Europe from the second phase of Azerbaijan's BP-led Shah Deniz gasfield, which will flow through Turkey via the new TANAP pipeline and then feed into the Trans Adriatic Pipeline (TAP) being built. This pipeline will start in Greece, cross Albania and the Adriatic Sea, and come ashore in southern Italy, allowing gas to flow directly from the Caspian region to European markets for the first time.
However, analysts warn that such alternative sources of gas, if and when they do arrive, will not solve the fundamental reliance that Europe has on Russian gas, which has been built up over decades. "That isn't something you can change overnight," notes Tina Fordham, senior political analyst at Citigroup, "but at a political level you will hear a lot more focus on reducing that dependence."
Russell Gamadia of KBC Process Technology points out that European demand for gas is set to peak in the medium to longer term; South Stream's developers are banking on long-term European gas demand rising by around 160bn cm over the next two decades from the 462bn cm consumed in 2013, while conventional European gas production continues falling and no significant shale gas comes on stream. "How are we going to supply that? If we look at the LNG market, things are very tight there. While in Asia there is not a real alternative to LNG, European infrastructures are already there and Russia has the gas," he says, concluding that Europe's reliance on Russian gas is set to increase. "Ultimately, when you consider all these facts, Europe’s gas deficit is clearly increasing."
That's music to the ears of Russia, which has assiduously played on fears in European capitals about gas supplies petering out, leaving Europe shivering in the cold. This has allowed it to pick off certain countries who put their own energy security needs above those of the bloc, thus preventing a unified voice coming out against South Stream. This divide-and-rule strategy is one that the Kremlin has mastered over the years. But will it continue to work?
Members for and against
The latest country to come aboard the South Stream express is Austria, joining Bulgaria, Serbia, Slovenia and Hungary in agreeing to host the pipeline. Other European countries involved in the project are Italy, France and Germany, through stakes that Eni (20%), EDF (15%) and Wintershall (15%) hold in the consortium developing the pipeline. Gazprom holds the remaining 50% stake in the consortium.
On June 24, OMV finalized a deal with Russia's Gazprom to build a branch of South Stream through Austria. "This investment decision is an investment into the security of the gas supply for Europe," OMV CEO Gerhard Roiss told a news conference after the signing.
This represents a remarkable about-face on South Stream by the Austrians, since OMV, 31.5% state owned, was until recently the biggest and most enthusiastic member of the consortium behind Nabucco – the EU's grand scheme (folly?) to build a giant pipeline that would bring gas from the Caspian, Central Asia and the Middle East into Austria's Baumgarten gas hub. That over-ambitious plan is now dead, replaced by the smaller but more realistic TAP pipeline.
Planning on the Hungarian section of South Stream is also well underway. Hungary too was once a big backer of Nabucco, but now is firmly in the Russian camp. South Stream fits well with the government's recent controversial policies toward the wider Hungarian energy sector. Lower gas prices stemming from South Stream would help the drive to push down Hungary's energy costs to the lowest in Europe. Regulated pricing has been slashed by 30% over the past 12 months. That has helped push foreign investors out of the market, with the state snapping up utilities via its new "national champion" MVM. The prime purchase was of Hungary's main importer of Russian gas from E.ON last year.
In contrast to many EU states, Budapest will worry little about provoking a clash with Brussels. In fact, it would likely prove a bonus for Prime Minister Viktor Orban, who has made the "defence" of Hungarian sovereignty a major plank in his domestic political popularity.
Serbia is not in the EU, though at the beginning of this year it began negotiations to join the bloc, so it doesn't want to threaten those talks. Yet First Deputy Prime Minister and Minister of Foreign Affairs Ivica Dacic said in June that building the pipeline is a "national priority" for the government.
Currently paying amongst the highest prices in Europe for Russian gas, Serbia argues the pipeline will bring both transit fees and lower gas prices that will help transform the economy. The national oil and gas company NIS – 51% owned by Gazprom's oil arm, Gazprom Neft – already invested €490m into the project last year after the ground work construction was begun and the total spending is planned to reach some €2bn. And the Russians are going make it easy for the Serbs by lending them the money to pay for the construction. This was planned to start in July and the first contracts are due to be signed after the Russian loan details are squared away.
However, the whole project for Serbia is now in jeopardy after the US and EU leant heavily on Bulgaria to halt work on South Stream, which Bulgarian Prime Minister Plamen Oresharski duly did on June 8 after being browbeaten by a group of US senators. Serbia can't build its stretch of the pipeline until Bulgaria, the primary transit country for the pipeline, finishes its section.
South Stream is popular amongst politicians and the public in Bulgaria, but that wasn't enough to help Oresharski resist western pressure to stop work on it. For his trouble, he's probably lost his job: halting South Stream work managed to upset both his allies and the opposition at home, which resulted in snap elections being called for September or October.
On the face of it South Stream is certainly in Bulgaria’s interests. It removes the vulnerability of its gas supply – 100% dependent on Russia – to a Ukrainian crisis, which has been the cause of actual interruptions several times in the past. In the short term it would create jobs – 5,000 of them according to Energy Minister Dragomir Stoynev, who also reckons it would have boosted this year’s otherwise lacklustre GDP growth to 2%. It would bring in big amounts of foreign direct investment at a time when quarterly investment is measured in the low hundreds of millions, not billions, of euros. It comes with gas-price sweeteners. And transit fees, via joint venture dividends, that will boost the budget. So what’s not to like?
The problem is the European Commission raised concerns that the contracts for the Bulgarian portion of South Stream were not awarded transparently; worse, the main contract was given to a consortium led by Stroytransgaz – a Russian company owned by Gennady Timchenko's Volga Group that is a target of US sanctions. One striking feature of the situation is that when government officials are called to account on the matter, they keep on referring to details that can’t be revealed because they are commercial secrets.
There’s also concern about who’s going to pay for what’s generally supposed to be a very inflated price (€3.5bn) for the Bulgarian bit of the pipeline. Stoynev’s position is that the pipeline won’t cost the Bulgarian taxpayer a single lev (at the time of last November’s deal he explained a scheme which offset some rather moderate debt against income from the pipeline, so there is no burden to the budget). In June, however, the opposition Reformist Block has been saying that it has seen a recently signed contract involving a €620m loan on (unspecified) unfavourable terms to cover the Bulgarian contribution to construction. Generally, there’s some fear that Bulgaria may find itself in a similar situation to that with the long-planned Belene nuclear power plant – ie. saddled with debts and lawsuits for a stalled project that it’s only half-committed itself to.
Analysts point out the EU has got a bit more leverage than it used to have over Bulgaria. The erosion of budgetary cushions built up during the boom years means the government and its budget is a lot more vulnerable to hold-ups and suspensions of EU funds than it used to be. Indeed, the EU has recently frozen funding for two regional development projects in Bulgaria after criticising the management and control of the projects, causing dismay in Sofia.
The probable winner of the snap elections, former PM Boiko Borisov's Citizens for European Development of Bulgaria (GERB), on whose watch the JV for the Bulgarian bit of South Stream was signed, has come out in defence of South Stream, though he said it must comply with all EU laws. And it is here that Brussels can apply most leverage on the pipeline's EU supporters as well as the Russians.
The EU has strict rules about energy infrastructure allowing so-called third party access, which is a crucial factor that allows competition in energy markets to develop. If, say, an owner of the electricity grid or gas pipe won't allow other producers of electricity or gas access to the distribution network, how can competition exist and grow?
The EU allows exemptions to this rule in order to allow network infrastructure builders to recoup the vast construction costs, but this must be agreed through tough negotiations with the European Commission. And Brussels has been in an uncompromising mood with Gazprom for some years now.
In September 2012, the Commission launched a formal investigation into alleged price fixing and monopoly practices at Gazprom, which could result in massive fines as well as subsequent lawsuits from individual countries. On March 26, the office of Joaquin Almunia, the European commissioner responsible for competition, said the antitrust investigation is ongoing and a completion date impossible to predict, but the timing would depend "on whether Gazprom will offer remedies that fully and effectively address the Commission's concerns," his office said in a statement. Russian delegations have reportedly visited Brussels several times this year, though details of the talks have been kept under wraps.
Certainly Gazprom has already made concessions to several European states over the past year, agreeing to big price cuts for countries like Poland, while hardball tactics by Lithuania over enforcing the EU's third energy package pressured Gazprom into agreeing on June 12 to sell its 37.1% stakes in Lietuvos Dujos and gas transmission system operator Amber Grid to Lithuanian state enterprises.
In a sign of its frustration, Gazprom in May complained about the EU's double standards in applying the rules to the offshore section of the pipeline that lies in Bulgarian waters, saying it is an import pipeline and so not part of the EU’s transmission grid, which would be subject to competition law. In a document explaining its legal position, Gazprom said the EU was applying rules to penalise Russian gas that it did not apply to the Greenstream, Maghreb, Transmed and Galsi pipelines that import North African gas into Spain and Italy. "The South Stream offshore pipeline in this regard… does not fall under the scope of the third energy package," the Gazprom document said.
Then there are the necessary permits Gazprom needs to build the pipeline across EU territory. It has the permits for the section of the pipeline that runs under the Back Sea, but it hasn't yet secured them for the whole onshore section.
What this means, Jonathan Stern, a fellow at the Oxford Energy Institute, told Petroleum Economist, is that Gazprom and its partners are likely to build just two of the four lines, which would be enough for only around 10bn cm/y of gas to flow through South Stream from around 2020. Gazprom wants the gas to start flowing in 2015, and full capacity of 63bn cm/y to be reached as soon as 2018.
Such a scenario of low gas volumes feeds into another big problem that Gazprom has to contend with: South Stream's economic viability.
Pipelines are hugely expensive, which necessitates getting as much gas down them over their lifetime in order to cover the construction costs. South Stream is especially expensive, given the offshore section will reach depths of up to 2,200 metres beneath the Black Sea – around six-times deeper than Nord Stream under the Baltic Sea – while the pipes nearer to the shore will be coated in concrete for more stability and protection. The whole project is built to last 50 years.
In December, estimated total costs for the pipeline, including the upgrades needed on the Russian side of the border, more than doubled from initial estimates to around €30bn. By the time it's completed, inevitably that will rise further. To make all that money back, Gazprom has to send enough gas down the line over many years.
Some pundits say that the Russians probably could make South Stream pay even with granting the EU's hallowed third-party access – for example, by allowing Russian independents to use it and by giving Azerbaijan the opportunity to use their internal grid for transit purposes (though with TANAP being built through Turkey, it probably won't take up the offer).
If the Russians manage that, plus the EU as a whole keeps up its insatiable appetite for gas while its member states continue to put their own interests above those of the bloc, then South Stream – against the odds at a time when Russia's standing in Europe couldn't get any lower – might actually get built.
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