James Henderson of Oxford Institute for Energy Studies -
The visit of Chinese Premier Xi Jinping to Moscow in May to celebrate the 70th anniversary of the end of World War II could also mark the next stage in Russia’s “pivot to Asia” if, as some expect, the November agreement to complete a second Russia-China gas export pipeline via the Altai region is confirmed.
Russia has already begun construction of a first line from East Siberia that is expected to be in operation by the end of the decade, carrying 38bn cubic metres per annum (cm/y), and the Altai line would allow a further 30bn cm/y of exports, not only making China Russia’s largest individual gas customer but also giving it access to gas from West Siberia that could otherwise be flowing to Europe.
This shift in Russian gas export strategy is a direct result of issues that Gazprom and the Kremlin have seen emerging in Europe over the past decade, and has been specifically catalysed by the crisis in Ukraine and the EU response to it, which has been to call for a diversification by European gas customers away from Russian supply. In the short term this would appear to be a viable strategy, as demand has been in decline and availability of gas supply is set to increase, but over the longer term the EU will need to be aware of the risks inherent in its strategy.
Over the past five years the pressure has been building on Gazprom to adjust its European export strategy. A slowdown in European gas demand due to economic stagnation, rising use of renewables and the availability of cheap coal has combined with the impact of the US shale gas revolution and the high price of Russian gas (linked to high oil prices) to reduce the natural demand for Russian gas on the continent. Gazprom has responded by offering price discounts and contract renegotiations, which generated a rebound in its exports in 2013, but 2014 saw a reversion to the new norm with a fall of more than 10% due to warmer weather a further decline in overall European demand.
However, a more important trend has emerged in the form of EU legislation and legal activity that has called into question Gazprom’s entire activities in Europe. Implementation of the Third Energy Package has effectively caused the cancellation of the South Stream gas pipeline and blocked full use of the OPAL pipeline in Germany, despite the fact that the legislation has yet to be fully sanctioned, while EU Competition Authority investigations into Gazprom’s business practices in a number of Central and Eastern European countries have raised questions about oil-linked gas pricing and anti-competitive behaviour.
Gazprom’s response has the potential to radically alter its export strategy. Firstly, it has switched the direction of its trans-Black Sea pipeline from the South Stream route to Bulgaria and Southeast Europe towards a Turkey-focused route, now known as Turkish Stream. This will allow it to focus on the one growth market for gas in Europe, but has also created the opportunity to catalyse a debate about new delivery points for Russian gas across the continent.
Gazprom has announced that it wants to deliver all the gas that it currently sends through Ukraine via the new Turkish Stream route to a “hub” on the Greek-Turkish border from 2019, when its current transit contracts with Ukraine end. At first glance, this appears to be fraught with legal and operational difficulties.
Gazprom claims that, under the Third Energy Package, infrastructure should be built to collect the gas from its new “hub” for delivery to existing customers. However, a number of customers have responded by stating that they have no desire to receive their gas via a different route. Furthermore any change in the delivery terms could catalyse a complete renegotiation of the contracts in their entirety, and would also mean that any new contracts would have to abide by Third Energy Package rules (the current Gazprom contracts are grandfathered through the TEP until their natural expiry dates).
The consequence of this rather complex set of drivers is that Gazprom appears to have set a negotiation in place concerning its export sales to Europe that is likely to continue through to 2019. Its suggestion of a Turkey-Greece hub seems to be a concession that new delivery points are an option, potentially at the border of Europe rather than at the borders of consuming countries. Indeed, Gazprom CEO Alexei Miller has conceded as much in recent statements where he has declared that: “The principle of our strategy in relation to the European market is changing. The decision on stopping South Stream is the beginning of an end to our operation model of the market [sic] within which we oriented ourselves towards supplying [gas] to the end consumer.”
However, a change in delivery point is likely to mean a renegotiation of contracts that could imply a change in price formula (to hub-based pricing) and a change in contract terms, with delivery to hubs in Europe suggesting that the take-or-pay element in contracts may no longer be needed. It is too early to say that this is a definitive Gazprom strategy, or a series of consequences that seem inevitable if Gazprom continues to pursue its current Turkish Stream plan, but in either case it would appear that there is at least some concession to the underlying principles of EU legislation.
Pros and cons
The interesting question is what the impact of this may be on Europe. In the short term at least, the answer would appear to be a positive one, although this may be less to do with the implementation of the Third Energy Package and more to do with the imminent arrival of a wave of liquefied natural gas (LNG) from the US, Australia and other new potential suppliers. If Russia has chosen to adapt to EU legislation on market liberalisation, then it will be forced to compete with this new gas on the basis of hub prices, creating a buyers’ market in Europe.
However, one consequence may be that it chooses to create a price war and to use the low cost of its gas supply, further reduced by the impact of ruble devaluation, to at least maintain its market share in Europe, and perhaps even increase it in some countries. The benefit to Europe, of course, would be low prices, while the risk would be further reliance on Russian gas. This risk may then be exacerbated as we move towards the end of the decade and into the 2020s as the surge of new LNG supply slackens (in particular if oil prices stay low, undermining the economics of oil-linked contracts for LNG projects). Then Europe could find itself with a reliance on Russian gas at higher prices, while Russia will also have the insurance policy of its growing sales to Asia which can further strengthen its bargaining power. In reality, these eastern contracts should not provide a volume threat, as there is plenty of gas in Russia to serve both markets, but psychologically it may give Russia a stronger hand in any gas-related negotiations.
In truth there is a certain inevitability about this outcome, irrespective of Russia’s export strategy. Europe’s gas import requirements are set to rise as demand gradually recovers and indigenous supply continues to decline. In the face of this reality, Russia will always have a strong bargaining position, as alternatives to its gas for Europe are limited.
So what is the logical response? In reality it is close to the latest ideas presented in the Energy Union concept in February. Not the coordinated negotiating institution supposed to present a unified force against the might of Gazprom, but rather the concept of increasing interconnectivity between European countries, expansion of supply diversification opportunities where possible and implementation of competition and market rules to ensure that a level playing field will allow customers to make choices that can keep prices reasonable.
If, in this world, Russian gas is the cheapest option, then extra supplies will arrive, with Europe having the comfort that they will have had to better the price of the most competitive alternatives and can be replaced by them if any security of supply threat emerges. Furthermore, Europe can also take comfort from the fact that it will continue to remain a vital market for Russia, even as the latter pivots to Asia, as it is unlikely that any country would want to be dependent on as powerful a negotiating opponent as China for too great a proportion of its export sales.
James Henderson is Senior Research Fellow, Oxford Institute for Energy Studies
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