Russia's North Korea Gas Deal
Image Credit: Russian Presidential Press and Information Office

Russia's North Korea Gas Deal

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Only a year ago, the idea of building a gas pipeline through North Korea to bring Russian gas to South Korea would have seemed out of touch with reality. North Korea had sunk South Korean corvette, the Cheonan, and would go on to kill two South Korean civilians when it shelled Yongpyong Island. Yet, in the last few months, Pyongyang has indicated a willingness to be involved in the project, while South Korean President Lee Myung-bak recently agreed to work closely with Russian President Dmitry Medvedev to push the project forward. A project once with extremely long odds of happening is moving closer to reality. But the pipeline still faces obstacles on both the commercial and strategic sides.

On the surface, the pipeline makes sense for all parties involved. The Russian Far East is rich in natural resources, including natural gas, and tapping the South Korean market would allow Russia to diversify its exports away from European markets and place pressure on China in their stalled gas talks. For South Korea, which is dependent on imports for its energy needs, the pipeline promises a supply of natural gas potentially 30 percent below current market prices. For North Korea, which is seeking to prop up its economy much as the Soviet Union did four decades ago with its first gas pipeline, the project presents the prospect of a significant infusion of hard currency from the estimated $100 million dollars in annual transit fees the pipeline would provide. Everyone would seem to have something to gain.

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But despite each party having something to potentially gain from the project, there are still concerns about whether North Korea can be trusted to not use the pipeline to gain leverage over South Korea’s energy supply. Russia has already had a series of disputes with the Ukraine that have interrupted supplies to Europe, and the regime in Pyongyang has a history of being unpredictable.

The political risk from the project can likely be managed. Russia would be responsible for the transit fees, and has indicated that it’s willing to structure the contract so that it is responsible for delivering the gas to South Korea if Pyongyang were to interfere with the pipeline. Additionally, South Korea has proposed running the pipeline to Seoul before it cuts back up to Pyongyang, meaning North Korea would cut off its own gas supply if it were to interfere with the pipeline.

If the consequence of shutting off the pipeline is a loss in revenue and gas for North Korea but no real impact on Seoul, it should reduce the incentives for Pyongyang to interfere with the pipeline. However, it wouldn’t eliminate the prospect of North Korea interrupting the pipeline. North Korea has shown a propensity for demanding wage increases beyond those laid out in their contractual agreement for the Kaesong Industrial Complex, and would likely try to use its leverage to increase earnings from transit fees from the pipeline.

For South Korea, it’s the commercial side of the agreement that may hold the most risk. The pipeline would require Seoul to enter into a 30-year contract for gas supplies from Russia. In the long run, this may not be the deal that it seems to be. Russia’s contracts with its European partners index the price of gas to oil. With gas prices beginning to fall in 2008, Europe saw a 50 percent price difference between the spot price and indexed price of gas by 2009. With new technology bringing more gas onto the market, and the looming prospect that the United States could become a major gas exporter, a fixed priced contract could mean that South Korea overpays for gas over the life of the contract if it’s based on indexed rather than spot prices.

However, despite the commercial risk in the project, the deal could fall apart on South Korean concerns over the transit fees for North Korea. Because North Korea could potentially put the money it earns from the pipeline into its nuclear weapons and missile programs, Seoul has offered to construct a gas power plant and supply gas to North Korea in lieu of Russia providing Pyongyang the transit fees from its earnings. It seems unlikely that North Korea would accept such an offer. The transit fees represent five times North Korea’s earnings from wages at the Kaesong Industrial Complex, and that kind of hard currency stream would likely be hard for the regime to pass up.

Contrary to what some have suggested, the pipeline isn’t a development project for North Korea. Unlike the Kaesong Industrial Complex, the pipeline doesn’t offer the prospect of serving as a platform for greater economic opening and reform in North Korea. It would make little sense for South Korea to enter into a 30-year contract with Russia merely to transfer cash to North Korea. This means the deal has to stand on its commercial merits, especially if it’s to overcome concerns that North Korea will divert earnings from the project to its weapons programs. This may be the hardest hurdle for the project to overcome – making the commercial side of the project viable enough to overcome the potential security risks that could arise from the pipeline.

Troy Stangarone is the Senior Director for Congressional Affairs and Trade at the Korea Economic Institute of America. The views expressed here are his own.

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