Russian gas exports face serious challenges from weak gas demand in Europe, the rise of more flexible European gas pricing systems, the unconventional gas boom in North America, and China’s aggressive hunt for alternative gas supplies. These factors are all dramatically changing the global gas landscape in ways largely unfavorable to Russian exports. Accordingly, the Kremlin faces weighty strategic decisions that will determine whether the Gas Empire can strike back.
Natural gas consumption in Europe and the Former Soviet Union (including Russia itself), which are Russia’s core gas markets, has stagnated for the past decade. Russian gas export volumes peaked in 2005 and have trended downward since. Yet Gazprom – Russia’s monopoly gas exporter – continues to insist on an outdated pricing system that links the price of Russian gas exports to crude oil prices, even though crude oil and natural gas prices are diverging dramatically in many areas.
Oil-linked pricing has kept the price of Russian gas high since global crude oil prices rallied in 2004, massively increasing Gazprom’s revenue and masking the reality that Russia was selling less and less gas to Europe. In 2012, Europe accounted for nearly two-thirds of Russian gas exports by volume and 12 percent of the country’s total exports by value, according to the Russian Central Bank.
Gazprom’s inflexible insistence on oil-linked pricing is keeping the price of Russian gas exports into Europe high, even as competitors such as Norway’s Statoil cut prices and use more flexible pricing systems to grab market share. Statoil is pushing to liberalize gas markets in Western Europe and move the gas pricing regime to one that prices gas against gas in a spot market. It is also targeting the German market, Europe’s second-largest, putting it in a head-to-head competition with Gazprom. Spot market pricing and higher competition between gas sources is Moscow’s worst nightmare given the high costs of the infrastructure needed to bring gas thousands of kilometers from Siberia into Europe and the significant transport costs this journey entails.
In addition to inflexible pricing, Russia has also proven itself willing to use gas as a foreign policy weapon against countries such as Ukraine, with little regard for the disruptions caused to customers further down the pipe in Western Europe. Such heavy-handed actions have catalyzed interest in shale gas throughout Europe.
Government missteps helped prompt major investors such as ExxonMobil, Talisman, and Marathon to pull out, citing regulatory uncertainty and poor results in test wells. Yet in response the Polish government has proven much more humble and responsive than the Kremlin has to gas pricing challenges, promulgating a new set of regulations that postpones the collection of taxes on shale gas production until at least 2020, in hopes of retaining foreign investors.
Bans on hydraulic fracturing in other countries such as France and the Netherlands have also hindered shale gas development. Still, while the European shale gas sector is unlikely to displace gas imports from Russia for at least five years, countries such as Poland and Spain have promising shale gas potential and strong economic and energy security incentives to develop their reserves. Even a partial European shale boom would help force Gazprom to liberalize its pricing system.
For the time being, Gazprom’s stubborn adherence to oil-based pricing endures in Europe because many customers remain bound by contracts. But in Asia, which will drive global gas demand in coming decades, Gazprom’s insistence on an oil-based pricing structure jeopardizes its ability to access the Chinese market, which will not accept prices as high as those paid by European consumers of Russian gas. China National Petroleum Corporation (“CNPC”) sells gas at prices fixed by the Chinese government and would incur serious losses if oil prices rose and increased the cost of gas imported from Russia while domestic gas prices remained fixed.
China does not “need” Russian gas to nearly the same extent as it does crude oil and unless Gazprom moves to a coal-based or gas-on-gas pricing regime, the prospects for reaching agreement with CNPC are doubtful. One option for Gazprom to get China to accept a higher gas price would be to allow CNPC to purchase equity stakes in the fields supplying a China-bound pipeline, as Turkmenistan has done because this would allow the company to offset potential losses from selling gas in China at controlled prices. Despite the mutual economic benefits, however, the Kremlin treats large oil and gas reserves as “strategic resources” that should be controlled by Russian owners, making such a deal structure extremely hard to sell politically.
Amidst the pricing stalemate in Sino-Russian gas negotiations, which have dragged on inconclusively for eight years and running, Beijing is rapidly hooking up to alternate sources of supply. First, China has financed a series of parallel large-diameter pipelines to import Central Asian gas and is likely to add additional China-bound lines as Turkmenistan brings its Galkynysh Field – the world’s second largest gas field – online.
Second, China has six liquefied natural gas (LNG) terminals currently under construction and when they are all online, they will be able to bring in an amount of gas nearly equivalent to Gazprom’s planned pipeline into Xinjiang. Eight additional LNG terminal projects and expansions are on the drawing board, and if brought to fruition would bring in nearly as much gas as Gazprom’s proposed Eastern pipeline that would link the supergiant Chayanda field to China.
Third, CNPC, Sinopec, and their foreign partners are working hard to develop China’s shale gas reserves, which could be as much as 50 percent larger than those of the U.S., the current global shale gas leader. China’s primary shale gas regions are the Sichuan Basin, the Ordos Basin, and the Tarim Basin.
To date, operators have drilled fewer than 100 shale gas wells in China, but activity is likely to ramp up significantly in coming years as capital and expertise seek opportunities. For instance, Shell, a leader among foreign investors in unconventional gas development in China, recently agreed to invest US$1billion per year in Chinese unconventional gas projects, including shale gas exploration and development. Shell says its main Chinese shale gas project, the Yongchuan-Fushun block, would likely begin commercial production around 2015-2016.
Chinese shale deposits tend to lie deeper and are harder to fracture than those in the U.S., and obtaining water supplies for fracking and pipeline access to get gas to market remain challenging. Nevertheless, Chinese firms and their foreign partners combine capital, will, and expertise in a way that makes breakthroughs likely, even if large-scale production does not commence until the 2018-2020 timeframe.
Beijing’s robust political commitment to clean up polluted air in Chinese cities will drive shale gas development and if China and Russia do not reach a gas deal within 12-18 months, the only way Russian gas will get into the Chinese market would be through slashing prices and seeking to displace existing supplies – not an attractive prospect when the pipeline to deliver the gas to Xinjiang from Siberia would likely cost at least US$14 billion.
Despite the time pressure, Gazprom is so far not making serious investments in a truly Asia/China-oriented gas supply system. For instance, the company plans to invest US$15.2 billion in 2013 and 2014 to develop gas fields in Northwestern Siberia’s Yamal Peninsula but only US$1.9 billion in all of eastern Siberia during that timeframe. This investment mismatch is critically important because it signals that Russia intends to sell gas from the same Western Siberian fields to both Europe and China – a scenario China will vociferously oppose because it would allow Moscow to play Chinese and European gas consumers against one another in a quest to force China to pay higher prices for Russian gas.
Instead, China likely wants to see Russian pipeline gas supplies come from geographically “stranded” fields deep in the taiga of Eastern Siberia, in particular the supergiant Kovykta and Chayanda Fields near Irkutsk and in Yakutia, where China would be the priority market. But for this to happen, Gazprom must abandon oil-linked pricing and accept China as the largest and most accessible market for East Siberian gas.
The ball is in Gazprom’s (and by extension, the Kremlin’s) court. A major signal will come later this year when the Russian government decides whether to break Gazprom’s gas export monopoly by granting Novatek, a major Russian gas producer, a license to export LNG from a large terminal it is building on the Yamal Peninsula.
The Gas Empire has the means to strike back – it can revise pricing methods, leverage massive conventional fields whose productivity is something U.S. gas producers can only dream of, and structure creative deals such as allowing China to make a large upfront payment for future gas supplies that funds new fields in Eastern Siberia, or allowing CNPC to purchase equity stakes in Russian fields to offset losses caused by domestic price controls. The question is how many more market share points and rubles Gazprom must lose before it finally adapts to a changing global gas market.
Gabe Collins is the co-founder of China SignPost and a former commodity investment analyst and research fellow in the US Naval War College's China Maritime Studies Institute.