The main international confrontation of the XXI century is between hydrocarbon despotisms and pipeline democracies.

2011/04/05

Novaya Gazeta

Yulia Latynina’s analysis backs up Viktor Pelevin’s statement. What is really going on with Russian natural gas?

The Kremlin’s natural gas policy has undergone a massive change since the time of the economic crisis. Instead of threatening to unleash its “energy weapon”, the Kremlin has started selling gas assets, and instead of striving to conquer the American market, it is seeking to bring domestic natural gas prices in line with those internationally.

The twists and turns of that policy have an uncanny connection to the goings on inside the Kremlin. Ever since Alexei Miller, a Putin ally, has been appointed as the head of Gazprom, the natural-gas giant’s name and the name “Putin” and vice-versa are inseparable. Gazprom’s history in recent years is one of how the Russian elite is getting richer, how it behaves and what it thinks of itself.

Nord Stream

The turning point in Putin’s policy was the signing of an agreement to construct the Nord Stream natural gas pipeline during his visit to Germany in September 2005. Nord Stream is not Putin’s brainchild, as preparations for it began back in 1997.

Shortly after the agreement was signed, however, the tone of Russia’s gas policy changed dramatically. As early as the autumn of 2005 we were being told that Russia is an energy superpower and that natural gas is our energy weapon.

It was a strange way of looking at things because what is now called an “energy superpower” used to be called a “resource appendage” of the Western countries. (“What is the difference between a guinea pig and a rat? A guinea pig has a better image.”). As for the energy weapon, imagine that you come to a sports shop and buy a baseball bat. Of course the shop will sell you the bat because the sellers assume that you are going to play baseball with it. But if you start swinging the bat and shouting, “I’ll smash your heads to pieces,” your chances of being sold another bat are slim.

Over the following years, Putin’s foreign policy was basically tantamount to demanding that the West sell Russia more baseball bats. But it was all in vain: attempts to buy natural gas networks in the United Kingdom, France and Italy were a dismal failure.

In 2006-2007, purchasing natural gas networks was not Gazprom’s obsession, but rather Russia’s foreign policy’s in general. In any meeting with any Western president, Vladimir Putin repeated the same mantra: “We will give you access to our [gas] fields and you give us your gas pipelines.”

The idea behind it was that if Western companies wanted to invest in the Shtokman gas and condensate field, the world’s largest, they should be prepared to give Russia a share in their gas pipelines. Upon closer inspection, Putin’s business proposal was very strange.

Imagine that a shop owner who sells you beef says: “Listen, I raise this beef on my farm myself and my farm is in need of repairs. Would you like to invest in my farm?” The client agrees, only to hear that “I’ll let you invest money in my farm if you give me half of your kitchen and your wife.”

The outlook for Shtokman’s development remains very murky. The deposit means having to venture out to the Barents Sea, where you have ice fields and semi-liquid silt deposits on the sea floor, and any pipeline laid in that silt may be pierced by a sunken ice flow. There are no other fields like Shtokman in the world. Alexander Nazarov, an analyst with the investment company Metropol, says Shtokman gas would cost about $250 per thousand cubic meters (for comparison, shale gas costs about $170).

Selling Shtokman on Putin’s terms, “in exchange for networks,” failed. Eventually, an agreement on its joint development with Total was signed in February of 2008, but shortly afterwards the financial crisis and shale gas practically wiped out its chances. Shtokman’s official website has pristine, beautiful landscapes that could serve as adverts for a cruise in the Norwegian fjords, not for an industrial project.

Putin’s foreign natural-gas policy revolved around three projects: Nord Stream, South Stream and Shtokman. Nord Stream was signed in 2005, but it was not until 28 July 2010 that its first line emerged from the Baltic Sea on the Russian end. The cost of laying 1 km of the pipeline on the Russian side turned out to be three times more expensive than on the German side (5.8 million euros versus 2.1 million euros). South Stream was signed in 2007, but has yet to be implemented. The construction cost is estimated at 15, 25 and even 40 million US dollars. Shtokman was signed in 2008, and the launching of the project has been officially postponed until 2016.

For the sake of comparison, China signed an agreement to construction a gas pipeline with Turkmenistan in 2006. The gas pipeline is already in operation, with 2000 km of pipeline built through the mountains having cost just $2 billion.

The Kremlin’s foreign natural-gas policy was a bizarre combination of greed, shortsightedness and megalomania. It saw Europe as a territory to be colonised by surrounding it from both sides with powerful natural-gas strikes (with North and South Stream), the assumption being that the Kremlin’s profits would be paid for by the dumb aborigines who would let Gazprom have their energy networks and pay for Shtokman.

There was just one catch in this grandiose geopolitical plan of natural-gas colonisation: Europe chose not to take part in it. Meanwhile, the deregulation of Europe’s gas market turned the formidable North and South Streams (even if the latter is built) into just another alternative route for supplying Europe with natural gas.

Price and production

There was yet one more difficulty arising with Russia pictured as a “natural-gas superpower”. In 2008, Russia indeed produced more gas than any other country, ie 640 billion cubic metres. But there was one other power that produced almost as much, or 580 billion cubic metres: the United States, which for some reason never claimed the status of “energy power number two”. Even Canada,which sold about 300 billion cubic metres of gas to the United States in 2008, did not entertain any plans to use its “energy weapon” to bring the United States to its knees.

Furthermore, in Russia what matters is not the total amount of natural gas produced, but the amount of Gazprom-producted natural gas. The natural gas other companies extract often is not allowed access to pipelines and has to be burned. In 2008, Gazprom produced 550 billion cubic metres of natural gas.

And that is not all. It is not only about the volume of output, but the amount of money earned by the sale of natural gas. The amount of money American producers earn is easy to add up. All the natural gas in the United States is sold at spot prices on Henry Hub, and in 2008, the average price was $323 per thousand cubic metres. At peak times it even rose to 700.

Calculating Gazprom’s earnings is not so easy. In 2008, more than half of Gazprom’s natural gas (287 billion cubic metres) was consumed in Russia at a price of between $50 and $80 per thousand cubic metres, 96 billion cubic metres were sold to the neighboring countries at between $100 and $200 per 1000 cubic metres, and only 150 billion cubic metres went to Europe at the staggering price of between $250 and $400.

According to Gazprom, its proceeds from the sale of natural gas to Europe amounted to $47 billion in 2008. One can easily add up that during the same period the gross earnings of the American “Gazprom” (consisting of thousands and tens of thousands of owners of individual wells) amounted to an astronomical $187 billion.

The situation changed after the crisis. First, natural gas prices plummeted, and second, because of high prices the United States has been steadily building up shale-gas production.

As a result, in 2009 the United States leap frogged Russia in gas production (620 billion cubic metres to Russia’s 575 billion).

Simultaneously, the price at Henry Hub dropped, and in September of 2009 natural gas prices in the US domestic market hit an all-time low, dipping further than domestic gas prices in Russia, “the energy superpower”, at $70 versus $80.

The main factor that diminished Gazprom’s share in the European market in 2009 was its reluctance to face market realities. The state-owned giant was held captive by its fantasies of natural gas colonisation and a “gas blitzkrieg” and insisted on its clients buying natural gas under long-term take-or-pay contracts at $350-400 [per thousand cubic metres]. With Algerian natural gas cost $80 in Holland, the client chose the minimum envisaged under the contract and bought the rest at market.

In 2010, Gazprom’s decline, if anything, accelerated. In 2009, its export to Europe dropped by 30% compared with 2008, while the overall gas consumption in Europe dropped by 5%. In 2010, Gazprom’s exports dropped by 25% compared with 2009.

If you look at fourth-quarter Gazprom’s natural-gas consumption figures for 2010 compared with the same period for 2009, then you see a 25% drop in Germany, 49% in France, 25% in Greece, 39% in Hungary and 44% in Slovenia.

Gazprom’s share in the European market dropped from 39% in 2000 to 27% by 2011. Unlike its European market share, Gazprom’s costs continued to rise. According to Nikolai Korchemkin (eegas.com), costs increased from $4 per 1000 cubic metres in 2000 to $23 in 2010.

Domestic market as the main reserve

As late as 2008 Gazprom’s main source of bumper profits was supplies to Europe, now we see an odd situation: the highest prices are gleaned from Russia’s neighbours. Thus, in the second quarter of 2010, Germany was paying Gazprom $150 per thousand cubic metres, while Estonia and Ukraine shoveled out $235.

Ukraine and Estonia are two countries bearing the brunt of the “energy weapon” and will continue to do so only until they find alternative sources. This then brings up another question: how will Gazprom, with its staggering 90 billion dollars in debt, make up the difference?

There is only one market where Gazprom will always be able to act like top gun, and that is the domestic market. According to Gazprom’s plans, domestic natural gas prices as of 1 January 2014 will be equal to its export prices minus export duties and transit costs. It looks as if the plan to equalise the domestic and foreign prices will be fulfilled ahead of schedule. Domestic natural gas prices in Russia increased by 30% over 2010 and will increase a further 15% in 2011.

It is notable that official releases do not mention the exact price that Russian consumers now pay for gas. While during the tumultuous times of the 1990s, when there was no political hierarchy, Putin or palace in Gelendzhik [palace built in South-West Russia on the Black Sea, allegedly with tax-payer money for Vladimir Putin’s personal use], Gazprom bragged about its low domestic tariffs of $20 per thousand cubic metres, now a Google search will only tell you that “tariffs will increase by 15%”. But what is the absolute figure?

The absolute figure does not exist because the domestic market is not transparent, tariffs vary from region to region and may even be different for two neighbouring factories, prices are different for gas supplied within the quota and over and above the quota, plus connection costs, etc., but on average prices are already in the neighbourhood of 2700 to 3900 roubles per thousand cubic metres. The figures are comparable to the United States domestic market and are about half of the European market: in socialist Europe (with the exception of the United Kingdom) enormous duties and levies are also charged inside the natural-gas network.

All this amounts to a failure of the “gas blitzkrieg” and a collapse of Russia’s policy of natural-gas imperialism. In country that has as much energy resources as the Sahara desert has sand, natural gas is coming to cost more than in the Himalayas. President Dmitry Medvedev, best known for his Twitter feeds, is beginning to grumble about inflated energy fees. Can’t you guess why, Mr President? Don’t you know the price of natural gas?

Energy networks and chemical plants

Let us now go back to where we started and ask one question: why was Putin so anxious to buy the energy networks? The answer is that energy networks mean hard cash.

The European gas market is in face opaque and entrenched with costs; the wholesale price for Russian gas at the Baumgarten hub is $250, while in the pipeline network it is $500. For whom does it make a difference? It makes a difference for the energy network companies, which are typically state-owned and often quietly finance the ruling political party.

Now an even more important question: why was gas so expensive in the United States and why is it that the US, with its warm climate, consumes twice as much natural gas than Russia with its cold climate? The answer is that in US gas is primarily a raw material for the chemicals industry. Considering the prices for 5th or 6th-level chemicals of the value added chain, the input price of gas is not all that important.

That is an important point to bear in mind. The obvious strategy for any natural-gas power is not to strangle the foreign consumer with its gas pipelines, not to sign a cartel agreement with other producers, but to develop the chemical industry.

This is the market recipe for obtaining multi-billion dollar profits. This is the road map for gas-rich Russia’s natural modernisation. Even China, which has sparse natural-gas resources, invests $5 to 6 billion every year in its chemical industry. Even Iran and Saudi Arabia – not the brightest economic stars – have adopted ambitious programmes to build chemical plants. Russia under Putin has not built a single chemical factory and has not even tried to do so.

The plans for turning Europe into a natural-gas colony were a paranoid combination of a St Petersburg robber-baron capitalists’ naïve dream of the early 1990s about cash spouting from the natural-gas networks they would control and the nostalgia of Soviet lieutenant-colonels for using gas as a weapon against open society.

It is hard to say whether the “gas blitzkrieg” plans went so far as foresee seizing political power in Europe through capturing natural-gas networks, but in any case these plans indicated an absolutely oblivious knowledge of market laws. The Kremlin forgot that natural gas is but a commodity and if there is demand for a commodity, supply cannot be far behind. Supply appeared in the shape of liquefied and shale gas, and although the latter has a much higher cost, it acts as a price cap.

The plan to turn Europe into the Kremlin’s natural-gas colony and to derive excess profits failed because it was doomed to fail. Now all Gazprom’s staggering costs (including the 7-fold growth in production costs, astronomical prices for laying pipelines and the $45 billion spent to buy non-gas assets) will be paid by the domestic colony, ie the Russian domestic market.

The consequences for the regime will be dire.

Yulia Latynina

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