Eurasia Dialogue: Security for Demand for Russian Gas

Last Friday in Moscow was held a conference entitled "Eurasia Dialogue: Security of Demand for Russian Gas." Disagreements occurred sometimes amongst experts but this is why it was called a dialogue. One thing is sure anyway: times are challenging for Russian gas exports to the European Union and the EU natural gas market legal and political moves are matters of concerns for Europe's main supplier. This article presents speakers' arguments and comments. 

Let's start with Dr. Tatiana Mitrova, Head of World Energy, Skolkovo business school Energy Centre. She opened the discussion by talking about the challenges posed by competing fuels. European low demand (EU demand fell by 9% in 2011) and its diversification policy (liquefied natural gas, pipeline diversification), the pricing policy in continental Europe are not good prospects for Russia. Indeed, the European demand has been stagnating for almost a decade now and this is not related to the economic downturn. Reasons for this are notably an aging population, more energy efficiency, more renewables, and a greater competition with other fuels. The future of gas in the EU seems surrounded by uncertainty, which is bad for suppliers but could also turn bad for European consumers. A good illustration is the electricity sector: not long ago gas was considered as an attractive energy for generating electricity. It was green, abundant, and reliable. Yet, as explained further by Dr. Mitrova, it is now ousted by hydro power, nuclear, and renewables, and even coal. With an ill-functioning carbon market that actually does not prove to be helpful for gas, coal is paradoxically re-gaining importance. For instance, in Germany, out of 26-planned power station, 10 are planned to be working with coal and 12 with coal. In other sectors such as the commercial and household, prospect are not all encouraging for suppliers in that gas demand has reached its maturity and no major hike is expected in demand. To add to this picture, competition with LNG, which is now representing 20% of European imports, is growing with many European states engaged in the building of re-gasification terminal.

So things are definitely not pink. Hence the question: can Russian gas export to the EU remain profitable? To this question, Mikhail Korchemkin, Director of the East European Gas Analysis, gave a rather harsh answer... 

In his view, there are conflicting trends between gas exports and pipeline investments. As a matter of fact, exports volumes turn to be always lower than forecasts, but investment for pipelines increase. This is running against Gazprom's principle that “the gas is sold first and then the infrastructure is built”. According to him, Gazprom loss of market share is due to Gazprom loss of wiseness. He further argued that Gazprom problem remains that it is the hostage of politics by the Russian government: this prevents it from being a competitive company. Over-investment is causing irreversible damage, and it can reduce the efficiency of Russian gas industry. Over the recent years, Gazprom sales decreased and by 2020 the cost of sales will be below the cost of pipeline assets. Gazprom should stop building lines when they are in fact not needed.  He illustrated the Gazprom over-investment policy by saying that South Stream is not economically feasible and that building this pipeline is like building a gas pipeline in the North Pole. Sergey Komlev noted that in so far as South Stream was bypassing a bad transit country where 80% of Russian gas is flowing, it is definitely in the commercial interest of Gazprom. A participant from the oil and gas and gas sector supported his view that underlined that South Stream was needed to avoid repeating the 2009 crisis, which, turned to be a damaging one. 

So is there good news for Russian gas export? Well it seems that yes, there is room for hope. As a matter of fact, the European Union indigenous production has been declining (mainly driven by the United Kingdom with minus 20bcm). Confidence in shale gas crashed following a recent evaluation by the European Commission of production by 2020, which should be... 1bcm. Further, as noted by a participant, the cost of increasing the share of renewables from 6% to 16% is that of 25 billion euros (only for production) to which must be added 5 billion euros for connection. And this might lead to problem in power supply, as nobody will invest such a large sum of money. So the Russian gas exporter should keep hoping that gas is still needed. And not everybody agrees that investing in new capacity is a commercial non-sense.

This is what Eric Dam, President of the Energy Delta Institute discussed. He emphasized the importance of security of capacity and the hurdles that companies planning to build infrastructure face, while clearly stating that the EU was in need for more capacity. As he said, the old (good) integrated approach where volumes were followed by pipes and where all was planned in the meantime has been now replaced by a fragmented regulatory landscape. It started after the unbundling with independent transmission system operators, news stakeholders such as national regulators and international traders. This new picture has lead to a high increase in risks and a decrease in return. And this is what a capital-intensive industry does not need: high regulatory risks and low rate of return. In addition to the Not-In-My-Backyard factor requires strong political support and more public investment. Dam concluded that Europe should actually be proud of companies and countries that still have the courage to meet all these challenges. 

Capacity and reliability of demand prospects are not all concerns for gas exporters. Gas pricing is a problem as well to make a market attractive for a supplier. Sergey Komlev, Head of the Contract Structuring and Price Formation Directorate of GazpromExport, discussed this. He particularly emphasized that oil-indexation and long-term contracts are not obsolete. He took the view that extreme liberalism should be avoided and that the EU pricing model differs from that of the US. He explains that suppliers need long-term contract and oil-indexation in particular if they must maintain flexibility in uninterruptible contracts. He refuted the sensationalist image easily attributed to Gazprom that shows the Russian gas giant setting high prices on purpose. Gas prices have increased over the last decade but slower than the price of other commodities. The erosion that Russian gas prices suffer may lead to the removal of the flexibility clause from the Gazprom long-term contracts. That would be bad news for the EU, especially if it happens at a time when more gas is needed. Henrik Valgma, Senior Vice President of Portfolio Management and Trading at the Danish oil and gas company DONG explained the market vision of an energy company on the price and contract issue. He noted that what matters is not that prices are high or low. What actually matters is that under the new EU gas market configuration, it is problematic for a company to buy to the producers at a certain price and risk (namely long-term contract with oil-indexation) and then to sell it under different condition (hub-price and short term). For this reason, it is no longer sustainable to have long-term contract and oil-indexation. He further explained that the European energy market is leading towards a future where commercial optimization is increasingly important. His statement was clear: the balance between risk and return has changed for bad. He concluded that the energy regulation in the EU will be more fragmented and to some extent more nationalistic. His advise was wise: it is important to develop a win-win situation with suppliers. And when asked about the UK model, he responded that the UK is only based on a supply-demand scheme with no long-term contract at all. This is a risky situation and there was a time where storage was empty, and the UK only relied on the BBL pipeline. 

A. Konoplyanik, Professor at the Oil and Gas Gubkin Russian State University, spoke in line with the previous arguments. He questioned the message sent by the EU through its forecast.  In the post-2009 European gas market, realities, risks, and challenges for Russian gas are definitely there. The competitive niche is decreasing while competition fro other suppliers is increasing along an increase in institutional and political risks. He noted the damage of the Ukraine/Belarus/Russia crisis, in particular because in the EU the perception of a risk (which does mean that the risk objectively exists) is turned into action. 

So to briefly conclude, the EU appears as having no real vision of where it is going, but still it is going there (let's hope that this is not right to a wall).  But two things are sure: 1) Brussels is too much ignoring its Russian partner; 2) in the end these are European citizens that will pay the price for mistakes made by some over-zealous European policy makers dreaming of being some sort of white knight, fighting heart and soul, to make the EU fitting in a “all-liberalized dress” that may not be tailored for her.  

Yasmina Sahraoui