“No Putin, then no Russia today.”
First deputy Chief of the Kremlin administration, Vyacheslav Volodin, at the 2014 meeting of the Valdai Club.
As the above quote from 2014 indicates, some Russians have identified Russia’s future with Mr. Putin. In turn, Mr. Putin in the past has identified Russia’s future with its mineral resources, in particular its crude and natural gas resources, writing that they will drive Russia’s economic future, its ability to catch-up with developed economies, and its ability to modernize the Russian military and military industry.
Consistent with securing Russia’s future (and presumably, therefore, his), Mr. Putin in May 2014 signed an agreement with PRC President Xi Jinping to supply 38 billion cubic meters (bcm) of natural gas annually to China from the Chayandinskoye and Kovyktinskoye fields in Eastern Siberia via a new 4000 km pipeline, Power of Siberia—at a total investment cost to Russia of $55 billion. While Russian commentators portrayed the deal as proof Russia can pivot successfully toward Asia and away from dependence on Europe and the United States, its real import is as a critical step in Mr. Putin’s ambition to dominate Eurasia’s natural gas markets. Power of Siberia, with 60 bcm capacity, and the two additional Asia-oriented pipelines that are planned (the Altai pipeline, 30 bcm, to supply China from Western Siberia, and the Sakhalin-Khaborovsk-Vladivostok pipeline, 30 bcm, with ~10 bcm potentially available for China), are expected to complement the extensive pipeline network already supplying Europe.
Mr. Putin’s ambition, however, faces significant headwinds and the prize, ultimately, may be worth less than announced.
The Prize (circa May 2014)
Dominating European and the Chinese natural gas markets is a prize worth seeking. The supply and demand data in the following table, drawn from the IEA’s natural gas Medium Term Market Report 2015, shows the potential revenues from natural gas sales to these markets based on $350 per thousand cubic meters (tcm), the price to which an anonymous Russian official said the Chinese agreed in the Power of Siberia negotiations. This price is also consistent with price Gazprom was receiving in Europe in 2Q 2014 when Putin and Xi signed the Power of Siberia agreement ($357/tcm).
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Gazprom, which has a monopoly on Russian natural gas exports via pipeline, covets the prize. Alexei Miller, Gazprom’s chairman, in an October 5 speech in St. Petersburg at the 5th Annual St. Petersburg International Gas Forum, highlighted Gazprom’s ambitions.
He emphasized Europe’s growing inability to supply its own needs, forecasting that Europe’s domestic output would fall below 200 bcm by 2025 from 305 bcm in 2010. He also ridiculed European efforts to find suppliers other than Gazprom, dismissed European anti-competitive objections to Gazprom’s business practices and its 55 bcm Nordstream 2 pipeline project, and insisted that Europe would soon have to sign additional long term contracts with his company. Meanwhile, Alexander Medvedev, Gazprom Deputy Chairman, speaking at a conference in Russia’s Far East at the end of September, cited 100 bcm as Gazprom’s annual target for China.
Threats East and West to Gazprom Volume Ambitions
Gazprom’s volumes face pressure both in Europe and in China.
In June 2015, the EU Commission, continuing its efforts to limit Gazprom’s share of the European natural gas market, expressed its opposition to Gazprom’s 55 bcm annual capacity Nordstream 2 pipeline, citing Gazprom’s existing excess capacity to supply current and future European needs for Gazprom’s natural gas. The IEA’s Medium Term Market Report described the outlook for Chinese natural gas demand “uncertain.” It noted that the rate of growth in natural gas demand in China had declined to ~8 percent-9 percent in 2014 from ~14 percent in the preceding five years. Furthermore, in 2015, the fortunes of China’s commodity-intensive, heavy industry-and-manufacturing-oriented, export-dependent economy faltered. Slower economic growth and a shift toward domestic, consumer-driven and less energy-intensive industries will exert additional downward pressure on demand for natural gas.
The globalization of natural gas markets exacerbates the pressure on volume. The Asian Quest for LNG in a Globalising Market, a 2014 IEA report in conjunction with the OECD, stated that:
“The Golden Age of Gas is one of changing markets that make the best possible use of abundant [natural gas] resources to boost development in individual regions and, for the medium term, minimise climate change for everyone. Those economic and environmental necessities make LNG a global issue, rewriting long-held tenets about gas being regional by nature.”
By the time Gazprom expects to deliver natural gas from the Chayandinskoye field to China via the Power of Siberia pipeline in 2019 or 2020, the IEA projects in its Medium Term Market Report 2015 that the Central Asia-China pipeline (sourcing from Turkmenistan) will have 85 bcm capacity and the U.S. and Australia will have brought LNG capacity on line four times that of the Power of Siberia pipeline–the U.S. 66 bcm and Australia, 72 bcm, adding to its existing 33 bcm capacity.
Since China’s regasification capacity will be at least 82 bcm in 2020, according to the IEA, Turkmenistan pipeline gas and Australian and U.S. LNG could cover China’s entire projected 2020 import needs. Thus, unless China committed to purchase a specific volume and/or the Power of Siberia agreement contains onerous take or pay terms—the two sides have not released the deal’s terms—China could, in theory, purchase less Russian natural gas than the Power of Siberia agreement envisages.
Threats East and West to Gazprom Prices and Pricing Power
Russia and China also have not disclosed any details on the pricing formula for Power of Siberia supplies—e.g., whether fixed price, oil-indexed pricing, hybrid pricing, hub pricing; selling and settlement currencies—Ruble, Yuan, U.S. dollar, Euro and/or basket; conditions, if any, for adjusting prices; reference market(s), if any.
Nevertheless, it is unlikely that Gazprom will achieve the $350/tcm price the anonymous Russian official claimed. First, it is probably safe to say that the Chinese will reject paying a (significant) premium to European prices, both because they will not accept unequal treatment and because the Chinese know that once the Power of Siberia pipeline is built, China will be the only outlet for its gas.
Second, Gazprom’s prices have fallen in Europe—they fell from $357/tcm in Q2 2014 to $251/tcm in 2Q 2015 (the latest quarterly prices available from Gazprom) and could remain well below $357/tcm in the future. In Europe, the share of hybrid pricing, which indexes prices primarily to natural gas hub prices, reached 50 percent in 2014. European hub prices are lower than oil-indexed prices. Also, the Saudi decision to let markets determine crude prices and to defend their market share, which caused crude prices to drop ~50 percent from 2014 levels, impacts Gazprom’s oil-indexed prices.
Going forward, several other factors will erode Gazprom’s pricing power both in Europe and in China.
In February 2015, the European Commission released its Framework Strategy for a Resilient Energy Union, a proposal to create “an integrated continent-wide energy system where energy flows freely across borders, based on competition and best possible use of resources, and with effective regulation of energy markets at EU level where necessary.” This policy, when implemented, could lead to a single EU entity rather than individual countries negotiating with Gazprom (and other suppliers), which would enhance Europe’s leverage on price. Also, in April 2015, after three years of investigation, the European Commission, the EU’s executive agency, sent a Statement of Objections to Gazprom accusing it of anti-competitive behavior and unfair pricing in Central and Eastern Europe.
Competition from U.S and Australian LNG could force Russia to price its natural gas below $350/tcm in both Europe and China. Pipeline natural gas customarily is quoted in currency unit/thousand cubic meters while LNG is quoted in currency unit/million British thermal units (Mbtu). Converting the price Gazprom averaged in Europe in 2Q 2014, 2Q 2015, and their mid-point gives the following prices in $/Mbtu:
The following table, based on data from the Asian Quest report and CME Henry Hub futures prices for U.S. LNG, shows the prices for which suppliers from Australia and the U.S. could deliver LNG to Europe and China (prices at or lower than $350/tcm ($9.21/Mbtu) in red font).
Moreover, the potential for surplus supplies aimed at the Chinese market could lead to the same sort of market share and price competition currently roiling the global oil market and lead to even lower prices. Faced with competition in China from Russian pipeline gas, Turkmenistan might decide to reduce its prices to drive volume. In the U.S., LNG suppliers may gain pricing flexibility. Abundant natural gas from the prolific Marcellus and Utica natural gas plays and technology-driven reductions in drilling and operating expenses could drive Henry Hub prices below $3.00/Mbtu (currently, prices are threatening to break below $2.00/Mbtu), while transport prices could also be lower, depending on the availability of LNG vessels (for example, due to a supply glut, charter rates fell from $140,000 in 2012 to $50,000 in the beginning of 2015). According to Leonardo Maugeri, in his December 2014 paper Falling Short: A Reality Check for Global LNG Exports, Australian LNG producers, to drive volume, may price on their operating costs to make their delivered prices competitive, rather than include in their price recovery of their capital costs.
Threats to the Value of China Natural Gas Revenues
Price and volume are not the only factors that will determine the value of Gazprom natural gas export revenues: for China, exchange rates, changes in exchange rates, the currency in which sales are priced and made, and the currency in which sales are settled will have an impact on the revenues Gazprom receives in Rubles and the value of the revenues in Yuan and other currencies.
Both Russia and China have been vocal in and adamant about displacing the U.S. dollar in international transactions. If the Power of Siberia agreement envisages conducting the bilateral natural gas trade in Rubles and Yuan, natural gas sales to be priced in Rubles, and no reference to a benchmark third-party currency (e.g., Euro) or price (Europe), then Russia’s Ruble revenue, and/or the value of that revenue in Yuan terms, will depend on the Ruble/Yuan exchange rate and whether the natural gas price is fixed in Rubles or adjusted for the Ruble/Yuan exchange rate. The U.S. dollar and Euro value of the natural gas sales will also depend on these factors (important because Gazprom and Russia have U.S. dollar- and Euro-denominated debt and Gazprom buys Western equipment and services).
For example, if price/tcm were fixed in Rubles, and the value of the Ruble fell versus the Yuan, 1tcm in sales would generate the same number of Rubles, but their value in Yuan (and U.S. dollar and Euro, if the Yuan maintained its value against these currencies) would be less and Gazprom would have fewer Yuan/U.S. dollar/Euro to purchase goods and services in those currencies.
Also, Yuan/Ruble exchange rate volatility and the volatility of these currencies against other currencies will complicate Gazprom’s pricing, capital planning, and assessment of its Chinese business’s operating performance.
Threats to the Value of the Power of Siberia Agreement
The foregoing discussion suggests that the Power of Siberia agreement may not achieve the volumes, prices, and therefore the revenues the Russian government expects.
This will negatively impact the financial returns from the agreement. The following table shows the approximate net natural gas revenues (in $billions) Power of Siberia will generate at three volume levels and three price levels, as well as their net present value (in $billions) over thirty years, assuming the $55 billion investment and discounted at 10 percent (reasonable given current Russian interest and inflation rates). The three volume levels represent Power of Siberia’s agreed volume (38 bcm), the Chayandinskoye field’s capacity (25 bcm), since the Kovyktinskoye field will come on stream several years after the Chayandinskoye, and the mid-point between them. The three price levels represent the natural gas price the anonymous Russian official cited as the agreed price, $350/tcm, the price Gazprom received in 2Q 2015 in Europe (~$250/tcm) and their midpoint.
The calculations suggest that the Power of Siberia agreement with China, on a NPV basis, will be profitable only at a price of $350/bcm, 38 bcm annual sales, and over a thirty year period—and then, barely (negative NPV in red font).
The calculations are rough. They do not include revenue from crude produced in the Chayandinskoye field (at least 1.5 million tons annually), and only two expenses: cost of goods sold (derived from Gazprom’s 2014 Annual Financial Report) and transportation costs, calculated from an analysis of Russian pipeline tariff rates in the Oxford Institute for Energy Studies’ Evolution of Gas Pipeline Regulation in Russia. Also, they do not incorporate tax expense. Under Russia’s Eastern Gas Program, Power of Siberia will enjoy extensive and material tax breaks, including 0 percent mineral extraction tax rate for forty years for natural gas production; 0 percent property tax on pipelines, power lines, gas production, treatment, and chemical facilities; mineral extraction and export customs duty incentives for crude output; and Federal corporate income tax relief for 10 years for gas treatment and chemical, helium and LNG plants (data from Gazprom’s June 18, 2014 presentation, Gazprom in Eastern Russia, Entry into Asia-Pacific Markets).
Lagging results from the Power of Siberia agreement with China will impede implementation of the Russian government’s plans to develop East Siberia and the Russian Far East. The Russian government expects the Power of Siberia agreement to ignite economic development in Eastern Siberia. For example, natural gas from the Chayandinskoye and Kovyktinskoye fields will be used to support the development of gas-processing and chemical industries in these regions and to promote their gasification (using natural gas to generate electricity and heating). Also, lower than expected demand from China will call into question whether Power of Siberia’s full 60 bcm capacity will be needed, and if some is, when. Finally, any reduction in revenue directly or indirectly will reduce the funds available for investment in other projects in Eastern Siberia and the Far East—adding to the losses in investment funds that tax breaks offered to Power of Siberia and other Eastern Russia projects cause.
The Natural Gas Wager
The Power of Siberia agreement with China is a Russian wager on China’s long term demand for natural gas and the price China is willing to pay for that natural gas, just as Mr. Putin’s emphasis on Russia’s mineral wealth to drive Russia’s economic performance is a wager on Russia’s future.
Like all wagers, the investments are being made in the present, but the outcomes will only be known years into the future.
By Dalan McEndree for Oilprice.com
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