Taking a Second Look at the Southern Gas Corridor

With Russia covering two-thirds of Europe’s gas needs, Europe’s buzzword du jour since the start of the recurring Russo-Ukrainian disputes in 2005 over prices, debt and supplies of natural gas has been energy supply diversification.  Aiming to maintain its presence in the European market and to meet its rising gas demand, Russia plans to boost its gas supplies to the European Union (EU) through its new Nord Stream (55 billion cubic meters (bcm) per year ) and the proposed South Stream (63 bcm per year ) pipelines, which are to take some of the gas capability from its troubled transit pipelines running through Ukraine.  But it does not look like Russian pipeline gas will keep Europe locked to Gazprom in the long run, as EU seeks broad powers to speed up its energy projects to diversify supplies. 

EU’s energy diversification priority projects include pipelines bringing natural gas from the Caucasus, Central Asia and the Middle East to Europe – the southern gas corridor – to cut dependence on Russian gas.  The southern corridor pipelines currently on the table are an abridged version of the original Nabucco, dubbed Nabucco West, the South-East Europe Pipeline (SEEP) and Trans Adriatic Pipeline (TAP).  These projects are now bidding for Azerbaijan’s vast Shah Deniz II gas field, which is expected to come online by 2017-2018. 

In the next few months, Azerbaijan will choose one of these proposed pipelines to carry its gas to Europe.  As Azerbaijan is currently the only source of gas supplies to the southern gas corridor, the strategic value of the southern corridor pipeline projects to the EU is questionable due to their limited capacity, the lack of committed gas suppliers to alleviate its dependence on Russian gas, as well as financing, legal and regulatory issues surrounding some of the pipeline projects.  More gas sources will be needed to fulfill the southern corridor’s projected potential of 60 to 120 billion cubic meters (bcm) per year.  The real gas diversification for EU may necessitate reliance on LNG imports and adjustment of long-term gas contracts with Russia, its energy partner for 60 years.  This paper will examine the challenges of the EU’s southern gas corridor pipeline projects, assess their viability to be a counterweight to Russian gas in the European market, as well as try to look at policy options.

Southern Gas Corridor in the EU Context and the Pipeline Dilemma

As illustrated in Figure 1, natural gas demand progressively increased in Europe over the last two decades (1990-2008), until the global financial crisis has slowed down consumption.

Figure 1: Natural gas demand in OECD Europe, 1960-2009 (in million cubic meters)

Source: IEA (annual), Natural Gas Information, part IV, table 3A (several issues) ; IEA (monthly), Natural Gas Survey, table 1 (various issues), and Anouk Honoré, Economic recession and natural gas demand in Europe: what happened in 2008-2010? (p. 24).

But owing to its environmental benefits and the growing unpopularity of nuclear power following Japan’s Fukushima disaster, natural gas is becoming a preferred fuel in the European energy market.  For instance, Germany, a major consumer of Russian gas, is bound to rely more on natural gas as it plans to phase out nuclear power by 2022.  EU’s primary natural gas suppliers are Russia (2009: 34 percent), Norway (2009: 30 percent) and Algeria (2009: 14 percent).   The European commissioner for energy, Gunther Oettinger, noted in fall 2011 that Europe’s present “annual gas consumption was about 500 bcm, of which 125 bcm/year was from Russia.”   According to the European Commission (EC), “in total more than 1 trillion euros of investment is needed for the European electricity and gas sector in the decade between 2010 and 2020.”   EU considers building an efficient energy infrastructure and greater interconnectedness between its member countries and external suppliers as important components of its energy strategy. 

In this regard, Europe sees an important opportunity to meet its energy needs by developing the southern gas corridor, at the core of which are gas supplies from the Caspian area (including Azerbaijan, Turkmenistan, and Kazakhstan) and possibly the Middle East (Iraq, Egypt, and the Mashreq countries).  To diversify gas supplies from Russia, the European Commission envisions that the southern corridor pipelines would potentially provide capacity to deliver 60 to 120 billion cubic meters per year of gas from these regions directly to Europe.  Such projections might be overly optimistic given the outstanding problems with securing committed resources and funding, geopolitical and domestic hurdles faced by prospective suppliers.  Compounding the problem, the economic downturn in Europe may mean that not all the planned pipelines in the southern gas corridor will to come to fruition in the near future. 

European analysts consider a new package of agreements signed between Turkey and Azerbaijan on October 26, 2011, which establish rules for the transit, volumes and prices of gas, as a precondition for the start of EU’s southern gas corridor projects.   At this juncture, all the proposed pipelines are centered on gas supplies from Azerbaijan via an expansion of the existing South Caucasus Pipeline (from Azerbaijan through Georgia to Turkey) and a recently agreed Trans-Anatolian Pipeline (from Azerbaijan to Turkey).  Under the new agreement, Turkey is to transit 10 bcm/year of gas from Azerbaijan to the borders with Greece and Bulgaria through the Trans-Anatolian Pipeline, which would then send gas to Europe via Nabucco West, Trans-Adriatic Pipeline (TAP) or South East Europe Pipeline (SEEP).  But now the viability of the Trans-Anatolian Pipeline (TANAP) might be under question given the fresh disagreements between Turkey and Azerbaijan over its ownership, causing more frustration to EU.   If they overcome this dispute, it will be up to Azerbaijan to choose one of these three pipelines to transit gas from its second stage of its offshore Shah Deniz II gas field through Turkey to Europe.  Whereas EU hopes to expand the transit capacity between Turkey and Azerbaijan to 60 bcm/year, the economic viability of any pipeline will depend on other committed suppliers. 

Trans Adriatic Pipeline (TAP). Backed by Statoil (42.5 percent), E.On Ruhrgas (15 percent), and Elektrizitaet Gesellschaft Laufenburg (42.5 percent), the 800-kilometer TAP has chances to be built, if it overcomes regulatory obstacles that it has been facing for four years.  Founded and dominated by non-EU shareholders, Norway and Switzerland, the strategic significance of the project seems to be ambiguous to both its stakeholders and EU.  It will have a capacity of 10 bcm of gas year, with a maximum discharge at 20 bcm.  TAP primarily targets the Italian gas market (see Figure 2), which is saturated with supplies from Russia, Africa and the Middle East, while the proposed Nabucco West and SEEP lines would deliver gas to parts of Central Europe most dependent on Russian gas.  It is uncertain whether Azerbaijan would select TAP over other pipelines to sell gas to Europe.  Its decision would be based on commercial benefits of any of the pipeline projects to Azerbaijan.

Figure 2: Trans Adriatic Pipeline project

Source: Trans Adriatic Pipeline website (accessed on April 15, 2012)

South-East Europe Pipeline (SEEP).  It is also unclear whether the new proposal by BP, a member of the Shah Deniz consortium with a 25.5 percent stake, to build the 1,300 kilometer SEEP will be a transportation route of choice for Azerbaijan over other proposals.  According to BP, SEEP would link Shah Deniz through the existing infrastructure with western Turkey to branch onward to Bulgaria, Romania, Hungary and Austria, which is essentially the same route as the original Nabucco project would have taken.  But compared to the old Nabucco proposal, SEEP would be cheaper, less risky and smaller, with an option to expand its capacity from the initial capacity at 10bcm/year, if other sources of gas appear.

Nabucco West.  The newest version of the Nabucco pipeline project, named Nabucco West, aims to link with TANAP to carry 10 bcm of gas annually to Austria via Romania and Hungary.  Nabucco West would be nearly half of its original length of 3,900 kilometers (see Figure 3) and a fraction of its 31 bcm/year projected capacity, with the Trans-Anatolian Pipeline replacing the original Nabucco on Turkey’s territory.  While the abridged version of Nabucco presents a more practical solution to its more expensive initial plan, the strategic significance of Nabucco West is more limited due to its smaller capacity.  In that context, Nabucco West may be as viable as SEEP to carry Caspian gas to Central Europe. 

Figure 3: The original Nabucco project and the abridged Nabucco West pipeline

Source: Image modified from the Nabucco website (accessed on April 15, 2012).

Weighing the Options

Project financing and regulatory issues as well as problems with reaching transit agreements with countries involved in pipelines continue to hamper the progress of TANAP, TAP, Nabucco West and SEEP.  Now the Turkish-Azeri ownership dispute over TANAP, a proposed gas pipeline which has recently redefined the strategies of other regional pipeline projects, casts more uncertainty over the viability of the southern gas corridor.  It is also putting to test EU’s patience over pipeline politics.  These factors combined with Azerbaijan’s ability to provide only 10 bcm of gas per year and the lack of other suppliers present a fallacy of the southern corridor’s capacity to significantly diversify Europe’s gas sources.  EU’s ability to obtain 60 to 120 bcm/year via the southern corridor is currently unrealistic until more committed sources come into play.

As Europe’s gas diversification options go beyond the southern corridor, the role of LNG in the European gas market is set to grow.  Liquefied natural gas (LNG) from Qatar, Algeria, Nigeria and Trinidad and Tobago made substantial inroads to the European gas market in recent years.   With a possible rise in competition between LNG and pipeline gas, LNG supplies from countries like Qatar are likely to gain more market share in Europe as the latter recovers from the economic crisis.   Committed to maintaining gas supplies to Europe in the face of the current market instability there, Qatar expects LNG demand in Europe to rise, particularly with the nuclear phase-out in Germany.   Existing European LNG terminals can annually bring 95 bcm and six new terminals that are being built could raise this yearly import capacity by 70 bcm.   The costs of building an LNG terminal have fallen.   While declining gas prices and demand slowed down the increase of new LNG supplies, the possibility of LNG to offset the pipeline gas has been appealing to the Europeans.  With a vast surplus of LNG, Qatar is bound to step up competition to win European customers.  EU has a chance to capitalize on LNG supplies as it anticipates the growth of gas demand.

Europe’s diversification agenda, however, cannot altogether negate the need for Russian gas, which supplies around a quarter of European gas imports.  Following Russia’s launch of its Nord Stream pipeline in November 2011, European leaders re-affirmed the long-term energy partnership between the EU and Russia.   Russia needs the European market as much as the latter needs its gas.  Gazprom is aware that its recurring transit problem with Ukraine has weakened Russia’s position in Europe, worsening its risk profile with falling gas prices since the onset of the global economic crisis.  As a result of the rapid fall of oil prices in late 2008, decoupling of gas prices from their traditional relationship to oil has forced Gazprom to adjust its prices accordingly.  The colder-than-normal winter of 2012 bumped up Europe’s gas demand for heating.  While Central European countries complained that Gazprom cut supplies this winter up to 30 percent,  demand in the rest of Europe in February 2012 increased by 1 percent year-on-year since December 2010.   Some analysts anticipate that the continued economic recession in Europe may cause re-assessment of its growth figures. 

Recent renegotiations of long-term gas price contracts with the Russian monopolist by major European utilities (including Germany’s E.On AG, Austria's OMV, and Italy's Edison and Eni, France’s GDF Suez (GSZ) SA) showed Gazprom’s willingness to give concessions.   But it is unclear whether the pressure of European utilities to fully scrap the historic method of linking the prices of pipeline gas with oil over a six to nine month period and instead linking gas prices to spot markets will materialize.  In view of the latest rise in oil prices, highest since 2008, European utilities continue to be hurt by oil-indexed gas rates, as they buy fuel at above-market prices and are forced to sell at a loss to maintain customers.  

Continued weak gas demand, which has dampened rising LNG supplies as well as pipeline gas to Europe, could be a window of opportunity for the EU to step up its leverage on Russia to redo some of the long-term contracts or continue pushing for take or pay contract minimums.  EU could step up such pressure, if the Ukrainian transit problem repeats that is bound to resurface under the ongoing disputes between Ukraine and Russia over gas prices.  Such leverage on Moscow may weaken in a few years, as gas demand picks up pace and nuclear power phases out in Europe.

By. Saltanat Berdikeeva