Russia/Gazprom: Commercial Realities Coming to the Fore

Speaking about the potential future of Russia's gas export strategy, both from a commercial and political perspectives, James Henderson, Senior Research Fellow at Oxford Institute of Energy Studies, contends that, although there are political catalysts and a political flavor to decisions about Russian gas exports, ultimately it is commercial decision making that comes to the fore.

Mr. Henderson shows a matrix to underline his idea, pointing to the overall decline in Russian gas production from 2008-14. “It's fallen by more than 100 bcm,” he says. “And that's essentially being driven by the commercial reality that the demand for Russian gas at the price that it was being offered has fallen across Gazprom's three main markets: Europe, the former Soviet Union and also the domestic Russian market.”

He adds that in all three the price of Gazprom's gas has made it uncompetitive.

The end is probably in sight, he says, and independent producers in Russia are likely to plateau their output some time towards the end of the decade. “Also, I think the political support that Gazprom is receiving means that we're not going to see a continuous decline in Gazprom's production, although I would caveat that with a continuing thought that this will depend very much on Gazprom's strategy.”

There is essentially a gas bubble in Russia, according to Mr. Henderson, despite the fall in Gazprom's production over the last 6 years, keeping in mind that the company's total production capacity could encompass 600 bcm.

He comments: “There is certainly spare gas out there, and the cost of production may be very low. So from a physical perspective, in terms of security of supply, there is no risk – there is a lot of Russian gas available to western markets and, over time, to eastern markets as well.”

Combined with the 200 bcm of capacity from independents in Russia, he says there's about a total of 800 bcm capacity including Gazprom, while Russian demand stands at around 640 bcm.

“That capacity is going to rise,” he says, offering a possible 1 tcm by 2020 as Gazprom and others develop new natural gas fields, like the Yamal Peninsula.

Unfortunately for Gazprom and Russia, explains Mr. Henderson, in the mid 2000s they ran into the perfect storm of economic crisis, shale gas, renewables and cheap coal, particularly in Europe, and as a result demand in core markets is still at risk, “and I think the key question going forward is how is Russia going to respond to that risk, particularly at a time when we're going to see a surge in new LNG which is going to add to the supply side.”

Gazprom, he says, has over 20 tcm of 2P reserves underpinning its output. “The Yamal fields in northern Siberia are going to be the foundation for future Gazprom production. They're relatively expensive in a Russian context, which is why independents have been able compete with Gazprom domestically, but in an international context, particularly now that much of the investment has been made, the marginal costs of supply are pretty low.”

Novatek and Rosneft, he says, are the catalysts for growth in Russia. He reports that among those companies' aspirations are exports via LNG as well as domestic sales. Novatek will likely rely on LNG post 2020, while Rosneft's LNG project has been pushed back. He comments, “And there are some questions over the growth of their production, given that the natural stress their currently under with the sanctions. Nevertheless, they should continue to grow.”

This means, he explains, that by 2017-18 Gazprom's market share of domestic sales will fall below 50% for the first time ever.

New markets, according to Mr. Henderson, include Asia. He says the two main projects to Asia are the Power of Siberia line, which will run from Chayandinskoye down into China by the Power of Siberia pipeline. He comments, “It's a separate, new gas field with no link to Western markets at all – no security of supply risk to Europe.”

He added that it bears about 38 bcm/year potential.

The second is the Altai pipeline, for which a memorandum of understanding has been signed and further negotiations are expected. “The interesting thing about Altai is that the gas is sourced from Western Siberia, which is the source of gas to Europe. Politically, this is a theoretical threat.”

Still, he says, it would be possible to supply both the Chinese market and Europe from that source: “From a security of supply perspective, there's plenty of gas for Asia and for Europe.”

Mr. Henderson recalls Gazprom's aspirations of getting into the LNG market, beginning with the Shtokman field, which he says got “knocked on the head” because of the US shale gas revolution, because the Russian gas had been intended for the US.

“The economics of that field have been called into question,” he reports, “and it's been deferred indefinitely.”

Now, he says, Gazprom's pivot towards Asia is seen as a catalyst for Vladivostok LNG, Sakhalin I & II projects. “With the sanctions, all three of those projects have been called into question, largely because of financing concerns, but also because of fear of expansion of sanctions and concern by potential customers that they're not to contravene any form of US sanctions against Russia.”

The only project that looks like it has a serious chance of producing LNG before 2020 is Novatek's Yamal project, despite concerns over financing, even with a slight delay, he predicts.

He also mentions Baltic LNG, Gazprom's plan to sell gas into the Atlantic basin.

“Fundamentally, we see a significant setback in Russia's LNG strategy,” he observes, explaining that now the focus of the Russians is a pipeline export strategy.

“It looks like the Asian strategy is going to be pipeline dominated for the foreseeable future,” adds Mr. Henderson.

One challenge to Gazprom, he says, is the competition from Rosneft on access to one or more of the pipelines. “It's a debate that's ongoing,” he explains. “I don't think Rosneft will be allowed to sell physical molecules to China; there may be some sharing of netback – we'll see how that develops, but certainly Gazprom seems to be in a much stronger position in that debate now than it has been in the past.”

He recalls that in May 2014, when Gazprom announced the plan to sell gas via the Power of Siberia pipeline there had clearly been a desire for Russia to demonstrate to Western markets that it had alternatives if diversification plans in Europe went ahead.

“Clearly, the Chinese sought to exploit that. Nevertheless, the deal was done at a pretty commercial price for both sides,” he reports, explaining that it had to be comparable to other sources of gas available to China.

“It's a demonstration that Gazprom is prepared to act commercially and at a pretty decent price to make a reasonable rate of return on it's investment – I reckon around 10%.”

While the fall in oil prices calls that into question, he says it is a demonstration of commercial reality and politics being drivers.

As for Gazprom's export strategy in Europe, Mr. Henderson says Russia is facing a more imminent challenge with a European market, where demand is stagnant and a potential for extra supply from the LNG market over the next few years, not to mention being faced with regulatory and political challenges.

The abandonment of South Stream and unveiling of Turk Stream, he says, reveals Gazprom's new “thought process” about delivery points for Russian gas. “There was talk of hubs, of not focusing on consumers but delivering gas to the borders. This marks the first steps of a gradual shift in Gazprom's gas export policy, away from the traditional, long-term oil-based contracts towards an acceptance that perhaps operating within European rules can still leave Gazprom in a very powerful position given, a) the amount of gas it exports every year, and b) the cost of that supply.”

Mr. Henderson shows a graph depicting how from 2005-2014 Gazprom's price over the years has not differed greatly from the UK's national base price (NBP). “In 2013, it was effectively the same price thanks to renegotiations of contracts, rebates effectively, although the contracts are theoretically oil-linked; in fact, they respond to the European market price.”

He contends that this trend is likely to continue, especially considering the mutual need between Gazprom and Europe.

While the Asian sales of gas provide Gazprom some insurance from 2020 on, “Russia, with its 30% share in Europe, is going to remain an important player. I would argue is what we're starting to see in Russia is an acceptance that they have to compete to maintain that market share, and competing means operating more around hub prices and under European market rules.”

As for whether Gazprom can finance its three major pipeline projects, he observes that the company has a strong balance sheet, relatively low level of net debt and robust cash flow. Considering it has spent $20 billion on transport over the last few years, says Mr. Henderson, the spending required on Turk Stream, Power of Siberia and Altai averages about $10 billion/year.

“Theoretically, at least, it's within the bounds of reality for Gazprom to do these three projects. It's also not impacted by financial sanctions directly, although implicitly banks are reluctant to loan.”

Some project finance for the Asian projects, he says, is likely to come from China.

-Drew Leifheit