Vol. 2, No. 15 (August 01, 2009)

Delivering gas to Europe: Russia or the Caspian?

Nazrin Mehdiyeva, Dr.
Pöyry Energy Consulting 

Questions of Russia’s reliability as a gas supplier to Europe have dominated headlines since the Russian-Ukrainian crisis of January 2009.  The emphasis, however, has been by and large misplaced, as Russia is interested in ensuring continuous and unimpeded exports of gas to Europe, not least given the nature of long-term contracts that govern its gas relations with European customers. 

By contrast, the volume of gas available for export is – and increasingly will be – subject to several constraints of political and economic nature.  Among the notable examples are the Russian leadership’s desire to serve its political goals by diversifying gas exports into the Asia-Pacific region, Gazprom’s willingness to strengthen its positions in the LNG market and the difficulty in liberalising domestic gas prices in Russia.  Aware of these competing demands, Gazprom has revised upwards its estimates of Russian production to 2030, but how realistic are they?

The pattern of exploiting the existing fields shows that when demand for gas picks up after the current recession, production could fail to keep up.  The problem will almost certainly be exacerbated by the fact that demand will resume almost simultaneously in Europe – Gazprom’s main and most profitable export market – and Russia, where Gazprom is selling some 70% of its gas production.  It is notable that in the draft law on tariffs for state-controlled monopolies that is currently being considered by the Russian government, the liberalization of gas prices is by and large absent.  It is equally notable that the company has asked the government to raise the controlled prices for the additional gas that companies purchase under five year take-or-pay contracts in Russia.  The latter indicates that Gazprom expects domestic demand to recover and start growing by 2012, while the former sends a strong signal that the government is not prepared to face the social backlash from drastically increasing gas prices under the conditions of economic hardship.  

This situation creates a problem for Gazprom and Russia.  The fact that the monopoly continues to make losses domestically has to be compensated for elsewhere – specifically, on the export market.  However, the fall of the oil price from the record high level in 2007-08 and the indexation to oil that exists in all contracts that Gazprom signs with European consumers mean that Gazprom will collect over USD 20 billion less in export revenues in 2009 than it did last year.  This will be inevitably reflected in reduced investment.  The key question then becomes: investment for which projects is likely to be slashed first? 

An examination of Russia’s foreign policy – which is beyond the scope of the present article – shows that pipeline projects, such as Nord Stream, will remain priority.  By contrast, some of the key investments in the upstream are likely to be postponed.  Indeed, the past weeks have already seen the beginning of this process, with the delay of the production launch of the super-giant Bovanenkovo field on the Yamal peninsula from 2011 to 2012.  Signals on another flagship project, Shtokman, have so far been contradictory, but evidence suggests that it is likely to be delayed by a couple of years, with technical difficulties possibly leading to further slips in the production schedule.  In brief, under the conditions of a financial crisis, the current focus on pipelines will reduce investment in the fields, heightening the likelihood of gas shortages when recession is over and growth resumes. 

The combination of these factors in Russia creates a “window of opportunity” for Nabucco, a project designed to transport Caspian gas to the European market.  At the time of the project’s inception, it was envisaged that the pipeline would be filled primarily with Iranian gas.  However, the complex geopolitical situation around Iran, coupled with the current under-investment in the Iranian hydrocarbons infrastructure that has turned this country with colossal reserves into a net importer of gas, has led to a shift of focus.  Attention now centres far more on Azerbaijan; specifically, on its offshore field of Shah Deniz.  Gas for Nabucco is expected to come from Phase II of the project, which could provide the base load for the pipeline. 

The remaining gas would have to come from other sources, of which Turkmenistan has been hailed as the most likely.  However, numerous issues need to be addressed before a pipeline receives a chance of being built.  These include rapid improvement in relations with Turkmenistan and an agreement over the still disputed fields in the Caspian offshore.  Stable and predictable relations with Turkmenistan are key to implementing the trans-Caspian pipeline that would link with Nabucco.  Without Ashgabat’s commitment, the trans-Caspian line stands no chance of being built. 

Meanwhile, securing such a commitment from Turkmenistan would raise Azerbaijan’s profile not only as an important supplier state to Nabucco but also as a key transit state for gas en route to the European market.  The role of the latter is currently being overshadowed by Azerbaijan’s rising oil and gas production; however, ensuring the passage of Kazakh oil and Turkmen gas through the Azerbaijani territory would solidify Baku’s role as an energy hub beyond the 2020 horizon when oil output is expected to plateau. 

Nabucco is undeniably the most high-profile international pipeline intended to supply the EU bypassing Russia.  The Nabucco pipeline consortium has existed since 2004, but many of its members are now also participants in a rival Russian project – South Stream.  There will most likely be space for co-existence of the two projects if European demand is high or if the South Stream pipeline is used to transport volumes that are currently being delivered to Europe via Ukraine.  However, if the European demand does not reach the projected high level and Russia successfully launches its vast fields on the Yamal peninsula, then the need for Nabucco will be greatly reduced.  Under this scenario, the only way to justify Nabucco would be as a pipeline that would enhance Europe’s security of supply.  But Russia is keen on building new routes to bypass transit states, and it will use this argument to promote an image of a reliable supplier to Europe.  The Caspian states need to show a genuine commitment to Nabucco today because delaying decisions risks eroding their bargaining positions in the future.       
* This article draws on the author’s findings presented in a 200-page study undertaken by Pöyry Energy Consulting.  For more information on the report titled “Russian Gas in Europe: Will there be enough to go around?”, please consult http://www.ilexenergy.com.