Resetting Gazprom in the Golden Age of Gas

September 17, 2012 | 00:00

Resetting Gazprom in the Golden Age of Gas

The Golden Age of Gas appears to provide more threats to Gazprom than opportunities. Shale gas has undermined the commercial rationale for the Shtokman project. The European Commission's plan to open up the European gas market and the recently announced antitrust investigation against Gazprom, threaten the company's position in European markets. However, Gazprom also enjoys substantial opportunities. Greater supply diversity in Europe reduces the 'Gazprom fear' which makes it difficult for Gazprom to acquire assets, access markets and deal with European customers and partners. And as the prospects for a larger European and global gas market grow, Gazprom as the holder of the world's largest conventional gas resources could also be well placed to benefit. But to be successful in the new gas age, the company needs to undertake a fundamental reform of its business model and market priorities. If it fails to do this it risks ending up as a 'supplier of last resort' for Europe. Does President Putin really want to preside over the decline of Gazprom?

Gazprom building in Moscow (c) Ruben van Eijk/Flickr

The three threats facing Gazprom

1. Shale gas

The number one threat to Gazprom is shale gas. The actual development of shale gas in Europe is less of an immediate threat than the impact of shale gas developments elsewhere, which are resulting in more gas being diverted into the European market in the form of LNG. As a result of the closing of the United States market to LNG due to the American shale gas boom LNG has been diverted to Europe and dumped onto the European market.

Next Gazprom faces the prospect of Asian LNG finding limited markets in its own region and also heading for Europe. There is a real question as to how much Australian, Qatari and Canadian LNG Asian markets can absorb in terms of both available market infrastructures and gasification terminals. There is also the question whether Chinese shale gas production will actually crowd out market infrastructure limiting the expansion of LNG imports to China. The resulting Asia to Europe switch is already likely to be a feature of this winter's gas market and it will increase as the Panama Canal widening is completed in 2014.

The next stage of the threat is US shale gas being exported as LNG. The case for LNG exports from the US is very compelling. Ultimately the decision rests with the United States Department of Energy, but it is difficult to see how export clearance will not be granted for a number of liquefaction plants. If the US gas market is unable to export given the enormous quantities of gas available there is a real danger of a drilling shutdown across many shale gas plays. Without exports prices will collapse and then rise rapidly while actually reducing the size, profitability and innovation of the industry. Worse still price instability will undermine the rebuilding of energy intensive US manufacturing which needs stable low gas prices in order to ensure competitiveness and growth. Additionally gas production and exports will also not insignificantly add to US tax revenues and royalties.

The US will also see a major energy security advantage by delivering shale gas LNG to Europe. Significant quantities of shale gas as LNG will provide a major alternative source of supply for European industry and consumers. The US will see these 'LNG Freedom Carriers' delivering 'free market gas' to reduce Gazprom's influence and boost the developing European spot markets.

Hence even without any European development of shale gas, Gazprom will be faced with increased liquidity in its markets and greater competition.

Gazprom also faces the prospect of significant quantities of gas making their way to Europe from the discoveries in the Eastern Mediterranean and from the immense shale gas resources of Algeria. In addition, there is the prospect also of Azeri, KRG and ultimately Turkmen gas arriving in Europe via the Southern Corridor. All of these prospects significantly increase liquidity in the medium term and reduce Gazprom's ability to maintain control and commercial pricing strategy over its traditional markets.

Even European shale gas development at scale cannot be ruled out for two principal reasons. First, at least one major EU Member State (Poland being the most likely candidate) may actually realize that the development of cheap shale gas production at scale will provide that state with a major competitive advantage over other states. That advantage is not just in cheap gas prices but also in the significant multiplier effect across its industrial sector. This multiplier effect in the US is one of the major reasons for the American industrial renaissance as energy intensive manufacturing is restored to US shores and for healthier US growth figures. Furthermore, once one EU Member State seeks this competitive advantage other states will follow for fear of letting the first mover gain significantly over the rest.

The second reason, and this may well be the most significant factor, is the Chinese interest in European shale gas development. Currently Russia and China are locked in negotiations in respect of pricing for Russian gas. Russia essentially wants prices indexed to oil. Indexation is under heavy legal and market attack but Russia maintains its insistence on oil linked contracts in its gas sales even if discounts are provided to some valued customers. However, if indexation were to disappear from European gas contracts Russia would not be able to sustain its argument for such indexation pricing with China. China therefore has a direct interest in investing in European shale gas. Development of European shale gas at scale would break the back of Gazprom's indexation policy. Once this occurred Russia would be forced to give way on pricing negotiations with China. As Chinese experience with shale gas develops Gazprom can expect greater engagement and investment by China in what Gazprom would once have considered its own back yard, Central and Eastern Europe and the ex-Soviet Republics.

2. Creation of a single European gas market

The second major threat facing Gazprom is the slow but sure creation of a European single market in gas. As a genuine single market develops gas can be delivered across the Union threatening Gazprom

The shale gas revolution provides the commercial dynamic for a single European gas market
with direct gas to gas competition. If another supply crisis were to occur, Gazprom's gas can be more easily replaced, making it much more difficult for cut-offs to have much effect and reducing the 'Gazprom fear' of a number of EU states. The impact of the gas single market is reinforced by the shale gas revolution as alternative sources of gas are able to take advantage of a more free and open European market to provide competition.

For many years a European single market in gas was nothing more than rhetoric from EU Commissioners. The reality was a patchwork of national gas markets, usually with one or two dominant vertically integrated incumbents who produced their own gas or had long term supply contracts with Gazprom, Statoil or Sonatrach. However, the double impact of the rolling out of the third energy package and the antitrust litigation against energy companies as a result of the sectoral inquiry are slowly but surely creating a much more open and transparent energy market.

There is also a major interaction between the impact of the shale gas revolution on the European gas market and the liberalization of the European gas market. One of the key and legitimate criticisms of the European energy liberalization project was that liberalization would have limited effect unless there were new sources of gas. If states were still largely dependent on the same external supplier for their gas liberalization a single gas market would not prosper.

The shale gas revolution provides the commercial dynamic for a single European gas market. In the form of LNG suppliers entering spot markets and later on domestic shale gas producers it enables the competitors to take advantage of EU liberalization and antitrust rules. New entrants will appear who will make the market work, who can threaten antitrust suits and engage with the European Commission to open market pathways.

This prospect is reinforced by the often overlooked but successful European Energy Recovery Programme which has spent approximately €1300 million on building interconnectors and reverse flowing pipelines across the continent. Hence in addition to the lifting of legal barriers to trade, and the entry of new market players to take advantage of the lifting of such barriers, the actual physical infrastructure of the single market is being put in place.

This triple impact of open legal regime, new competitors and physical access is beginning to open more and more national markets to competition from new players.

3. The internal threats facing Gazprom: competition, investment and domestic pricing

The third threat is internal. It part it stems from competition from Novatek,, Rosneft and other Russian energy companies seeking to remove Gazprom's export monopoly and control of the pipeline network. More fundamentally the threat Gazprom faces internally is the investment capacity to keep gas flowing into domestic and international markets. According to the World Energy Outlook 2011 report on the Russian gas market, approximately 634 bcm (billion cubic metres) of Russian gas production will have to be replaced by 2035. Together with new transmission and distribution systems, refurbishments and upgrades Gazprom will have to spend $730 billion (in 2010 dollars).

Given the pricing pressure that Gazprom will face from increased competition combined with the lack of incentives for foreign direct investment into the gas market, it is open to question how gas production will be maintained even at current levels.

The exit of the Russian Federation from the investor protection provisions of the Energy Charter Treaty (ECT) in 2009, the elevated level of corruption, concern at the inability of the Russian Federation to guarantee property rights and lack of independence of the courts all undermine the willingness of investors to provide capital at scale into the market. In addition, even if foreign investors were willing the state imposes significant barriers to entry, particularly in respect of the distribution and transmission system.

This threat is reinforced by the prospect of significant gas field depletion from the supergiant fields. Although Gazprom has itself invested heavily in external pipelines such as Nordstream, the compelling need is for greater investment in new gas fields to maintain production levels. This is particularly so in relation to the Nadym Pur Taz fields in Western Siberia where around 80% of Russian gas which reaches Europe comes from. As these Soviet era fields begin their depletion track far too few new fields are coming on stream to replace them.

One option is to sharply increase domestic gas prices to increase revenues for capital investment. Price increases particularly for industrial customers have been significant. However, there are political limitations on how far domestic customers can continually face price increases without undermining Gazprom and the Kremlin's political support. The Kremlin also has to be aware of another factor stemming from the shale gas revolution: any increase in Russian industrial gas prices must not undermine Russian export markets. The US and soon China may well be able to match or even obtain lower industrial gas prices than Russia, making it more difficult for Gazprom to again raise revenue domestically.

The end of Gazprom?

At first sight Gazprom's position looks almost hopeless. The traditional system of gas supply to Europe that Gazprom relied upon for all of the period since its creation in 1993 and prior to that as an arm of the Soviet gas ministry, of long term supply contracts priced by a link to oil negotiated with vertically integrated nationally dominant incumbents across Europe is passing into history. The incumbents themselves are being painfully unbundled and where not unbundled subject to intrusive European regulation. Meanwhile, the lifting of legal barriers together with greater third party access rights is opening up opportunities for new market participants such as LNG shippers and contractors, and potentially later on shale gas producers. Spot markets are developing apace and with some hiccups increasing in scale and liquidity as gas to gas deals begin to draw level with contracts linked to oil. In addition, physical interconnection is ensuring access to new sources of gas, new competitors and EU regulation into parts of the European market where hitherto Gazprom was the sole importer or supplier.

Recently Gazprom's position appears to have worsened. In late August Gazprom climbed down from its commitment to develop the Shtokman field in the Arctic, in large part because the company did not see where it could sell this very expensive gas. In addition, in early September, the EU's competition authorities (DG Competition) initiated proceedings against Gazprom for abuse of market dominance across Central Eastern Europe and the Baltic States. 'DG Comp' is the US Marine Corps of the European Commission, it does not usually launch proceedings unless it has already obtained significant evidence against a business. As Microsoft found out, taking on DG Comp is a challenging task and one which usually ends in failure. No company has prevailed in the EU’s court, the European Court of Justice, in an abuse of dominance case since the EU competition rules came into force in January 1958.

However, while Gazprom's position at first sight looks bleak it has to be remembered that the decision to cancel Shtokman was in fact a good one, in that it the company cut its losses and recognized that the project was no longer commercial. And there is even an upside to the antitrust litigation being brought by DG Comp. DG Comp is challenging business practices which in fact no longer work in Gazprom's favour, from indexation through long term supply contracts which foreclose market to market division policies. Thus Gazprom may well be able to use the EU litigation as a face-saving reason to abandon its old business model.

It has to be remembered that Gazprom controls the world's largest conventional gas resources. The Russian Federation and Gazprom could use the threats its faces to construct an alternative business model which would provide Gazprom with a much more profitable and long term future.

Resetting Gazprom in the Golden Age of Gas

Resetting Gazprom means first of all recognizing that shale gas, which is a great threat to the company's existing business model, is in fact a major opportunity for a reset Gazprom. This is for three reasons.

First, the existence of new gas sources coming into Europe and indeed extracted from within Europe lessens the fear of Gazprom. In principle it makes it possible for Gazprom to sell more gas into the European market as there is no longer any fear that a European economy can be dependent on Gazprom given there are many alternative sources of gas.

Second, because of increased gas liquidity and diversity lower gas prices will drive up market demand for gas, from which Gazprom can take advantage.

Third, Gazprom has access to potentially cheap sources of gas, particularly the shale gas around its existing gas fields and gas in many of its secondary fields in Western Siberia.

The core part of any Gazprom reset is to source large scale cheap gas resources so that it can compete in the European market. This requires three major developments in the Russian gas industry. First, a focus as indicated above on gas that can be extracted cheaply. There has to be a much greater focus on

The core part of any Gazprom reset is to source large scale cheap gas resources so that it can compete in the European market
cost and efficiency in order to maintain and increase market share. Second, Gazprom needs to deploy the cheapest pipeline routes to market. This would suggest Gazprom has to consider negotiating pipeline access with Ukraine. One approach to doing so would be to look at returning to the Energy Charter Treaty’s draft Transit Protocol proposal in order to introduce third party international guarantees into the supply route. This does not mean that Gazprom should abandon all external pipeline network projects, only the most expensive ones. Hence, while South Stream should be abandoned by Gazprom if it cannot reach an agreement with Ukraine, the company could look at building a Yamal 2 pipeline through Belarus and Poland, which would be much cheaper than South Stream.

The overriding issue for Gazprom is to ensure that gas delivered to market can compete profitably in spot markets where indexation will have less and less sway. This focus on keeping costs low and efficiency suggests that the Russian Federation and Gazprom are also going to have to grasp the most painful part of any reset: liberalisation of the Russian gas market.

This does not have to be a full European style liberalization but it does require creating pressures to push prices down and encourage throughput. One option for a Russian approach to liberalization would be to adopt the Thatcher government technique of introducing golden shares which allow the state to call and control companies that have been privatized.

It would be possible to design a Russian gas market where there was a privately owned gas pipeline network, Moscow owned a minority of the shares but maintained a golden share to ensure supply security and state interests were protected. Meanwhile a series of baby Gazproms would provide supply in competition with Novatek and others. Some of the baby Gazproms would be privatized and some sold to foreign investors. Those holding key supply facilities would also be subject to golden shares. This Russian approach to liberalization would allow more competition, more foreign investment and increase cost pressure while giving the state the means to maintain a significant degree of control.

Such a Gazprom reset would provide for a much more successful innovative Russian gas market. The baby Gazproms could grow into major international players and the privatized Russian gas network company would find it much easier to acquire network assets across the continent without regulatory or political fears.

The argument against such a reset is the traditional one that the Kremlin would never accept any form of breakup of the existing Gazprom. That however overlooks the scale of the threats that Gazprom faces. The compelling question for the Kremlin is: what is the alternative? Gazprom can continue to defend its old business model. However, that would be fighting a rearguard action. There is no future for the company in defending every last stronghold of its current market until market forces dislodge it stronghold by stronghold. The danger for Gazprom is that it ends up the supplier of last resort for Europe.

If the Russian Federation does not recognize the range of threats faced by Gazprom and take effective action to protect its European market and profitability, Russian gas will be utterly marginalized. Gazprom will lose profitability, revenue and influence. Does President Putin in his third term really want to preside over the decline of Gazprom?

 

About the author

Alan Riley is Professor, City Law School, City University, London. See also his article "There is life for the Southern Corridor after Nabucco" of 12 March 2012 on EER and his recent comment on the anti-trust investigation announced by the European Commission against Gazprom.

And for another worthwhile take on Gazprom's current dilemmas, see this article from our regular analyst Matthew Hulbert on Forbes.com.


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