The Vital Relationship: Why Russia needs Qatar (and Qatar could use Russia)

January 19, 2012 | 00:00

The Vital Relationship: Why Russia needs Qatar (and Qatar could use Russia)

The European gas market is undergoing a profound change. Spot trade is rapidly gaining importance, with lower-priced spot supplies increasingly undermining the long-term, primarily Russian contracts that have traditionally dominated the market. With Gazprom's main buyers losing market share, it seems only a question of time before the Russians are forced to adjust their pricing policies and adapt to the liberalised European market. There is one way out for the Russians, though, argues energy security specialist Matthew Hulbert: to strike some deal with their main rival Qatar. In this article, Matthew sketches various scenarios under which such a Russian-Qatari cooperation in the gas market could develop - and what this could mean for Europe.

LNG terminal at Doha, Qatar (photo: Global Arab Network)

Gazprom’s preferred pricing method, based on long-term, oil-index contracts, is in serious trouble, as most market observers know. The reason is that overall demand for gas is down in Europe, while new, non-Russian sources of supply are seriously up. The shale gas revolution in the US has freed up large amounts of LNG, originally designed for American ports, to hit European spot markets.

As a result, spot prices are now structurally lower than the oil-indexed prices of Gazprom’s contracts. Russian gas has become the most expensive game in town. The impacts of this on the gas market are visible everywhere you care to look. Eni is taking more Libyan gas from the Greenstream pipeline again – up to 15 billion cubic metres (bcm) from 4bcm in the depths of Tripoli’s toils. Rome is unlikely to sign up Gazprom take or pay volumes into 2012. France has seen a significant upturn in LNG uptake to over 16bcm despite flat domestic consumption. Spain remains happier to purchase Algerian than Russian gas, both on geographical and cost related grounds. A raft of other European players are doing everything they can to get Gazprom and other upstream suppliers to revise the terms of their long-term contracts.

These developments are worrisome for the Russians, but not disastrous. It’s the UK National Balancing Point (NBP) where the real headaches for Russia have been created. Not only are prices on this spot market lower than the oil-indexed prices, they have also become increasingly recognised in the market as independent benchmarks. They have thus become a very real and very attractive alternative to oil-indexed contracts.

The NBP, by far the largest gas trading hub in Europe, has acquired this position by attracting large sources of alternative gas supplies. For example, LNG imports to the UK topped 22 bcm (billion cubic metres) in 2011, 85% of which was sourced from Qatar. After having signed up additional supplies to Belgium, Spain, Italy and France last year, Qatar’s total share of the European gas market is now fast approaching 10%.

Such liquidity (both in terms of physical volumes and subsequent virtual trades) underpins the price

It’s the UK National Balancing Point (NBP) where the real headaches for Russia have been created
signals currently playing out across North West Europe, including the gas hubs Zeebrugge in Belgium and TTF in the Netherlands, which are physically interconnected with the NBP and with each other. The longer this NBP-LNG jamboree goes on, the more spot prices will affect continental prices, all the way to the Russo-German oil-indexed border price – and beyond.

Statoil, the Norwegian supplier and main competitor of Gazprom, has seen the spot market writing on the wall. It recently signed a £13billion supply agreement with UK utility Centrica, pegged to NBP benchmarks. Centrica has since followed up with a 2.4 million tonne (3.26 bcm) per year deal with Qatar for even more LNG supplies. Gas Natural from Spain has gone one better signing up gas from the US spot market Henry Hub from 2016-17 onwards. BG Group in the UK had already done so earlier.

The overall result: just 56% of all physically traded gas in Europe was done under oil indexed formulas in 2011, according to industry estimates.

German merger talks

The problem for European utilities, and in particular, big German beasts such as RWE and Eon, is that their long-term contracts have left them seriously out of the money relative to those sourcing cheaper spot. No gentleman's agreement with Gazprom can be struck on price; maxing out flexibility clauses in the contracts isn't nearly enough to do the trick. The result is that they are losing market share. Eon nine month physical gas sales volumes were down 4% in Germany to 31.3 bcm and 9% further afield in Europe (2011). RWE sales have tanked 17% to little more than 20 bcm in Germany.

European Energy Commissioner Günther Oettinger seems to think that things are so bad he recently even suggested the two German giants should consider joining forces. That may be desirable for some reasons, but it won’t change the fact that Nord Stream gas flowing through German soil is out of the money relative to UK spot. At the moment only a third (and probably much less) of the 27.5bcm/year capacity of Nord Stream is reportedly being used.

Gazprom for its part continues to preach the oil-indexed gospel. It had hoped (and still does) that gas fundamentals would tighten at some point, but this has not happened. Gazprom says oil-indexation is

Doha has found it pretty hard going selling gas to China
needed to provide ‘security of demand’, which Russia needs to support upstream investment. At various recent energy forums Gazprom officials have warned that the giant new gas province Shtokman could not be developed if fickle spot trade were to rule the market. This, they say, would hurt European security of supply.

Yet no matter how many times Gazprom repeats this line, being out of the money is still being out of the money. That's a game no European utility can afford to play these days thanks to growing inroads liberalisation has made over the past few years. If both sides refuse to budge on contractual wars, arbitration will be the outcome. Good times for Stockholm's lawyers await.

GECF smoke, bilateral mirrors

Although the numbers quoted here are new, the narrative is one that we all know well. Surely this can only be a case of game set and match to Europe to establish independent gas benchmarks and geopolitically blunt its supplies?

You'd certainly be excused for thinking so, but this is unlikely to be the end of the story. Alexei Miller is not about to roll over and die on this. Gazprom will almost certainly switch to plan B and try to skin some supply side rabbits instead.

From the numbers quoted, it is obvious that Qatar is easily the biggest prize going. Take them out of the equation and NBP liquidity would rapidly dry up. Qatar is Russia's vital relationship, and it's the one it has to get right. Much will depend on what Russia is willing to offer and whether Doha is willing to make things tick, and indeed on where Asian consumers see their long-term interests residing. But if we strip things down to the bare essentials, then it's the Russia-Qatari nexus that stands out as the key supply side relationship to watch for 2012.

Turn to the most recent meeting of the Gas Exporting Countries Forum (GECF) – the 12-member “Gas Opec”, as it has been dubbed – in November in the Qatari capital Doha. As is customary for GECF events, the wording of official communiqués are pretty irrelevant relative to the informal messages put out. Russia was quite clear at the fringes of the latest gathering: it wants Qatar to focus on Asia and sell its gas under long term oil-indexed contracts and stop feeding European spot markets. Russian Oil Minister Sergei Shamtko was more than happy to claim such a decision had 'in principle' been made. Unfortunately for Russia, Qatar had a markedly different interpretation of events. No such deal was struck, nor was it likely to be in future, Qatar said. The country made it clear that it has contractual commitments to be honoured in Europe, and more importantly, that Russia was unwilling to strike a quid pro quo with Doha not to place any more Russian gas into Asian markets.

Yet the fact that such messages were being relayed, points to the underlying fact that both sides know exactly what they need to do to tighten the market if things get worse for them. There is no doubt that Qatar would make more money selling LNG to Asia under long-term indexed contracts than they will feeding European spot in the short to medium term. Qatar is currently selling around 26 million tons (36 bcm) a year of gas to Asia, and no doubt would be happy to incrementally increase such supplies up to 50 million tonnes or more. 7 million tonnes of LNG (9.6 bcm) are still being negotiated with Beijing beyond quotas already allotted to the mainland. Netbacks on Qatari spot into Asian markets are around $14 per million Btu (mmbtu) (which is roughly $430 per 1,000 cubic meters or Mcm). This is around twice the figure achieved in the UK and Northwest Europe where benchmarks are currently trading at about $8/mmbtu (or $245 per 1,000 cubic meters).

Politics versus price

Despite this massive spread, many analysts think we'd need to see Japanese benchmarks hit a steep $25 per mmbtu for Doha to comprehensively dump Europe, and ship its gas East.
That's the whole point here: for the Qatari's this isn't just about price, but politics. Given its tiny population and vast riches, profit maximisation is basically an afterthought for Doha. The ruling Al Thani family know they have enormous leverage, not just in Moscow, but London (and Washington) so long as they keep playing the spot market game. They are genuinely sitting at the epicentre of the liquid gas supply world.

Merely telling the Qatari's to go long on Asia and dump Europe will have zero effect. If the Qatari's decide to divert major shipments away from European markets to save Russian blushes (and balance sheets), they will want far bigger economic and political returns than red carpet treatment in Red Square and a few more riyals filling Qatari coffers. Doha has already dropped hints about Qatar Petroleum International (QPI) joining Russia's Yamal LNG project in the Arctic and taking a stake in Novatek, the majority shareholder in play. That's a start, but not enough. You would need to start thinking about major upstream Russian concessions (both in Western blocs and East Siberian fields), access to downstream European stakes thanks to Gazprom's tutelage, and for Moscow to reduce prospective Asian provision to make supply side collaboration a runner for Qatar.

A complex Asian game

But before we get that far, we need to point out a snag: this automatically assumes that Asian demand will be sufficient to soak up 23 bcm of diverted Qatari supplies from European markets. Fukushima has obviously helped firm Japanese demand (by some 11%). South Korea is normally keen to strike deals where possible. India's geographical location means that LNG will be its major source of gas supplies. Even Malaysia and Indonesia are finding themselves importing increasingly large quantities of gas these days. But in broader terms, the make or break market for LNG is China. Gas demand is expected to increase by over 5% each year towards 2030 in the Middle Kingdom. This is where the Beijing, Doha, Moscow, connection comes into play; it's also where any nascent Russian supply strategy will ultimately stand or fall.

Past practice would almost certainly have seen Beijing put security of supply ahead of price and sign up for whatever it could get, but that dynamic is changing, precisely because China has opened up sufficient scope from past strategic investments to start hedging price risk far more effectively. Beijing

Few analysts are fooled: Russia has made a mess of its Eastern export strategies to date

played the game very well throughout the 2000s by signing numerous governmental memorandums of understanding with Major Reserve Holders for prospective supplies, all the while sourcing actual supplies from Central Asia. Turkmenistan has been critical, with 30 bcm of Turkmen gas expected to flow into the Chinese mainland by 2015. (China produced 97 bcm in 2010 and consumed 109 bcm, but its import needs are set to grow sharply.) Additional agreements towards 65 bcm are in place, with Uzbekistan and Kazakhstan added to China's Caspian ranks. Note that China-Turkmen prices actually fell under $200 per thousand cubic meters last year – which in rough and ready terms equates to around $6-7/mmbtu). The upshot is hardly surprising. China is playing increasingly 'hard to get' for other suppliers on price, most notably Russia, but also Qatar. Beijing is nobody's sweetheart; they are well aware which way the gas wind is blowing in a buyers' market.

Doha has thus found it pretty hard going selling gas to China. It has failed to reach conclusive agreements over contract duration and pricing formulas for full oil parity. In part that's linked to burgeoning Australian LNG production where Sinopec has been the latest Chinese major to snap up deals. Many analysts actually think that Canberra will be the largest LNG player in the world by 2020, with China understandably keen to keep producers on their toes and chasing the Dragon's tail.

More marginal LNG players such as Nigeria and Trinidad have also been trying their luck in the Pacific Basin. Obviously Doha could be more accommodating with China over price given European spreads, and indeed other Asian markets where it has only shifted 1.7mt/y (2.3 bcm) under marginally cheaper terms. But for now, it remains happy to maximise its global economic and political position from playing multiple markets, feeding not just Europe, but further afield Latin America. The trick for Qatar here is to make sure it doesn't drop the Beijing ball and miss out on long term Chinese deals assuming that Australia continues to rapidly rise up the LNG ranks.

The perfect move for Qatar would be to sign Chinese contracts just in time to stymie a Pacific Basin LNG price war with Australia - all the while making it look like a strategic shift to help Russia out of its European fix. Given the depths of Gazprom's crisis, Qatar could clearly set the bar high as to what they would expect to gain from any prospective deal. But if Al Thani is to lay claim to serious Russian booty, he must sell it as a strategic shift, not market fundamentals forcing Doha's Asian hand.

Domino effect

For China's part, Beijing is no doubt more than happy not to take too much Qatari gas at premium prices. Allowing European spot markets to solidify on the back of Qatari gas will come in handy for

Independent gas benchmarks might be cheap in Europe right now, but who is to say they won't be remarkably expensive tomorrow?

China, precisely because it knows it will have to start sourcing increasingly large amounts of Russian gas in the long term. By foregoing relatively small quantities of Qatari supplies now to support spot markets in Europe, it can drive a harder bargain with Russia in the future, with a prospective 60 bcm on the Sino-Soviet table initially by 2015.

Assuming Beijing is able to force Russia's hand to agree to spot dynamics in their pricing, China can then place further downward pressure on future Central Asian supplies as a 'domino effect'. It's already revised price offers downwards to Turkmenistan in return for infrastructure loans. Such pressures would also be used against Australia for long-term Chinese contracts by using Qatar as a potential hedge to check Australian LNG price ambitions. Without getting bogged down in any more ‘price points’, the general idea should be clear: Qatar provides China far more arbitrage options in Central Asia, Russia, Australasia and Middle East/North Africa by keeping them in the spot game rather than bringing them under Beijing's wing. If you're having a race to the bottom on price, soaking up European liquidity is a no brainer for China - at least at this stage.

The Russian response to all this has been as tedious as it is obvious. Moscow has made noises about developing gas-to-liquids in its Eastern fields and selling LNG into jurisdictions such as Vietnam and Thailand beyond Chinese markets. Few analysts are fooled: Russia has made a mess of its Eastern export strategies to date. It fell for lazy assumptions that it could sell expensive Siberian gas into China, which in turn would be used as leverage over other Asia-Pacific consumers, and more importantly, over its core European demand base. That situation has been turned on its head: the Russians have been unable to conclude a deal with China.

LNG plant at Darwin, Australia. Australian LNG  production is on the rise (photo: The Australian)
As long as Qatar remains on the market, the chances of Russia providing Russian gas at Russian oil-indexed prices to China look remarkably slim. Moscow apparently doesn't have the imagination or ability to move Eastern Siberian gas beyond logical (and geographically proximate) Chinese markets. Wait much longer, and Russia could even find itself playing Asian spot market hubs incrementally popping up in Singapore and maybe even China, (cargo swaps are already in fashion). Russia is also painfully aware that China is investing in shale gas exploration and production and has earmarked future shale production of 30bcm per year.

Russia's trilemma

So, what's Russia to do? Take it on the chin or get back in the game? Moscow basically has three options. The first is to do nothing, hope that broader fundamentals tighten; gas becomes a sellers' market, both in Europe and Asia, with oil-indexation returning. That remains a possibility given that high oil prices will help keep Russia in the black, but not one that Gazprom will exactly relish.

The second option is to bite the Chinese bullet and agree to long term volumes, albeit with Beijing calling the price shots. Russia could eventually play the arbitrage game between competing Asian and European markets, with the likes of Qatar becoming far more marginalised. Russia would wield a heavier hand in Central Asia rather than worrying about Turkmenistan eating its 'Chinese lunch'. No doubt this would be politically and commercially lucrative for Russia, but it would take a very long time to piece together. Arguably too long for President Putin given recent scenes on Muscovite streets.

Plan C is the quickest and most appealing for Russia, and it comes in the form of Qatar, pointing us back to the Vital Relationship. Admittedly, things might not be as simple or straightforward as we sketch out, but step one is for Russia to start limiting gas sales into Asian markets, ensuring that China flinches first on Qatari offtake for greater security of supply. To grease the Eastern wheels, step two is

In the end, a truly independent gas price is one that would give much more stable price signals underpinning gas investments

offering Qatar Petroleum major Russian upstream swap agreements alongside downstream stakes wherever possible in Europe. Close collaboration on price and market spreads would obviously help - even to the point of bilateral moratoriums on further production - as would tugging on Qatari fears over Australian (and more tangentially US) LNG ambitions. Playing up European fears over Qatari transit routes (Strait of Hormuz!) will probably remain something of a sideshow, but the overall rationale is very clear for Russia: any significant Qatari shift towards Asia will see Russia's spot market pressures eased in Europe with few (if any) other producers looking likely to ever fill Qatar's LNG boots.

Leap of faith

As soon as things look like getting back onto the oil-indexed straight and narrow for Gazprom, European utilities would call off arbitration wars. Wholesale costs would be passed through to consumers; it was only ever cheaper spot markets that were letting new entrants steal market share in the first place - not some kind of ideological opposition to oil indexation per se from European CEOs.

Whether this scenario really proves to be in Russia's long-term interests is a different story. Independent gas benchmarks might be cheap in Europe right now, but who is to say they won't be remarkably expensive tomorrow? In that case, Russia’s long-term contracts would be priced pretty cheaply compared to spot prices.

In the end, a truly independent gas price is one that would give much more stable price signals underpinning gas investments. In such a case, Russia would wield real market power assuming it sorts out upstream investment, by becoming the 'swing producer' of the gas world. It's perhaps just as well that Moscow doesn't appear to have the nerve to take such a leap of faith to explore and exploit a brave new world of global gas benchmarks.

 

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