In 2014-2015 Russian gas industry found itself in a completely new, quite unfavorable environment, which can be described as a real 'Perfect Storm': increased competition and demand stagnation has led to an oversupplied domestic market, while frozen regulated prices, rising non-payment and rouble depreciation have further undermined its attractiveness.
With weak demand and unfavorable regulation in Europe and declining gas consumption in the CIS, coupled to the drive towards reducing dependence on Russia, the traditional export markets provide little relief. Moreover, declining gas prices undermine Russia`s government tax income and Gazprom`s revenues.
Widely discussed expansion of the Russian gas exports to the East thanks to the recent China deal could hardly change the situation before 2025, in this timeframe the volumes are limited to 38 bcma of “Power of Siberia” at maximum, which is approximately one quarter of the current Russian gas export to Europe. There are negotiations on other projects ongoing, but uncertainties over China’s future demand and indigenous production, as well as its pricing strategy, make it very unclear what external supply it will need, while the collapse in oil and gas prices has made negotiating future contracts very difficult. So, there might be some diversification to Asia, but it is difficult to call it “reverse”.
Similarly, LNG option provides low relief in the medium-term: several Russian LNG projects, which are currently under consideration, face commercial, technical or regulatory challenges, especially under the sanctions regime. In the new situation, only 15 mtpa of Yamal LNG look realistic before 2025. Of course, Russia was planning higher LNG production volumes, but inability to get western financing and technologies made a dramatic difference.
Summing up, it seems certain that in terms of overall revenues, the European market will remain the main source for both the Russian state and Gazprom for many years.
Adaptation of the gas pricing strategy
Europe is a mature, increasingly competitive market, and, in the future, the competition will only increase. In this situation, the most reasonable strategy is just to protect market niche (without any ambitious plans to expand it). In fact, Russia has a huge advantage compared to its competitors: it has created an incredible portfolio of long-term contracts, which guarantees even at minimum take-or-pay contractual obligations off-take of about 115 bcma by 2020. These 110-120 bcma could be regarded as the floor volumes of Russian gas export to Europe, and, on top of that, Russia is able to deliver more gas on spot basis or over take-or-pay obligations, if it provides competitive prices to its customers.
During the last years, when the gap between oil-linked contractual prices and spot prices was widening, Russia was preserving the traditional pricing model, while all European stakeholders were demanding competitive, spot-linked pricing. Nevertheless, statistical analyses demonstrates that although Gazprom still formally follows the traditional oil-indexation rhetoric, it has in fact already significantly reviewed its pricing policy. During the period 2009 –2014 nearly 60 gas supply contracts were reviewed with 40 clients, providing price discounts, easing of take-or-pay obligations and introducing spot component into the price formula. In 2013 Gazprom started to implement a new price discount model with so-called retroactive payments. According to this model, the company has to compensate its customers for the difference between contract price and spot price by the end of the year. This was an elegant way of executing a de-facto switch to spot indexation, while remaining formally within the framework of oil-indexed contracts. Calculations made using Russian Customs Service statistics, Gazprom reports and the Nexant World Gas Model, clearly show the increasing differential between calculated traditional oil-linked price and real Russian gas export prices to Europe: by 2015 Gazprom had already provided nearly a 25% average discount to its European customers compared to its pre-crisis traditional oil-linked price formulas.
So, Russia is trying to adapt to the fundamental changes occurring in the European gas market, though in a “concealed” manner; formally following the principle of oil indexation, while de-facto providing strong price discounts and linking pricing to spot prices via the retroactive payments model, and also introducing the new model of “gas auctions”: the first round took place in September 2015 in Saint-Petersburg, the second is planned by Gazprom in December at a time when Russian contract prices in Europe will likely be lower than the spot market.
The price concessions provided by Gazprom contributed to recovering of its gas exports volumes to Europe in 2013, though political events in 2014 and the desire to reduce dependency on Russian gas destroyed all these achievements. But, at least, Gazprom managed to restore its market share of 30%. In 2015 another factor added to the price game: as oil prices went down, so did the prices in the oil-linked contracts, driving Russian gas more and more attractive to the consumers.
The impending surge in LNG imports
However, what remains unclear is how Gazprom may respond to the impending surge in LNG imports in the future. Will it remain reactive, just providing refunds and lower prices where necessary, or will it adopt a more proactive marketing strategy to try and disincentivise the development of new LNG projects, even if it can’t stop the flow of gas from projects already under construction?
Theoretically, comparing LRMCs (long-run marginal costs) of the Russian pipeline gas and of all the new LNG supplies, which could reach Europe, we can see that Russian gas is still very cheap, if Russia would decide to compete on the cost basis. But this strategy would lead to significant decline in the export revenues, which are extremely important for the Russian government in the period of low oil prices and economic decline.
So, Russia`s first choice would be post-facto adaptation by providing limited concessions to its buyers. In this way, Russia can continue to focus on price maximization, employ the tactic of minimal price concessions, or defend its position on oil indexation in arbitration. But, in the longer term, it will undermine the competitiveness of Russian gas vis-à-vis that of the new suppliers targeting the European gas market. When massive new supplies would become available and when long-term contracts, which are now fixing the structure of the European gas import, would start to expire, Russia is likely to switch to the strategy of anticipatory adaptation with transition to spot pricing. Obviously, the future strategy choice will largely depend on the market supply-demand balance and the availability of cheaper supply options that are able to compete effectively with Russian gas. So the threat to Russia’s position will not be that great over the next few years, as there are no real supply alternatives, and Gazprom’s export volumes are well protected by long-term contracts, while beyond 2022-2025, when much more gas supply options would become available, Russia would have to become more market-oriented.
Anyway, Russia will not hurry to start this transition: it would only act once some of the many unknowns in the gas market - what will be the direction of gas demand in Asia and Europe, how much LNG will head to the European gas market and how low will US LNG producers be prepared to drop their prices – become clearer. Until then Gazprom in unlikely to start acting in an aggressive way, but it is certainly clear that if and when its market share in Europe starts to face a significant challenge it does have sufficient low-cost gas to respond. Russia would try to avoid complete switching to spot indexation as long as possible, as it is leading to significant loss in revenues. With the growth of alternative supply, primarily with the coming wave of LNG glut, Russia will have to enter into stronger price competition with the new suppliers, provide additional discounts, and introduce an explicit spot price component.
Improvisation in the pipeline strategy
Analysis of Gazprom’s statements of last 2 years showed many contradictions and a fast change of positions. It is especially visible in the announcements on infrastructure projects: South Stream, Turk Stream, North Stream extension and other ideas come and go. That gives an impression that Gazprom does not have a detailed strategy yet.
But, actually, the external conditions are changing at a fast clip: Russia has never before experienced such turbulence zone in the European gas market. The country has to adapt to the current circumstances. With the clear political goal of terminating completely Ukrainian gas transit, Gazprom is exploring ways to comply with new European gas market rules [like the Third Energy Package] with the new pipeline projects, but is trying to do so in a way that allows it to demonstrate some continuing control over the process. The offer to create a new “hub” at the Greece-Turkey border was one example of this, although so far it seems very unlikely to succeed. The recent auction of Nord Stream gas was another example, with the possibility of future auctions being held in St Petersburg. However, gradually Gazprom is adapting to the new reality, it is moving towards a position where it is accepting that trading on hubs is inevitable, and it seems likely that it will ultimately do this on the existing European hubs, albeit reluctantly.
So, improvisation is the best term to describe the situation: an inability to make a long-term strategy in such uncertain environment leads to the numerous options to allow for a flexible adaptation in the future depending on the market conjuncture and political barriers.
Today it is hard to tell which pipeline project is going to be completed exactly. One of the options is still using Ukrainian transit without any additional construction. Of course, the present geopolitical situation makes this unlikely. Other variants include construction of one or two lines of Turkish Stream and one or maybe even two lines of Nord Stream and different combinations between them. The impression is that neither Gazprom officials, nor the Russian Government know exactly what will be the result of the game, it depends on too many factors, mainly political: like relations with Turkey, the European Commission and Russia’s Western partners. So, having high hopes on a single project would be irrelevant for Russia.
Anyway, the desire to more comply with the new European rules is visible and one can state that Russia`s new gas export strategy is indeed more focused on adaptation to the new market reality rather than struggling with it, and in this case, from the purely commercial perspective, Russia has very good chances not only to maintain its position in Europe, but even to expand its export volumes in the longer term, as European indigenous production would further decline.
Dr. Tatiana Mitrova is Head of Oil and Gas Department of the Energy Research Institute of the Russian Academy of Sciences.
Image: Gazprom. By: Thawt Hawthje. CC-BY licence.