April 26, 2013

As Moscow Shifts to Eastern Energy Vector, Gazprom Faces Uncertain Future

Gazprom has long enjoyed the title of Russia’s “national energy champion,” but in a race to meet rising energy demand in Asia, Moscow’s shifting gas strategy could enable the rise of alternative gas producers Rosneft and Novatek, and weaken Gazprom’s position at home and abroad. Novatek, Russia’s second-largest natural gas producer, is working hard to bring the Yamal LNG project online and to secure future gas export contracts to Asia. Meanwhile, after recently acquiring significant offshore natural gas reserves, Russian oil major Rosneft has announced plans to enter the Russian gas market and has chosen independent gas producer ITERA to operate its future gas projects, increasing competitive pressure on both Gazprom and Novatek. A government decision to liberalize LNG exports, anticipated very soon, could be the final straw that breaks Gazprom’s stranglehold on the Russian gas export market. Yet, Gazprom remains hopeful in light of new supply agreements with China. Now, all three gas producers are gearing up for a heated competition over the future direction of the Russian gas industry.

In October 2012, Russian President Vladimir Putin warned Gazprom that the company’s position in Europe is under threat on several fronts. In September, EU antitrust officials opened an investigation into Gazprom to determine whether the company has hindered competition in European gas markets, for which it could be fined as much as ten percent of its global revenue. Meanwhile, global shifts in energy balances caused in part by the North American “shale revolution” have led to a displacement replacement of natural gas in Europe by cheaper coal, further weakening the outlook of gas demand in Gazprom’s primary export market. To re-balance the gas sector, Putin proposed a new program to develop new energy infrastructure and export hubs in Russia’s Far East, opening an “Asian Vector” for the gas industry.
However, Gazprom stands to lose more than it gains in Moscow’s new energy strategy. The company’s designated role in the “Eastern Gas Program” is to build a new LNG terminal in Vladivostok and a pipeline system in Russia’s sparsely inhabited Far East. Investment risks are high. Gazprom estimates that the program will cost $45 billion. Yet, factoring in the development of new gas fields in East Siberia (Chayanda and Kovykta), along with new pipeline and LNG infrastructure, costs could reach as high as $80 billion over the next 20 years. Yet, Gazprom faces another challenge to its position at home: the rise of Novatek and Rosneft in the Russian gas industry.
The rise of Novatek
Novatek first gained a foothold in Russia’s domestic gas market in the early 2000s. After initially entering into a strategic partnership with Gazprom, Novatek began actively selling natural gas directly to end users in Russia in December 2002, and gradually increased its activities on the domestic market by selling growing volumes of gas to Gazprom. As an independent producer, however, Novatek enjoyed an important market and regulatory advantage over Gazprom.
Russian gas prices are currently regulated by the Federal Tariffs Service (FTS), requiring Gazprom to sell gas on the domestic market within a fixed price range that is much lower than the export price for Russian gas. In 2011, the average price for FTS-regulated Gazprom gas for Russian consumers was $89 per thousand cubic meters, compared to the EU average of $480 per thousand cubic meters for Gazprom gas in 2011. Due to the extreme price difference, Gazprom was limited in its ability to finance major domestic gas projects, since it would face major profit loss by shifting activities away from the export market. As Gazprom focused on exporting gas, over which it has enjoyed a monopoly since 2006, Novatek expanded its activities on the domestic market. By the end of 2012, Novatek had even won major supply contracts with key former Gazprom customers in Russia, such as steel- and coal-producer Severstal for 12 billion cubic meters (bcm) of gas to 2017; Magnitogorsk Iron and Steel Works for more than 50 bcm through 2022; and Moscow region utility Mosenergo for 27.2 bcm to 2015.
Novatek’s principal operating areas are in the Yamalo-Nenets Autonomous Okrug (hereafter Yamal), an area bordering the Arctic Ocean in northwestern Siberia, 7,000 kilometers from Moscow. The Yamal region is a critical area for natural gas, accounting for approximately 83 percent of Russian gas production and 16 percent of total global gas production. The region is also home to Novatek’s key joint project with France’s Total, Yamal LNG.
In 2009, Novatek acquired a minority stake in the $20-billion Yamal LNG project, set to come online by 2017 and provide customers in Asia with a new source of Russian gas. However, since only Gazprom is currently allowed to export gas, Novatek had to enter into an “agency agreement” with Gazprom Export, making Gazprom the sole agent for future Yamal LNG export sales. Novatek unsuccessfully lobbied for a change in gas export policy last year, primarily due to its lack of government connections. Now, however, an anticipated government decision to partially liberalize Russian LNG exports could finally help the company break into the gas export market independently of Gazprom. New national energy champion Rosneft has thrown its weight behind the initiative and has announced plans to enter the Russian gas industry, presenting an unexpected opportunity for Novatek and spelling trouble for Gazprom.
Enter Rosneft
In mid-January, the Russian government announced a new offshore development program that would give Rosneft and Gazprom access to over 80 percent of energy reserves on Russia’s continental shelf. The government’s Agency on Subsoil Use estimated that Russia’s shelf reserves are up to 20 times underexplored compared to Norway’s, and pushed for ambitious new offshore production targets for both companies to meet by 2030.
In the first issuance of offshore development licenses at the end of January, Rosneft acquired an estimated 21 trillion cubic meters (tcm) of natural gas in twelve Arctic offshore blocks in the Kara and Barents Seas. Several weeks later, at a presidential meeting on Russia’s energy and fuel complex, Rosneft CEO Igor Sechin announced his support for partial gas export liberalization. Pointing out that natural gas now makes up almost half of Rosneft’s new offshore reserves, Sechin proposed adopting “LNG export liberalization for gas produced at offshore fields, on Russia’s continental shelf, and on the Yamal and Gydan peninsulas.” Moscow should prioritize LNG projects, according to Sechin, since developing a new gas pipeline transmission network through Russia’s Arctic zone would require enormous capital investment and leave little room for profit. President Vladimir Putin seemed to approve. “If we do not carry out an active (LNG export) policy, then we risk giving up practically the entire market for LNG to our competitors,” Putin said at the meeting.
At the time of writing, the Russian gas industry continues to wait for the government decision on gas export liberalization. President Putin’s warning to Gazprom in October 2012, what some in Moscow have called the company’s “Sputnik moment,” led to a sense of urgency over Gazprom’s direction. LNG export liberalization would rid the company of its monopoly over gas exports, but likely only to Asian markets. Russia’s energy minister announced mid-March that independent Russian gas producers are not likely to gain access to European export markets. However, with European gas demand lagging and its future uncertain, Gazprom must look elsewhere to secure its position.  With Rosneft’s sights set on new Asia-Pacific-oriented projects in Russia’s gas sector, Gazprom’s sense of urgency could turn into panic, if the company is unable to realize its East Siberian projects. The race to new markets in the Asia-Pacific is heating up, and China, the region’s largest potential market for Russian oil and gas, is playing a key role.
Shifting balances in the Russian gas industry: the role of China
There is tremendous potential for Sino-Russian energy trade, since both Asian giants are the region’s leading producers and consumers of oil and natural gas. Yet, over the past 15 years, Gazprom has failed to break into the Chinese gas market due to constant pricing disputes. For years, Moscow tried to sell gas to Beijing at the same or similar price that it sells gas to Europe, since the majority of Gazprom’s China-bound gas supplies would come from the same West Siberian fields supplying European customers. However, China was unwilling to pay European prices, since it had access to much cheaper Kazakh and Turkmen natural gas coming from Central Asia. Now, after a high-level Chinese visit to Moscow at the end of March, Gazprom may finally have a chance to come to an agreement with Beijing.
In late March, a government delegation led by China’s new president, Xi Jinping, visited Moscow and signed several new major oil and gas supply contracts with Rosneft and Gazprom. Weeks before, Gazprom officials, led by CEO Alexey Miller, began negotiations with China’s National Petroleum Corporation (CNPC) in Beijing over a new supply contract for gas coming from Gazprom’s fields in East Siberia. The company proposed transiting new supplies from its East Siberian hubs at Chayanda and Kovykta via its planned pipeline project, “Power of Siberia,” to northeastern China by as early as 2018. At a Kremlin ceremony on March 22, Alexey Miller and CNPC counterpart Jian Jiemin signed a memorandum of understanding for a 30-year supply contract for up to 60 bcm of Russian gas annually, and announced plans to sign a final long-term contract by the end of 2013.
During that same visit, however, Rosneft chief Igor Sechin also signed a new supply agreement with CNPC and invited the Chinese company to explore three offshore fields in Rosneft’s newly-acquired Arctic exploration zones in the Barents and Pechora Seas. The new Rosneft-CNPC supply contract could make China Russia’s second-largest buyer of crude oil after Germany. Furthermore, Rosneft received a $2 billion line of credit offered by China’s Development Bank during the Moscow visit, which the company said that it plans to direct towards infrastructure development in East Siberia and new natural gas projects. China’s Sinopec also took part in negotiations with Rosneft, offering to increase bilateral cooperation efforts in long-term LNG projects.
China could now play a leading role in shaping the future of Russia’s gas industry. Yet, Gazprom is far from saved by the promise of a major new supply contract to Beijing. Several important questions, particularly regarding access to financing major new energy initiatives, remain.
First, Gazprom must accomplish the major task of bringing its Eastern Gas Program online by the 2018 timeframe, the proposed start date of Russian gas deliveries to CNPC. Unless Gazprom receives a major source of outside funding, however, it is doubtful that the company will be able to accomplish this goal. Gazprom is already faced with lagging investor confidence, due to an anticipated decline in production from the company’s existing and planned fields through 2020, as well as doubts over the company’s ability to finance major pipeline projects, like the $24 to $30 billion South Stream and a proposed expansion of the company’s $20 billion Nord Stream, currently operating at below capacity. The enormous additional capital investment requirements associated with the Eastern Gas Program, ranging from $45 to $80 billion, cast doubt over Gazprom’s ability to finance all of these projects.
Second, Rosneft is likely in a much better position than Gazprom to attract financing for its upcoming offshore oil and gas projects. In February, Rosneft negotiated a $25 billion loan-for-oil deal with CNPC, probably helping the company close its TNK-BP takeover and surpass ExxonMobil as the world’s largest publicly-traded oil company a month later. At the end of March, Rosneft announced plans to acquire up to $10 billion more in Chinese financing, bolstering its ability to invest in new infrastructure projects, LNG, and even gas pipeline projects to China. On the sidelines of the Russo-Chinese meetings in Moscow at the end of March, Rosneft and CNPC also announced intentions to build a new gas pipeline to China.
Finally, if LNG export liberalization is realized soon and Novatek is able to break into the gas export market via Yamal LNG in 2017, it would outpace Gazprom in the race to markets to Asia-Pacific. Novatek announced in March that supply contracts for 80 percent of its gas from Yamal LNG are ready to be signed, and that it is in “advanced negotiations” with customers in Japan and elsewhere. Yet, the rise of Rosneft on the Russian gas market will likely hurt Novatek as well in the long run. Rosneft’s growing resource base will enable the company to increase its activities on the domestic gas market. A gradual increase in Russian gas prices will probably lure Rosneft further into this sector. In addition, Rosneft has already signed several major supply contracts with former Novatek customers, including Fortum, E.ON Ruhrgas, and Inter RAO. If Novatek is unable to sign enough new supply contracts to compensate for its losses to Rosneft this year, the company will likely have to review its production plans and growth strategy.
Gazprom’s role in the Russian race to Asian energy markets is uncertain. The short-term outlook does not look bright for Gazprom. Yet, with the rise of Rosneft as Russia’s new national energy champion, and Novatek as a new player on the gas export market, the long-term might be even dimmer.


This article was published in ICDS Diplomaatia magazine.

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