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Derek Brower: Crunch Time

Europe is still worried about what Gazprom will do next. The bigger problem is what it won’t do By Derek Brower, Journalist DO YOU want Putin’s paw on the pipe, asked the Economist not too long ago. It summed up nicely Europe’s biggest worry. What happens the next time the Russian President gets in a huff about one of his neighbours and cuts off gas exports again, as Gazprom did to Ukraine in 2006? But there is a better question: what happens if Gazprom doesn’t have enough gas to supply all of its customers in time?

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Something needs to fill that pipeline

That question is less sexy. And at first glance, it doesn’t involve the same geopolitical gamesmanship that many took to be at the heart of the so-called gas war between Ukraine and Russia at the beginning of last year. But it is the question that sits at the back of almost all of Gazprom’s activity right now. The gas Opec threat? Meddling in Central Asia? Shady deals with European companies? All of them, to some extent, reflect Gazprom’s insecurity in its own upstream. The numbers aren’t encouraging. Vladimir Milov, a former deputy energy minister of Russia and now the head of the Institute of Energy Policy in Moscow, says that Russia could face a gas shortage of 100bn cubic metres (cm) a year by 2010. That would be just shy of a quarter of Russian demand, and would represent a grave failure for a company that controls 27% of the world’s natural gas reserves. Others forecast the number to be even higher. In a paper for the Centre for European Policy Studies, Alan Riley says that the supply crunch will be around 126bn cm/y by 2010. But it could be as high as 200bn cm/y, he adds. Gazprom rejects such numbers. Alexander Medvedev, head of the company’s Gazexport arm, told me last year that there would be “no shortage of gas in Russia either by 2010 or by 2020”. But taking the company at its word in the face of other statistical evidence is not easy. Between rocks and hard places Any shortage would leave Gazprom facing a difficult choice. Should it break its supply agreements to European customers, who pay market prices for its gas? Or should it cut supplies to Russian industry and people, the constituency of Gazprom’s famous “social obligation”? Given that Gazprom alone accounts for around 20% of Russia’s tax revenue, income from exports is important. But the Kremlin won’t want its gas company to punish Russian voters, either. Who is to blame? One fact is indisputable: Gazprom hasn’t spent enough in its own upstream to keep production growing. Some $70bn is required to develop three new giant gasfields in the Yamal peninsula. In the meantime, it has been spending money to buy other companies, like Sibneft. That has brought some new gas reserves to Gazprom. But it has also brought lots of debt. And, as investors in the energy industry like to remind their companies, buying reserves from other companies isn’t the same as finding more of them in the ground. And Gazprom has also spent large sums on “other” sectors, such as media – round $14bn, according to some estimates. That’s almost as much as it would cost to develop the Bovanenkovskoe field, the largest of the new fields Gazprom wants to bring on stream in Yamal, according to Wood Mackenzie, an oil consultancy. There are, of course, other factors. Demand for gas in Russia continues to grow by around 2.5% a year. And it is being bolstered, says Riley, by Gazprom’s “perverse” decision to press on with rural and urban gasification. The company wants 60% regional gasification by 2008 and is spending $1.3bn adding another 12,000 km of pipelines to its network. That might be good news for pipeline efficiency and the environment, but it would add at least another 9bn cm/y to demand. Riley says the figure could be closer to 20bn cm/y. Meanwhile, losses from inefficient gas processors on the network amount to some 46bn cm/y. Losses from gas flaring in Russia amount to 60bn cm/y, according to the International Energy Agency. That’s almost as much gas as Italy consumes in a year. (Officially, Russia admits to 15bn cm/y of flaring.) Meanwhile, over the last six years, Gazprom’s production growth has been stagnant, with the decline of the producing fields in the north particularly stark. Milov blames state interference in Russia’s energy sector. In contrast with Gazprom, whose majority stakeholder is the Kremlin, the independent producers in Russia have rapidly increased their production. Cheap gas A deeper problem is in Russia’s economy, says Jonathan Stern, of the Oxford Institute for Energy Studies. Russia’s industry is addicted to cheap natural gas. Increasing prices is part of the answer, and one that the Kremlin seems to have accepted. In November, it said prices for natural gas to industrial users would rise to around $125 per 1,000 cm by 2011 – double, in real terms, what they are now. That gives Gazprom some of what it wants. My sources in Moscow tell me that the company has effectively held off spending on new fields in Yamal as a way of forcing the government’s hands over price increases. That makes sense. Stern says that developing the Yamal fields could cost around $70 per 1,000 cm. Until prices in the domestic market pass that mark, Gazprom would make a loss on the fields in its own country. Gazprom hopes to have those fields on stream by 2011, though most analysts say that is optimistic. The OECD predicts that they will be on stream in 2015, at the earliest. Those reserves are critical to Gazprom. Bovanenkovskoe field alone, which Gazprom wants to bring on stream first, could eventually produce 115bn cm/y. As for fields like Shtokman, in the Barents Sea, if Gazprom is truly to develop the reserves on its own it will need even more cash to do it. The likelier outcome is that the company will concede that at least one foreign partner is needed – both for financial and technical reasons. But until some clarity emerges about how the field will be, the date of its debut gets more distant. That means that the gas shortages could emerge despite the increase in natural gas prices that Gazprom has been seeking. And it returns the issue to the fundamental problem of Russia’s ageing industrial stock and its colossally inefficient use of energy, says Stern. Only 20% of the country’s Soviet-era plants and infrastructure has been replaced in the last decade; even less was replaced in the Yeltsin period. That leaves the bulk of industry badly in need of being replaced if Russia is to use gas more efficiently. In turn, suggests Stern, that means the country’s industrialists must have faith that their property is safe and worth the large investment needed to replace it with new expensive, but more efficient, machinery. The legacy of the Yukos affair, he says, has undermined that confidence. What is to be done? So what can Gazprom do? There are two other sources of gas that the company wants increasingly to tap. The first is domestic: the local independent gas producers. Their growth in production has been spectacular, especially compared with Gazprom. The government forecasts that they will account for 20% of supply by 2020, compared with 13% now. The IEA suggests that the figure could be much higher, closer to 40% by 2015. But that success has attracted Gazprom. It bought Sibneftgaz (and the Beregovoe gasfield), Yamal LNG (and the South Tambey gasfield) and part of Novatek in 2006 and is likely to take control of the Kovykta gasfield from TNK-BP later this year. Milov says Gazprom’s involvement could destroy the sector’s growth. Stern disagrees, and says that a “sea change” in attitudes inside the state-controlled company means that the independents are now seen as “part of the solution”. Since Gazprom bought 19.99% of Novatek its production has not suffered, he points out. And he says that there is evidence of Gazprom offering the independents access to its infrastructure. However, until and unless these companies are ever allowed to build and own their own infrastructure – and export their gas – their role will be strictly controlled by Gazprom, even if they remain independent in name. The other source of gas is Central Asia. Gazprom hopes to import up to 105bn cm/y from Turkmenistan, Kazakhstan and Uzbekistan by 2011. Bizarre as it seems that the world’s biggest gas exporter should import gas from its neighbours, Stern says it makes good sense: Turkmenistan’s gas is cheaper to buy than Gazprom’s Yamal gas is to develop. But Riley warns that Gazprom ought not to rely on those volumes of gas from the region. Turkmenistan’s own chronic underinvestment means that exports of some 80bn cm/y to Russia by 2011 are optimistic. And the pipeline infrastructure in Central Asia that Gazprom relies on for those imports is decrepit. Nor is there much faith among independent analysts that Turkmenistan has as much gas as it says it has. But the region’s importance to Gazprom means that Moscow will continue to keep a close eye on how Turkmenistan, in particular, develops politically. Not just Russia’s problem All of this should worry the EU, Russia’s most important foreign market. While politicians have, since the Ukraine gas war, focused on the political risk associated with imports from Russia, Riley says that has distracted them from the real issue, that Gazprom might cut supplies for good old market reasons of scarcity. Stern says that even if Gazprom succeeds in meeting all of its commitments, its exports to Europe will be limited in future to 200bn cm/y. The EU, he says, hasn’t realised that, either. What the European politicians haven’t realised, the continent’ companies have. The prospect of a supply crunch in Russia, or of a cap on exports, has triggered a rush among importers in Europe to sew up contracts while they can. That has worked in Gazprom’s favour. A deal in November 2006 with Italy’s Eni guaranteed Russian sales into Italy of 28.5bn cm/y (36% of Italian demand) until 2035. In exchange, Eni offered Gazprom a downstream foothold in one of Europe’s biggest gas markets. The small print seems also to have included a stipulation that Eni participate in a shady deal to buy assets on Gazprom’s behalf at the Yukos auctions earlier this month. Hungary and Germany have also seen the writing on the wall. Their bilateral deals with Gazprom to build new pipelines into Europe will effectively turn both countries into satellite energy states for Gazprom. The company is already publicly referring to both countries as “hubs” in Europe for its gas. Those pipelines should guarantee supply of gas into Germany and Hungary. But in exchange they hand over the security of their supplies to Gazprom. The strategy seems to be: sign the contracts now – while there is gas to be bought; and worry later about the consequences. It seems likely that Gazprom will soon move to buy downstream assets in continental Europe, too. For a company with limitations on its exports, that would make sense, allowing it to maximise prices on sales by marketing the gas itself. And the essential upstream weakness of Gazprom is another reason for the gas Opec bluff. Lack of spare capacity and the fundamental nature of the world’s various gas markets mean any effort to form an international gas cartel would be unlikely to work. Russia, above all other exporters, knows that. But talking up the prospect of a gas Opec is another matter. It helps mask the problems in Russia’s own gas sector while at the same time tries to convince consumers that power is in the producers’ hands. But Russia’s upstream problems should also be an opportunity to move into a new era of energy relations between Moscow and Brussels. As Milov points out, Gazprom’s problems are chiefly related to state interference and the lack of liberalisation in Russia’s energy sector. This could be the hour of the Energy Charter Treaty. Russia needs heavy upstream spending, competition among its gas companies, full price liberalisation and a fundamental overhaul of its Soviet-era industrial stock. As long as the state’s grip over the country’s energy sector remains so strong, none of that is likely. Winning that argument in Moscow might only be possible after the supply crunch really starts to bite.