The Empire Strikes Back: European Energy and the Return of Gazprom

Compared to the Eurozone’s public finances, European energy policy looks decidedly bright. Capacity margins are high, prices are low, even emissions have dropped of late. The EU’s ‘Third Package’ of gas and power market reforms, which took effect in March, is set to further enhance supply security, increase competition and improve consumer choice and services. It all sounds very good, but the problem is that such ‘policy hits’ are grounded in weak fundamentals–not silver bullet policy making.  Shale gas developments have turned LNG markets on their head, while deep seated financial frailties and economic slumps have kept fundamentals weak and growth anemic across EU27 states. That’s making energy policy look good, and political populism all too easy.

But with growth showing tentative signs of recovery and climate policies still placing a premium on natural gas over coal, complacency and energy populism will come with costs. Nowhere more so than on natural gas – and the 158 billion cubic meters (bcm) of Russian supply that the EU will gobble up this year. After dipping to 2002 levels in 2009, EU gas consumption has surged by 7.2% in 2010, with most analysts expecting that by 2013, demand should have rebounded to pre-crisis levels. Increased LNG shipments to Asia have already added upward pressure on prices, and Germany’s snap decision to decommission its last nuclear power plants in 2022 will sustain demand growth for the foreseeable future. The European Commission, meanwhile, has taken its eyes off the Asian ball and remains undecided how it should deal with Russia, its single largest supplier. If RWE, Germany’s second largest electricity producer, and Gazprom, the world’s biggest gas firm, implement their recently announced Memorandum of Understanding (MoU) and establish a joint venture to manage coal and gas plants across Germany, the UK and the Benelux countries, the EU’s Third Package might well follow Germany’s 2011 decision to toss nuclear power into the dustbin of history. 
 

Thanks to European politicking, Moscow holds the energy aces. Berlin’s accelerated nuclear phase out may be popular, but it is likely to add as much as 20bcm/year to German gas imports alone. The French ban on shale gas drilling is hardly going to help reduce energy dependency, while Europe’s renewed commitment to democracy and good governance in its neighborhood may chime with European values, but has done little to reassure the authoritarian rulers who control alternative upstream sources in Central Asia and the Middle East that Europe is a credible energy supply bet. Any European state that follows Germany’s nuclear example, emulates France’s disdain for fracking,  or thinks it can ‘play nice’ and win with suspect neighbors will simply strengthen Russia’s hand.

Missing the point?

Overly dramatic? Perhaps. Conventional wisdom in Europe holds that Gazprom is in deep trouble.  The main reason for this relates to cheap spot markets that have been growing in liquidity. Oil indexed gas from Russia is deemed too expensive for European consumers to bear, with independent benchmarks on Western European hubs the preferred option. Move over or lose market share is the clarion call from consumers: current price spreads clearly point towards this way of thinking between UK wholesale hub and oil-indexed Russo-German border prices. Unsurprisingly, producers have been screaming murder. In 2010 Gazprom reportedly agreed to cut oil indexation levels in some long-term contracts to 85%, but insisted that the three years exemption would not change its long-term contract system. Algeria went a little further and called for the formation of a fully fledged gas cartel. So far, it was only really Norway that took price corrections on the chin by rapidly revising contractual relations to retain its stake in European supplies.

 

You’d think that with Gazprom on the ropes and shale gas starting to blossom beyond US shores that European capitals would not offer Russia an opportunity to regroup. Not so. In June, the German government shocked utilities, already out of the money on oil-indexed prices and burdened with an onerous nuclear fuel tax, when it reversed the October 2010 amendment that had extend the lifespan of nuclear plants by an average of 12 years in exchange for an annual €2.3bn ‘fuel rod tax’. Faced with a massive capital expenditure program, ratings downgrades and a negative outlook, RWE went cap in hand to Gazprom to offer the Russian company a major downstream stake in a rare and combustible blend of commercial and political brinkmanship.

Commercially, RWE’s gamble might pay off if Gazprom’s entry into the downstream game made it more amenable to price discounts that would narrow the gap between term prices and lower hub-based spreads. A more flexible Russian partner might also add pressure on E.On, RWE’s main competitor in Germany, whose supply contracts expire in 2012 having voiced its preference for ‘100% spot’. But the fact that Alexey Miller, chairman of Gazprom, has been talking with both RWE and E.On about prospective tie-ups suggests that he is far more likely to pitch the utilities against each other rather than to make concessions. If discounts are offered, they will be given on the strict understanding that oil indexation will remain the basis of Russian supply pricing in any long term take-or-pay contract. In short, Gazprom intends to use RWE and E.On as ‘sledge hammers’ to crack the European spot market ‘nut’ before it really takes off.

 

Although Gazprom will haggle to raise the current (alleged) $300/million cubic meters (mcm) target price, Moscow knows that it needs Chinese cash to consolidate its Eastern Gas Program and that spare funds could enable it to upgrade the integrated gas production, transportation and supply system that connects Eastern Siberia and the Far East. Gazprom also knows that while China may not be prepared to pay European gas prices, it is likely to agree to some kind of oil index link. Beijing is too cautions to buy into a buyers’ market, not the least because both Sakhalin and Shtokman have been earmarked for LNG development and might produce as much as 62 million tons a year by 2030. Even before the Fukushima meltdown boosted Japanese demand, Gazprom had been discussing prospective LNG deals with the likes of South Korea, India, Vietnam, Thailand and Singapore down the line to secure market presence and market share well beyond traditional Western European hunting grounds. 

 

There is no point in pretending that European politicians have woken up to these developments, let alone contemplated a ‘doomsday’ scenario in which Russia links its East Siberian reserves to the Unified Gas Supply System in a way that would allow it to switch between LNG or pipeline exports and route supplies to either the Atlantic or the Pacific basin at a mouse click. Even if the engineering and financial strains mean that Yamal will feed the EU for some time to come, Europe needs to understand that as the gravitational pull of supplies is shifting eastwards, Gazprom’s—and Russia’s—strategic focus will be on arbitrage not compromise.
 

Gazprom’s return thus highlights a number of bad moves the EU made while it was lulled by a soft gas market. Investment in storage capacity has been low, reforms to reduce pricing pressures have been meek and grid integration has been treated as a regional, if not local problem. More recently, the EU’s plans for upstream diversification have been debunked by its blatant failure to project military power across the Middle East and North Africa, and Germany’s decision to phase out its nuclear assets just as tighter markets were heralding the golden age of gas has been reckless at best; no matter what showings in local elections will prove, voter ‘preferences’ in Germany will not eclipse rising Asian demand, the energy needs of a European recovery, or potential supply side constraints as the downside risks of fracking and cracking unconventional gas become more apparent.  
 
European posturing has not only placed supply side eggs into predominantly Russian baskets, it has also encouraged Gazprom to renew its efforts to move downstream across the European value chain. If Russia manages to cement supplies to the East and enhance internationalization strategies across North African and Central Asian markets to boot, the prospects for European energy will be incredibly bleak, and even more so when markets will tighten.  Who knows, we might be truly grateful to retain an oil-indexed link by that stage to keep a lid on spiraling gas prices, and applaud those who turned a policy failure into a ‘crowning success’. But like with the Eurozone debt crisis, we will still wonder whether the price to appease the German voter is worth paying. 

 

Source ensec.org