Monday, January 21, 2013

Russia China Gas Talks Stymied

Russia and China ended 2012 no closer to a gas deal than when they began it.  The two countries continue to squabble over the construction of two natural gas pipelines designed to bring 68 billion cubic meters (bcm)    
to the Middle Kingdom.  The pipelines have been on the drawing boards for over 3 years, and Russian President Vladimir Putin believes that Eastern markets will be a focal point of Russian natural gas development.  Talks fell apart in 2011, however, when China increased its purchases from Turkmenistan.

In late April 2012, Chinese officials signaled optimism that the talks might resume.  Liu Tienan, head of China's National Energy Administration, told reporters China had  a new model for gas cooperation.  He did not specify what the new model was.  "Now all that remains is the question of prices," he said.  Tienan said Chinese Vice Premier Li Keqiang had presented Moscow with "a completely new model of development of cooperation...and received a positive assessment from the Russian side."  Tienan said both sides were interested in having private corporations from the two countries begin consultations.  Jiang Jiemin, the chairman of China National Petroleum Corporation, sounded upbeat as he explained that most of the key points to a gas deal had been agreed upon.  Putin also sounded conciliatory, "We are looking for compromises and are finding them," he said.  In an op-ed piece he wrote in June for a Chinese newspaper, Putin declared cooperation to be a Russian strategic goal:  "The energy-sector dialogue between our two countries also has a strategic dimension.  Our joint projects have a big impact in shaping the global energy market's entire configuration.  They offer China more reliable and diversified energy supplies for its domestic needs, and offer Russia the chance to open up new export routes to the fast-growing Asia-Pacific region."

According to Li Lifan of the Shanghai Academy of Social Sciences, however, when Germany renounced nuclear energy following the Japanese nuclear accident at Fukushima, Russia believed European demand for its hydrocarbons would increase.  The Russians refused to make compromises on the price question with the Chinese because Russia felt no need.

In June, Gazprom produced a new idea of its own: swapping production fields.  Russian Energy Minister Alexander Novak said, "Gazprom offered to let the Chinese participate in development of fields on Russian territory on the condition that Gazprom could participate in the development of fields on Chinese territory."  The asset swaps would be factored into the price of Russian gas shipments.  Gazprom CEO Alexander Medvedev said chances for an agreement in 2012 were very good.  "The talks are going on uneasily, but we have an understanding," he said.

In September 2012, Novak again reported progress.  He said Russia was requesting China pay in advance for natural gas from the proposed $14 billion Altai pipeline, up to 40% of the construction costs.  Matthew Hulbert commented that Russia remained unwilling to offer the price discounts the Chinese wanted.  Russia wanted $350-$400 per thousand cubic meters (tcm), while China wants to pay only $200-$250 tcm.

Putin ended the gas year making the same call for Eastern exports that he did at the beginning.  "The priorities should be supplies to the domestic market, our own economy and our enterprises, as well as diversification of markets to account for the prospective Asian segment and means of delivery," he said.

With cooperation between the two countries  uncertain, in September 2011 China signed an agreement with Kazakhstan increasing the capacity of the China Kazakh pipeline by 80% to 25 bcm.  They also signed an agreement to double pipeline capacity with Turkmenistan.  The Turkmen agreement will bring an additional 60 bcm to China by 2015, almost the same amount as the proposed Russian pipelines.  Beijing is also awaiting the completion of the trans-Burma pipeline for another 14 bcm.  Even Uzbekistan's tiny gas production is headed for China.  In May 2012, Tulagan Zhurayev, head of Uzbektransgas, said they were ready to start shipping gas immediately, as soon as some legal issues were settled.  "We haven't started shipping gas yet," he said.  "We pan this year to supply between 2 bcm and 4 bcm.  We have the gas and everything is ready."  The Uzbeks began their gas flows in August.  In short, while the talks stall Russia is losing market share to its competition.

Friday, January 18, 2013

Ukraine's Days Numbered as Natural Gas Conduit

Ukraine continues to argue that repair of its aging pipeline structure is an economical alternative to construction of the more costly South Stream pipeline.  According to Uralsib's Chris Weafer, however, such an alternative is a non-starter from Russia's point of view.  Weafer argues that repairs would continue to deprive Russia of control over the delivery of Russian oil, would remove Russia's ability to extend its economic interests into countries to be serviced by South Stream, and it would provide Central Asian gas a viable alternative transit route to Europe--thereby depriving Gazprom of its Eurasian monopoly. 

Russia could overcome one of these objections if it owned or controlled the pipeline network.  An unidentified Ukrainian  Presidential aide reported that Gazprom had offered $4 billion for the system.  The Ukrainians refused to transfer ownership of the pipelines, however, and various proposals for joint operations remained unconfirmed.  In December, 2011, Kommersant-Ukraine quoted an unnamed official in the Ukrainian Energy and Coal ministry as saying Ukraine and Russia had agreed to form a group to handle the pipelines.  The only real disagreement was that Russia wanted the new unit to be formed bilaterally, while Ukraine was hoping for European participation.  According to Ukrainian Ambassador Viacheslav Kniazhnytsky, however, "I have no information about this kind of consortium.  Besides, Ukrainian legislation doesn't provide for a consortium within which Gazprom can run Ukraine's pipeline."

To force the ownership issue, Russia is trying to use transit pricing as a weapon.  In December 2011, Prime Ministers Putin of Russia and Azarov of Ukraine failed to agree on a Ukrainian-demanded reduction in the price of gas, because Ukraine would not give Gazprom a stake in the pipeline network.  Gazprom CEO said Kyiv was demanding a $9 billion annual reduction in price, while citing the cost of modernization of the network between $3-8 billion.  Kyiv estimated the value of the system as roughly $20 billion, but Miller speculated the value could drop significantly once South Stream had been constructed. 

In reply, Ukraine announced it would reduce the volume of gas it would purchase from Russia from 40 billion cubic meters (bcm) in 2011 to 27 bcm in 2012 unless the price came down.  An angry Miller replied that gas sales to Ukraine were on a "take or pay" basis, and the price would be the same (based on 33 bcm per year) regardless of the quantity Ukraine imported.  "We are working strictly in line with the contract, strictly in line with this volume, " Miller told reporters.  Gazprom spokesman Sergei Kupriyanov added, "The time for discussion on contract volumes in the new year has passed.  And, unfortunately, we must remind our Ukrainian friends again that the terms of gas delivery are determined only by contract, and cannot be changed unilaterally by this or that letter."  Kuriyanov believed that time was on the side of the Russians:  "South Stream to full capacity, Nord Stream with additional lines and our existing capacity through Belarus and the Black Sea will reduce Ukraine's importance for transit to zero," he wrote in an email.

Ukraine may have felt pressured to procure a lower gas price because of pressure on its balance of payments position.  Deputy prime minister Serhiy Tigipko said that if the Russians did not agree to a lower price, the country would be forced to raise household gas fees by 30 percent.  Renaissance Capital's Anastasia Golavach explained:  "It is becoming crucially important for Ukraine either to reduce the volumes of the gas it buys or renegotiate the price, otherwise there will be huge pressure on its balance of payments, which are especially strained in the current global environment."  Golavach predicted it was only a matter of time before Ukraine gave in to Russian demands and sold the pipelines.  "The government realizes it's high time to sell the network because Russia has already launched one alternative pipeline and is planning construction of another.  But they won't do it before the elections because the move would be too unpopular domestically."  In the end, the government did not raise the rates.

Ukraine decided to up the ante by exploring alternative sources for its energy needs.  In January 2012, Minister of Energy and Coal Industry Yuriy Boiko told journalists he had entered into negotiations with Turkey for gas shipments via a new route.   There were also reports of plans to purchase LNG from Azerbaijan.  Prime Minister Azarov discussed plans to buy the gas from Germany.  No one addressed how any of these purchases would take place, since there was no direct pipeline connection with any of these countries, and Ukraine lacked a gasification plant if it tried to buy LNG.

In the midst of the controversy, Russia reduced the flow of natural gas to Western Europe because of a spike in domestic demand caused by an abnormally cold winter.  The Kremlin blamed the shortage on the Ukraine, arguing that the transit country was stealing the gas destined for Europe.  Ukraine denied the charges.  (See my blog entries "Kyiv Pulling Away from Moscow" and "Russia-Ukraine Price Dispute" for additional details.)

As Moscow threatened to cease using Ukraine for any gas transport, the European Union weighed in on the side of Ukraine.  EC spokeswoman Marlene Holzner demanded Ukrainian officials develop a plan to maintain their crucial role."The unique geographical location of Ukraine and its gas storage capacities mean that Ukraine can offer increased flexibility of gas supply.  The European Commission is convinced that Ukraine needs to elaborate a long-term strategy to ensure its position as the leading gas transporting country."  To help, the European Bank for Reconstruction and Development agreed to a $308 million dollar loan for emergency repairs, but only if the state energy firm Naftogaz agreed to a restructuring.

The Ukrainian parliament agreed to the breakup to the company in March 2012, lifting a previous ban on any reorganization of the company.  The law required, however, that the successor gas companies to be fully state owned--which would prevent Kyiv from selling shares to Gazprom, according to Reuters.

Ukrainian President Viktor Yanukovych held out hope for a new gas deal with Russia, but IHS Global Insight analyst Andrew Neff said such a deal "would probably be part of an agreement that would give Gazprom a stake in or control over Ukraine's gas transmission system."  Russia cranked up the pressure, with Gazprom confirming they were redirecting gas to the newly-opened Nord Stream and through Belarus. Gazprom spokesman Kupriyanov e-mailed, "We are at the start of a big move to redistribute gas transit volumes from Ukraine to our Beltransgas unit and new undersea pipelines."  Naftogaz's deputy CEO Vadym Chuprun admitted at the end of March that gas-transit flows to Europe had been halved. 

In April, the Ukrainian National Commission of Energy Regulation announced the gas distribution and storage system would be open to any gas producer, Ukrainian or foreign.  In theory, this removed the monopoly held by Gazprom; in practice, however, without alternative sources of gas, nothing changed. 

Gazprom then agreed to make an advance payment of $2 billion to Naftogaz so the company could purchase sufficient gas to fill its storage facilties.  "If Ukraine needs more money to fill up underground storage facilities in order to live through the next winter without any issues, we will consider providing these additional funds,"  said Gazprom's Miller.  Such actions would indicate that, while the Russians continue to pressure Ukraine by reducing gas flows, they are not abandoning the transit route entirely.  It is unclear that this money was ever received, however; as President Putin in December 2012 said Russian would have filled the system with fueld if Ukraine had agreed to its offer to lease the pipeline network--implying that it had not occured.

In a July meeting with Russin President Putin, Ukrainian President Yanukovich held out a possible compromise:  instead of giving Gazprom ownership rights in the transit network, Ukraine would consider a different Russian request--Ukraine might join a Customs Union with Moscow.  "We are not saying 'No', we are thoroughly and seriously studying these integration processes," he said. 

Such words were not backed up by action, however.  Instead of pulling closer economically to Russia, in August Ukraine passed over the Russian oil company Lukoil in favor of ExxonMobil and Shell for an $8.1 billion project to develop the Skifska hydrocarbon field in the Black Sea.  Prime Minister Azarov expressed confidence that Ukraine could become energy independent.  He predicted domestic gas production would increase 25% over the next three years, and opined that hydrolic fracturing technology could cover all of Ukraine's needs.  (There is an estimated 5.5 trillion cubic meters (tcm) of shale gas in Ukraine, of which 1.18 would be recoverable using current technology).

Boyko announced the country had begun importing gas from Germany, at a price 20 percent cheaper than Gazprom.  He also said there were plans to build an LNG terminal on the Black Sea, to be completed by 2015.  Buying gas from Germany is a reversal of gas flows, which traditionally have been East to West.

Azarov again brought up the possibility of a trilateral consortium (Ukraine, Russia, Europe) as a way to modernize the pipelines, He proposed transferring control of the network to the group, which would then involve all members in the projected 4.5 billion Euro modernization project. The EC's Holzner's response was coy, stating no specific proposals had been presented.  She then offered qualified support to the idea:  "The EU has consistently emphasised that it is up to Ukraine to decide how to manage its gas transmission system and should Ukraine and other parties be willing to move in the direction of a consortium, including the EU gas industry, the European Commission is ready to play a facilitiating role, provided that the application of EU and international law, including as enshrined in the Energy Community Treaty, is guaranteed."

Putin claimed that Russia supported the consortium, and that Ukraine had ultimately rejected t.  "It was a strategic error on the part of Ukraine to turn down an offer by Russia and its European partners to lease its gas pipeline network without breaching the Ukrainian legislation and providing for it to remain Ukrainian property," he said.

In the end, the two countries appear to be in a lose-lose situation.  Ukraine wants to remain the main transit route for Russian gas, but only if Russia will sell gas to that country at rates significantly below those stipulated in the 2009 project.  Russia refused, and Ukraine unilaterally announced a reduction in the amount of Russian gas it would take.  In retribution, Russia reduced the amount of gas it was selling--to the levels Ukraine had previously unilaterally set.  Russia, on the other hand, wants to buy or lease the Ukrainian network, a demand Ukraine has refused.  In the meantime, the valuable transit route continues to age, without sufficient money to effect necessary repairs.

Tuesday, January 15, 2013

Russia Accelerates Oil Sales to the East

With the December 2012 opening of the second leg of the East Siberia-Pacific Ocean (ESPO) pipeline, analysts have begun to focus on Russia's turn to the Pacific Basin--and what it means to Europe.  Russia's interest in its oriental frontier is not new, however;  it was the whole purpose behind building ESPO in the first place.  "We will have a future of accelerated growth when we have two strong legs:  not just one in Europe, but one in Europe and the other in Asia," said Igor Shuvalov, the Russian first deputy prime minister for economic affairs.  Then-Prime Minister Vladimir Putin in August 2010 said the project created "notable competition" to European deliveries.

The first leg of ESPO began shipping East Siberian oil to the Chinese city of Daqing in January 2011, but the last leg of the Russian pipeline--to the port city of Kozmino on the Pacific Ocean--was delayed.  Oil shipments to the Pacific had to complete the last leg of their journey aboard railroad cars.  In January 2011, however, Russia began sending ESPO oil to the United States when the Trans Alaskan pipeline was shut down after developing a leak.  To make up the shortfall of product to their West Coast refineries, BP contracted the tanker Nelga Spirit to take 100,000 metric tons (700,000 barrels) of oil to the United States.

With the opening of ESPO's Daqing connection, the transfer of oil sales to the East was felt almost immediately in Russia's major oil port, Novorossiysk.  Chris Weafer, chief strategist at UralSib Financial Corporation, said "Investors are shy of Novorossiysk stock right now because there is uncertainty over how long the gap between losing oil and picking up other cargos will last.  Jonathan Kollek, vice president of TNK-BP for sales, trading and logistics, said the Black Sea route would probably bear the brunt of falling crude flows as ESPO came on line.  Elena Sakhnova, a transportation analyst at VTB Capital, predicted that oil volumes at the port would probably decline at a rate of between 3 and 6 percent for a couple of years before stabilizing (presumably at the lower level.)

The pipeline has a tremendous capacity.  Oil exports can be increased from the current level of 15 million tons annually, to 50 million tons.  The total estimated capacity of Russian oil exports to the region is 80 million tons, according to Vladimir Feigin, general director of the Institute of Energy and Finances.  The question becomes, from where will the oil come?  Until now, ESPO oil has come primarily from Rosneft's Vankor oil field, but production there is only expected to increase next year from approximately 80,000 metric tons to 90,000 metric tons.  "It would be quite a challenge for Russia to fill the pipeline.  And some of the east Siberian fields have not been performing as expected,"  said UBS oil expert Julius Walker.

Without easy access to sufficient East Siberian oil, Russia is turning to the West Siberian fields that send oil to Europe.  The Moscow Times reports that a first-quarter loading schedule shows that Russia will cut Europe-bound oil supplies, with the biggest decline (20%) expected at the Baltic port of Ust-Luga.  "There is just enough East Siberian for the existing pipeline," said Sberbank analyst Valery Nesterov.  "But expanding this pipeline further would be impossible without West Siberian oil - and that oil is already meant to go west."  Alfa Bank senior analyst Alexander Kornilov added, "Of course, there is a risk of oil-flow cuts to Europe."  The cuts could be based on economics, or on political considerations as remarks from Transneft CEO Nikolai Tokarev demonstrate."We do not owe a single EU country a thing, and we are certainly not obligated to account for ourselves,"  he said.  "If they want to hold a normal proper conversation, they should change their approach to such a dialogue." 

Tokarev outlined who the main customers for the new oil flow would be, and led off the list with the United States.  "The American market will receive 35 percent of Kozmino oil.  Around 30 percent will go to Japan and 28 percent to China.  The rest will go to Singapore, Malaysia and South Korea."

Tokarev's predictions do not take into account the effect of the fracking revolution in the United States.  Oil production in the United States for the week ending 4 January 2013 is up almost 15 percent over the same time a year ago, and the country met 83% of its energy needs in the first 9 months of 2012 from domestic production, according to the Washington Post.  As a result of the increase in US production, the International Energy Agency is predicting that the US could surpass Saudi Arabia as the world's leading oil producer by 2020.  Should Russia divert its oil shipments to the Pacific, it might find its markets have been flooded already with cheap, American product.