EU Reliance on Russian Gas Increasing

The European Union's dependency on Russian energy continues to increase.  Demand for natural gas has grown from 325 bcm (billion cubic meters) per year in 1990 to an estimated 550 bcm in 2015, according to the International Energy Agency.  Consumption is projected to increase to 669 bcm by 2035.    Some European countries, such as Belarus, Latvia, Lithuania and Slovakia depend on Russia for 100% of their natural gas, according to the US Senate's Committee on Foreign Relations.  Several others, such as Austria, Bulgaria, the Czech Republic, Estonia, Finland, Moldova and Turkey rely on Russia for over 60% of their gas needs.

European consumption of Russian gas had been expected to decrease in face of competition from coal, LNG, and shale fuels.  Alternative fuel sources, combined with the slowdown in European economies, was supposed to reduce the demand for Russian gas, which is priced at a premium to the market.

Faced with these forces, Gazprom has initiated a series of price cuts for its European customers.  In 2012 they reduced prices 7-10% on average, even returning money via "retroactive payments" to customers with long-term supply contracts.  These rebates totaled $3.22 billion.  In June 2013, Gazprom export chief Alexander Medvedev announced that prices would be further reduced, but "The price correction will be even less than in the previous round of talks."  Medvedev estimated the new reductions would total less than $800-$900 million.  Medvedev also said that the company would cut prices in new contracts in which the price of gas is tied to the price of oil.  As a result, the average gas price for Europe would decline to approximately $375 per 1,000 cubic meters, from the 2012 price of $402.  (Of course, not all European countries benefit from this action:  Ukraine is stuck with a long term contract with a price of $440 per tcm.)

As a result of these actions, in the first eight months of 2013 Gazprom shipments to Europe and Turkey increased 14%, to the highest level since 2010, according to Gazprom Export.  The reasons are price (the premium over the spot price dropped 66% over the previous 12 months) and the failure of LNG supplies to materialize.  "The European gas market is shifting again, to a certain extent, from a buyer's market to a seller's market because of a sharp decline in LNG supply," said Sberbank analyst Valery Nesterov.

The increase in demand is providing Gazprom a rationale to limit further price concessions.  Gazprom, and its owners (the Russian government) rely heavily on the European market for its revenues--and the Russian budget relies on the income.  50% of the Russian government's budget comes from energy export revenues; with the decline in price for Gazprom's product, the funds are coming more from Rosneft's sale of oil.  80% of energy export revenues today are due to oil, not natural gas. according to the Atlantic Council's senior fellow Dr. Frank Umbach.  This has led to a shakeup in the Kremlin's hierarchy, with Rosneft's Igor Sechin increasing in influence at the cost of Gazprom's Alexey Miller.

  

Transneft-Rosneft Kiss and Make Up

The summer battle between two energy barons in Vladimir Putin's inner circle has been resolved.  On October 11, 2013 Rosneft chairman Igor Sechin and Transneft chairman Nikolay Tokarev reached agreement on financing the further expansion to China of the Eastern Siberia-Pacific Ocean (ESPO) oil pipeline.

The spat began in anticipation of the June 2013 signing of a contract between Rosneft and the China National Petroleum Corporation (CNPC).  That contract obliges Rosneft to deliver an additional 365 million tons of oil over the next 25 years.  This is an increase over the previous contract Rosneft signed to supply 15 million tons annually for the next 20 years.

With negotiations underway for this landmark agreement, Rosneft's Sechin began lobbying for the expansion of the ESPO pipeline spur to China.  Transneft's Tokarev would have none of it.  In a rare public display of disagreement within Putin's siloviki, the Transneft chair identified the source of the conflict:  money.  "Who will pay to expand the pipeline spur to China?" he asked in May 2013.  "Transneft isn't just a service company for Rosneft."

Despite Tokarev's objections, the contract was signed at the International Economic Forum in Saint Petersburg.  With the question of pipeline financing unresolved, Transneft upped the ante by announcing they would stop pumping Rosneft oil on July 28 because at that point Transneft would have fulfilled its previous contract with the state-owned oil company.  Sechin was unperturbed.  "We are in contact and interact with Transneft's CEO Nikolai Tokarev.  There was no conflict.  Obviously, during commercial work the companies may have different positions.  But this is not a conflict but a regular negotiations process."

Sechin's position was that Rosneft would pay an "economically justified tariff", but he did not believe he should finance the expansion of Transneft's network.  Igor Demin, spokesman for Transneft, disagreed.  He said that the pipeline project would be solely for the benefit of one oil company, Rosneft.  If Transneft had to find financing for the project, the entire Russian oil industry would have to pay for it.

The Russian government remained neutral.  Deputy Energy Minister Kirill Molodtsov basically said he didn't care who paid for the pipeline, as long as it remained profitable.  "Profitability is the top priority.  That applies both to Rosneft and Transneft.  This is what we are looking at when we consider the investment projects proposed by Transneft and Rosneft."

In August, the two oligarchs tried to use their ultimate trump card, their connections with President Putin.  Sechin began by writing an eight page letter accusing Transneft of charging too much to transport oil.  "The current system of Transneft's transport tariff system is not transparent and does not suggest reduced tariffs for oil companies, which invest in this region and supply the Far East region with oil products."  Tokarev responded with an analysis that Transneft tariff's had not contributed to a rise in gasoline prices.

Transneft then accused Rosneft of signing delivery contracts it could not fulfill.  Speaking to a ministerial meeting in September 2013, Transneft vice president Alexei Sapsai warned that Rosneft was in danger of being short at least 3.9 tons for its eastern routes.  If a planned Rosneft petrochemical complex (VNHK) comes on line, the shortage would stand at 15.9 million tons.  Transneft even decided to withdraw their role in the refinery because of the disagreement on tariffs.

Despite the fireworks, the two sides reached an agreement on October 11, 2013.  According to a statement on Rosneft's website, "Rosneft President and Chairman of the Management Board Igor Sechin and Transneft President Nikolai Tokarev have signed a number of agreements in fulfillment of the strategic plans on mutually beneficial terms and based on principles of co-financing to increase oil supplies volumes to China and to the Rosneft's Tuapse refinery in the Krasnodar region.  The package of agreements on oil supplies increase to China envisages commitments by the Parties to finance and implement the activities aimed at the capacity expansion of the Skovorodino-Mohe oil pipeline, as well as to increase respectively the volumes of crude shipment in this direction.  The pipeline capacity is expected to reach 20 million tons of crude per year beginning on 1 January 2015 and 30 million tons per year beginning 1 January 2018.  It means that 15 million tons per year will be supplied to China from 2018 to 2037 in addition to existing volumes."

According to Vedomosti, Transneft will finance the expansion of the pipeline, while Rosneft will pay back the investment through a special long-term tariff to be determined by the Federal Tariff Service.  This is a clear victory for Igor Sechin, who had made the same proposal in July.  In addition, it appears that Rosneft will only have to pay for a small portion of the ESPO expansion.  The Russian Ministry of Energy estimates that the total cost for the development of ESPO will be $1.46 billion (Transneft puts the figure around $2.29 billion), but Rosneft is only financing the Skovorodino-Mohe section, whose cost is an estimated $300 million.

The world's largest oil company has trumped Transneft, a company that is led by Putin's former KGB boss.

Putin leaves Azerbaijan With Limited Improvements

Russian President Vladimir Putin traveled to Azerbaijan in August 2013 to enhance Russian interests in the near abroad.  He was accompanied by six key ministers, including the Russian Minister of Defense, Sergei Shoigu and Minister of Foreign Affairs Sergey Lavrov.

The visit was surrounded by rumors.  Leonid Gusev, senior research fellow of the Institute of International Studies, Moscow State Institute of International Relations, focused on the inclusion of the defense minister.  "Why take Shoigu with you?  Because recently there was information that Azerbaijan and Turkey will create a unified army, and Georgia may join as well.  I think that the leadership of Russia wants to find out what it is, because you understand that Turkey is a NATO country."  Gusev's sources were remarks from Azerbaijani parliamentarian Zakhid Orudzh and Georgian Defense Minister Irakli Alasania.

Gusev's imaginings were quickly dismissed by Azerbaijani parliamentarian and political scientist Rasim Musabekov.  "There are issues in the military area that should be discussed," he said.  "It is not just military cooperation.  It is very important to consider issues that may affect Azerbaijan, such as the situation on the Caspian Sea where military activity has been gaining momentum; there is also the Iranian context, Middle East events and, most importantly, the settlement of the Nagorno-Karabakh conflict.  It is difficult to imagine the settlement of this conflict without Russia."

The Armenians also reacted negatively, convinced that the meeting would result in closer ties between Russia and Azerbaijan.  "Naturally, any bilateral relationship between our enemy and partner states cannot fail to worry us," said the chairman of the Armenian parliamentary committee on foreign relations.  "Azerbaijan is ready to exploit its relationship with any state for painting a distorted picture of its actions in the region."  Similarly, Armenian opposition leaders sounded the alarm.  Armenian National Congress spokesman Vladimir Karapetian said, "These are very worrisome developments for Armenia.  We must be prepared for further developments, especially in the Nagorno-Karabakh peace process."  Gior Manoyan of the Dashnaks criticized the Russian president, stating the visit was "not an ally's behavior."

The Armenians need not have worried.  Azerbaijani president Ilham Aliyev tried to enlist Putin's cooperation on the issue.  "Azerbaijan would like to see Russia as a referee," he said.  "The occupation of Azerbaijani land has continued for more than two decades.  What could be demolished has been demolished.  Twenty percent of our territory is occupied; the U.N. resolutions remain on paper."  In reply, Putin responded with a bland statement that any solution would have to be political.  "I want to stress that Russia is actively facilitating the search for the fastest conflict resolution, which is only attainable by peaceful means," he said.

Relations between the two countries have been strained over the past year.  Against Russia's wishes, Baku cancelled its use of the Baku-Novorossysk pipeline because it was uneconomical, and Russia cancelled its lease of the Gabala radar station rather than pay the rent Azerbaijan was demanding.  Despite these setbacks, Russian Foreign Minister Lavrov insisted the relationship had been neither affected nor deteriorated. 

Emphasizing the good relations between the two countries, President Aliyev highlighted the growing defense cooperation between them.  He said that Azerbaijan was among the top buyers of Russian arms and other military equipment, and the defense relationship was already worth $4 billion dollars.  This defense cooperation was highlighted by a visit of the Russian warship the Dagestan.

Missing from the summit’s summary were any agreements for Azerbaijan to join in Russian initiatives such as the Commonwealth of Independent States Free Trade Area (CISFTA), Eurasian Economic community (EurAsEC), or the Collective Security Treaty Organization (CSTAO-Azerbaijan allowed its membership to lapse in 1999)

The two presidents discussed the legal status of the Caspian Sea, a long-running dispute with ramifications for the underwater deposits of oil and gas there.    Putin described the discussion to reporters:  “During the talks we paid a lot of attention to the issues of the Caspian region,” reported Radio Liberty.  “There really are a very great number of unresolved problems, including security, border delimitation, preservation of biological diversity of the Caspian Sea, etc.  We have a vested interest in seeing all of these issues solved.”  In the past, Russia has used these issues to demand a veto over Azerbaijani proposals to build a Trans Caspian Pipeline.  No progress appears to have been made on these issues.

There were some positive results from the meeting.  The Russkiy Mir Foundation reported that a document on cooperation between emergency ministries was signed, as well as intergovernmental agreements on cooperation in air search and rescue, on the construction of a road bridge over the river that marks the border between the two countries, and a humanitarian cooperation program.

More importantly, Rosneft chief Igor Sechin signed an agreement with State Oil Company of the Azerbaijan Republic (SOCAR) cheif Rovnag Abdullaev.  The two CEOs pledged to cooperate on unspecified joint projects.  Sechin told reporters these would include "reciprocal deliveries, swap operations and opportunities for the use of joint infrastructure."  Rosneft subsequently released a statement that, "The companies agreed to cooperate in marketing and trading operations for hydrocarbons and petroleum products as well as jointly operate certain infrastructure facilities, such as pipelines and terminals."

In the end, both Azerbaijan and Russia emphasized the agreements that were signed, and labeled the visit a success.  On balance, however, when one balances what was achieved with the issues that were left unresolved, one can only conclude that Putin left empty-handed.  The summit meeting, Putin's first visit to Baku in seven years, was a lost opportunity.

Possible New Plans for Baku Novorossiysk Pipeline

Following Azerbaijan's cancellation of the northern flow of Azeri light because of decreasing profits, the Russian firm Rosneft is considering sending Urals crude south through the Baku-Novorossiysk pipeline.  The oil would then either be processed in Azerbaijan or be added to the Baku-Tblisi-Ceyhan (BTC) flow for onward shipment to the world market.  The BTC pipeline currently has spare capacity, as flows from Azerbaijan's offshore flows gradually decline.

Urals crude is a mix of various grades of Russian oil that trades at  approximately $4 per barrel less than Azeri light.  It was the mixing of Urals crude with Azeri light in Novorossiysk that reduced the value of the northern flow of oil, causing the cancellation of the use of the pipeline.  After Azerbaijan announced its suspension of the northern deliveries, Russian Prime Minister Dmitry Medvedev revoked the intergovernmental agreement that had authorized the northern use of Baku-Novorossiysk.

 The discussions on the possible reversal of flow in the pipeline was originally announced by the head of the State Oil Company of the Azerbaijan Republic (SOCAR) Rovnag Abdullayev.  The talks should be completed by the end of the year.  The announcement may have been premature, however:  the pipeline is controlled by the Russian pipeline company, Transneft, who had not been advised of the developments.  According to Mikhail Barkov, Vice President of Transneft, no one had coordinated anything with the company.  Barkov expressed concern that the plans might adversely affect Lukoil, which uses a portion of the pipeline to pump crude from Makhachkala to Novorossiysk.

Rosneft President Igor Sechin, possibly the most powerful oligarch in Russia today, hinted that the Abdullayev report might be correct.  Speaking to reporters, Sechin noted the pipeline was originally constructed with a southern flow in mind.  "Use of all possibilities is simply the effective work in the market," he said.

Transneft President Nilolay Tokarev noted that Rosneft has a refinery on the island of Sardinia, which would probably be the destination of the oil to be shipped from Ceyhan.  Speaking on the Russian television channel Russia 24, he pointed out that the Transneft system through Russia would cost Rosneft $45 less than use of the BTC.  (He possibly was referring to a metric ton, but it is unclear from the text).

The future of Baku-Novorossiysk thus requires two sets of negotiations:  SOCAR/Rosneft, and Rosneft/Transneft.  The latter may be adversely affected by difficulties between the two Russian companies arising from investment requirements for the expansion of the Eastern Siberia/Pacific Ocean pipeline.  Flows to the Mediterranean and flows to the Pacific have become interrelated.

Possible Reopening of the Baku-Novorosiysk Pipeline

Following a visit by Vladimir Putin to Baku and the signing of an energy cooperation agreement between Rosneft and SOCAR (State Oil Company of the Azerbaijan Republic),  the two oil companies have begun discussions on possible joint projects.

Rovnag Abdullayev, head of SOCAR, told reporters that he is in discussion with Rosneft to reverse the flow of the Baku-Novorossiysk pipeline.  This pipeline was recently closed when Russia refused to keep it running below capacity, and Azerbaijan refused to increase the flow because SOCAR lost money on the product.  (Russia mixed Azeri light with Urals crude, decreasing the value of the Azeri light).

Abdullayev said the two sides would hold talks through the remainder of 2013, and it was possible that Urals crude could begin traveling south in 2014.  Once the oil reaches Baku, it could either be put into the underutilized Baku-Tiblisi-Ceyhan pipeline for onward shipment to Europe; or, it could be used as feedstock for new Azerbaijani refineries scheduled to be completed by 2018.  Abdullayev said that the use of the pipeline would be negotiated directly by Rosneft with the Russian pipeline company, Transneft.

The two sides are discussing shipping 5 million tons annually (100,000 barrels per day) through the pipeline.  If the entire amount were shipped onward to Europe, the BTC would still have capacity.  Originally built to carry 1.2 million barrels per day, it is currently shipping approximately 750,000 barrels per day as Azerbaijani oil production begins to dwindle.

Russia and China Sign Major Petroleum Deal

On 20 June 2013, Russia and China signed a deal worth $270 billion dollars.  Rosneft agreed to double its sale of petroleum to China by 300,000 bpd over the next 25 years (5 years prolongable,)  from 15 million tons to 30 million tons per year.  The agreement was signed by Rosneft chief executive Igor Sechin and China National Petroleum Corporation (CNPC) chief Zhou Jiping in the presence of Russian president Vladimir Putin.

An important part of the deal is a $60-$70 billion prepayment for the oil, alluded to by Putin at the announcement of the contract.  JP Morgan analysts said, "If confirmed, this would be a transformational event for the company's balance sheet:  Rosneft could even potentially be able to show a net cash position, though working capital would be negative.  The prepayment could minimize financing risks for the leveraged state-controlled oil company."

The increased petroleum flows began even before the contract signing.  Reuters reported on June 18 that Russia was increasing its oil supplies to China by 13 percent in July-September over the previous three month period.  With this increase, Asia as a whole was importing 17% of Russian oil exports.  According to Valery Nesterov, analyst from Sberbank CIB, "Russia has been losing its interest in Europe where oil consumption is stagnant.  It's looking increasingly to the East."

Then came the June 20 deal, in which China acquired the rights to buy from the world's largest gas station:  Russia.  According to Liao Na, Vice President of the energy consulting company, ICIS C1 Energy, the timing was right.  "The seller and the buyer both have strong willingness to reach the deal provided the price was comfortable for each of them.  It is good timing, considering current international oil prices."

It was originally announced that fuel for the deal was to come from East Siberia fields.   In the annual meeting with Rosneft shareholders, Sechin named two fields as the main source of the oil, Vankor and Verkhnechonsk, that are nearing peak output.

In fact, the oil is not coming from East Siberia, but is being diverted from fields that service the European market.  Igor Katsal, Transneft deputy vice president, told reporters, "We supplied those 800,000 mt to the west and now will redirect them to the east.  They won't be replaced in the western direction."  Transneft confirmed that at least half of the redirected crude will be produced at Samotlor in West Siberia.  Deputy Energy Minister Kirill Molodtsov confirmed Russia planned to increase oil exports from the Pacific.  "The balance between West and East will change," he told reporters.

The reason for the diversion is that Russia has promised large quantities to Asia.  In addition to the current flows of 750,000 bpd, Russia promises to send another 9.1 million mt per year to China after a CNPC-Rosneft joint refinery is completed in Tianjin.  These changes are taking place at a time that Russian domestic consumption of crude is also rising.

How the oil will be delivered physically is still undecided.  Transneft spokesman Igor Demin said that there has been no change in its contract with Rosneft.  As a result, although Transneft has adjusted its transit schedule to accommodate the larger oil flows through the East Siberia-Pacific Ocean (ESPO) pipeline, Demin said that shipments might soon be suspended because it will have fulfilled its obligations under existing contracts.

The eastern "black gold" rush is encouraging others to enter into the field.  Lukoil CEO Vagit Alekperov confirmed that they are increasing exploration in East Siberia.  Alexei Kokin, an oil and gas analyst at UralSib Financial Corporation, wrote, "Other Russian companies' experience probably convinced Lukoil that East Siberian projects can be attractive.  As a late entrant, Lukoil will be able to learn from the pioneers' mistakes and be more efficient."

Russian Energy Flows Move East

In a move with major geopolitical ramifications, Russia is diverting increasing amounts of energy from the European market to the Asian.  Economically, it makes sense that Russia would want to be less dependent on the stagnating European economies, and the growing economies of Asia are a strong alternative.  "Russia has been losing its interest in Europe where oil consumption is stagnant.  It's looking increasingly to the East," said energy analyst Valery Nesterov.

The East Siberia-Pacific Ocean (ESPO) pipeline, originally opened with a branch line to Daqing (15 million tons delivered in 2012) has now expanded.  In January 2013 ESPO 2 opened to the Pacific Ocean.  ESPO oil flows are scheduled to increase from 30 million tons in 2012 to 80 million tons.   Bloomsberg estimates that in February 2013, Russia sent 1.1 million tons (22 percent of total oil exports)  in an easterly direction, up from 18 percent in October 2012.  By 2015, when ESPO reaches full capacity, Russia is scheduled to send 25 percent of its crude exports to eastern markets.

In addition to ESPO, which traverses only Russian territory, there is the possibility that Russia could sell additional oil to China via Kazakhstan.  Kazakh Energy Minister Sauat Mynbayev reported he was in negotiation with Russia to begin the sales as early as 2014.  The oil would reach China via the Kazakh Atasu-Alashankou pipeline. (Russia shipped oil to China through this pipeline until 2010.)   Kazakhstan would deliver 7 million tons of oil to China, and Russia would give Kazakhstan an equal amount in a "swap operation."  Such a move would be opposed by the Russian pipeline operator Transneft, who believes they would lose $1.5 billion in transshipment revenue.  Transneft CEO Nikolay Tokarev opined that the deliveries could proceed if the the lost revenue was compensated in the budget.

In March 2013, Rosneft and the China National Petroleum Corporation (CNPC) signed an agreement to increase oil exports to China.  In return for the agreement, China reportedly agreed to make an advance payment of $8-10 billion.  In addition, China Development Bank agreed to extend an additional credit line of $2 billion to Rosneft for the duration of the contract.  Russian Energy Minister Aleksandr Novak implied the delivery would be via the Kazakh swap mechanism.  No date was given for the signing of the contract.

As for natural gas, the situation is more complicated.  Russia already has agreements to send China 68 billion cubic meters (bcm) annually.  Deliveries have not begun, however, because of an inability to agree on price.  In March 2013, Gazprom and CNPC signed another memorandum of understanding in which the Russian company agreed to supply 38 bcm per year for 30 years, beginning in 2018. Price remains an issue.  Gazprom chairman of the board Viktor Zubkov was optimistic that an agreement could be reached by June, and hoped the price could be pegged to the cost of oil.  He admitted, however, that "the Chinese side probably believed there were other parameters that prices could be pegged to."  

European Commission Challenges Gazprom

With the industry's eyes turned toward the BP-Rosneft deal, little attention is being paid to the  Russian state-controlled natural gas company, Gazprom.  This institution has held a monopoly on the control of gas to Eastern Europe, and a controlling interest in the gas to the rest of the continent.  Now, however, Gazprom's position is being challenged by the European Commission.

On September 4, 2012 the EU's antitrust authories opened a formal investigation into whether the company had blocked fair competition in the natural gas markets of Central and Eastern Europe.  The European Commission said Gazprom may have divided markets by hindering the free flow of gas across European Union member states, and imposed unfair prices on its customers.  "Such behavior, if established, may constitute a restriction of competition and lead to higher prices and deterioration of security of supply," they said.  If found guilty on such charges, the EC could fine Gazprom as much as ten percent of its worldwide income. 

The EC investigation is currently focusing on the Eastern European countries of Poland, the Czech Republic, Slovakia, Hungary, Bulgaria, Estonia, Latvia and Lithuania--although it could be expanded.  It follows last year's raids on the office of Gazprom's European partners, probably in search of evidence to support the charges.

Russian President Vladimir Putin responded quickly, issuing a decree that strategicially important companies--including Gazprom--could not provide information to regulators from "unions of foreign states" without prior approval of the Kremlin.  Further, no approval would be granted if the changes "damage the economic interests of the Russian Federation."  Gazprom spokesman Sergei Kupriyanov characterized the investigation as commercial pressure, and threatened to direct Russian gas away from Europe.  The investigation "can be viewed as pressure from the European Union on Gazprom, with the goal of influencing prices and the results of commercial contracts, which clearly contradict the principles of market," he said.  Kupriyanov added the investigation is encouraging Gazprom to look to Asia for new markets.

The EC's actions are generally popular in Eastern Europe among a population that has been paying high gas prices under "take or pay" contracts.  "It is important what Brussels is doing," said Szymon Kardas, a Russian energy expert at the Center for Eastern Studies in Warsaw.  "This is the Competition Commission that took on Microsoft for its dominant position in Europe."  Lithuanian deputy ambassador to the European Union, Arunas Vinciunas, said, "For a small country it means a lot.  It shows that we can defend our interests through solidarity inside the E.U."  Not everyone agrees that the investigation is a good idea, however.  The Suddeutsche Zeitung called it an unprecedented action and a direct attack on Russia's President Putin.

Anders Aslund, a senior fellow at the Peterson Institute for International Economics, predicted Gazprom will be found guilty on all charges.  "The proceedings can take years," he wrote in the Moscow Times, "but the outcome appears obvious.  The oil-linked prices are likely to be deemed anti-competitive, as the very long-term contracts with fixed prices and volumes.  The Gazprom take-or-pay clauses that force a customer to take the whole volume or pay for it in any case will be prohibited, and prohibitions against reselling are evidently anti-competitive.  Finally, Gazprom will in all likelihood be fined billions of euros for its long-lasting malpractices."

Separate from the investigation, Gazprom is also under pressure because of weak demand in Europe and Asia.  In September, Gazprom announced it was restricting access to their pipelines by independent producers.  "Today the gas market in Russia has an excess of resources over demand," said Gazprom's deputy head of marketing and liquids processing, Alexander Mikheyev.  "In this situation we are looking at cuts to gas intake from independent producers."

The Europeans had long demanded that independents have unrestricted access to the pipeline network, as a way to insure a diversified supply for the European market.  But Merrill Lynch oil analyst Karen Kosanian points out that Russian domestic demand for natural gas is down 3.6 percent so far this year.  "In this environment Gazprom would have to shut in its own production to sustain the independents," she said.

The falling revenues, EC investigations, and competition from shale gas and LNG, have led Gazprom to lose its favored position in the Kremlin constellation of stars.  Gazprom has been the principle source of Kremlin revenue for decades.  The Russian government owns over 50% of the $119 billion company, and Gazprom accounts for 12% of all Russian exports, according to the Washington Post.  Profits were $44 billion in 2011, but have declined more than 23% in 2012.  Russian deputy minister of Economic Development, Andrei Klepach, said the company could face serious problems because of shale gas competition.  Further, the company has not made sufficient investment to modernize their operations.   "It's the nationalization of costs and the privatization of profit," wrote Rusenergy analyst Mikhail Krutikhin.

BP May Open Britain to Russian Gas

Additional ramifications of the BP-Rosneft deal are now coming to light.  With the purchase of TNK-BP by Rosneft, BP's Russian partners have agreed to end their legal battles with British Petroleum.  Sources claim that the two sides agreed to settle all their disputes after BP  made a $325 million payment to the Russian consortium AAR.  Supposedly, this move has been taken to give BP the freedom to pursue the development of Arctic oil.  "BP is not taking an equity position in Rosneft as a portfolio investor," said chief strategist at Sberbank CIB Chris Weafer.  "they are looking at a future relationship through which they can grow production and reserves in Russia."

It appears, however, that this deal has also cleared the boards for BP to work with Gazprom to bring Russian natural gas to Great Britain.  AAR had previously taken the position that their partnership with BP mandated all BP business opportunities in Russia be run through TNK-BP.  With all claims settled, sources report that the consortium has relinquished all claims on BP's future Russian activities.  That could include moving into the natural gas market.  Gazprom's  Chief Executive Alexi Miller reported in June that BP was interested in participating in an expanded Nord Stream pipeline, one that would carry product to Britain.

Such a move is a  questionable investment decision by the British company, given the plummeting price natural gas is commanding, and the large quantities of liquified natural gas (LNG) coming on the market to compete with pipeline gas.

Reprecussions from the sale of TNK-BP

With the recent decision of OAO Rosneft to purchase TNK-BP from its various owners, one of the most strained partnerships in Russian economic history comes to an end.  Rosneft has agreed to pay a total of $54.8 billion to BP plc and the Alfa-Access-Renova consortum (AAR) controlled by four Russian billionaires.  These oligarchs--Mikhail Fridman, German Khan, Viktor Vekeselberg and Len Blavatnik-- defied the stated policy of the Kremlin last year to prohibit BP from entering into an artic exploration agreement with Rosneft.  With ill feelings all around, it was apparent that this business union was headed for a divorce.

Initially, AAR offered to buy BP's 50% ownership in TNK-BP, but this offer was withdrawn when Rosneft offered to purchase AAR's shares instead.  AAR is slated to receive $28 billion for it's half of the company.  Rosneft then offered BP the chance to sell its shares, as well.  Anxious to raise capital to pay its Gulf spill-related expenses, BP agreed to accept $10-$15 billion in cash,and a 12.5% share in Rosneft.  BP plans to use part of the cash payment to purchase an additional 5.66% of Rosneft which, combined with the 1.5% share they already hold, will bring their share of ownership to approximately 19.75%.  75% of Rosneft is owned by the Russian state, while the remainder is sold in the market. 

Analysts believe that the majority stock holder Russian state will help finance the purchase.  "For Rosneft to buy both AAR and BP to form a fully state-owned oil champion would be the cleaner solution for the Russian state, and is likely to require further state injection into Rosneft, given that the company had previously been sounding out the market for a loan to buy part of BP's share," said RBC Capital Markets Corporation's Peter Hutton.  Not as much cash is required for the deal as the original figures would indicate, since BP and AAR are owed about $2.5 billion in dividends from TNK-BP.  According to journalist Paul Whitfield, this means the cash proceeds from the two deals are actually $26.75 billion for AAR and $15.85 billion for BP, falling to $11.05 billion for BP after its acquisition of Rosneft stock.

Russian President Vladimir Putin appears happy with the deal.  "This is a very good signal for the Russian market.  It is a good, large deal.  I would like to thank you for this work," he told Rosneft CEO and longtime ally Igor Sechin.  Putin should be happy:  the deal gives Rosneft a seat on BP's board.  This will give Russia a voice in BP operations outside of Russian territory such as in the Caspian where BP is the lead oil company.

The deal puts Rosneft ahead of Gazprom as the leading energy producer in Russia.  After the deal is consummated, Rosneft will produce 4 million barrels of crude oil a day.  This does not appear to be the result of any inside-Kremlin politics, but economics.  As the price of natural gas declines in the face of the shale revolution, it should be anticipated that Gazprom's importance would also decline.  Moscow needs revenues, however, and the price of oil remains high.  Igor Sechin, driven out of the cabinet by former President Medvedev, is back in the cat bird seat.

China Russia Energy Cooperation Moving Slowly

You would think that the most natural thing in the world would be for a large energy producer to partner with a large energy consumer, but in the case of China and Russia logic does not always prevail. The Washington Post quotes a Western energy executive who said, "They look like the perfect partners, but this is a marriage made in hell." He added the two sides were so afraid of being outdone by the other that negotiations tend toward all-or-nothing combat. The issue, whether discussing gas or crude oil, is the relationship between price and transportation distance.

In the case of oil, in October 2008 Russia and China signed an agreement in which the China Development Bank lent Transneft the funds to build an extension of the East Siberia-Pacific Ocean (ESPO) so that Russian crude could be delivered to the Chinese city of Daqing. The loan was to be repaid by supplying China with 300,000 barrels per day of crude for twenty years. Everything appeared on track, and on December 31, 2010, the first Russian oil crossed the Chinese border.

In April, Transneft reported that it was losing $20 million a month in the oil deliveries, because China had unilaterally decided that they were paying too much and reduced payments. Russia threatened to take the Chinese National Petroleum Corporation (CNPC) to the London Arbitration Court. China wanted a discount, because the oil they were purchasing traveled less than oil destined for Japan. according to Transneft spokesman Igor Dyomin, "There is no price difference for oil companies as to where they enter ESPO and where they exit...Russia is long out of socialism--we want fair market pricing."

Chinese Foreign Ministry spokesman Hong Lei was sanguine about the dispute. Reuters reported his comments that, "As for some concrete problems encountered during cooperation, we believe both sides can fully resolve this in a positive way via friendly negotiations and on a mutually beneficial, win-win basis."

Some progress was made in late May 2011, when China paid about three-fourths of the money the Russians claimed they were owed. Shortly thereafter, China resumed discounting its payments. After talks in early June, a Russian Energy Ministry spokesman said that the pricing formula would remain unchanged. "The price formula will be kept unchanged, we have agreed on that and China is ready to make payments according to it," quoted RIA Novosti. The Russians were overly optimistic, however. "They actually went back to the level of negotations which we had prior to the signing of the contract," Pravda quoted Transneft officials.

A Russian source stated anonymously that if the Chinese did not pay for the oil in full, that the dispute would go to the arbitration court, and that Transneft was prepared to repay its 20 year loan ahead of schedule, according to oilprice.com. With the loan repaid, Transneft could cease oil deliveries. China then moved the dispute from the state-owned company level, to the governmental level.

Russia's Deputy Prime Minister, Igor Sechin, tried to calm the situation. He said he did not see any problems that could not be solved, and that not all opportunities had been exhausted, according to RIA Novosti. Finally, in October, Premiers Wen Jia Bao and Vladimir Putin jointly announced a breakthrough. "The two countries agreed on crude oil prices and decided to actively push forward cooperation on oil and gas," China Daily quoted Wen. No details of the agreement were released but anonymous sources told oilprice.com that Russia, who had claimed China was underpaying by $3 per barrel, had agreed to a $1.50 discount.

At least a compromise had been reached. Natural gas is a different story. Currently, China consumes about 150 billion cubic meters (bcm) of natural gas per annum, approximately 4% of its energy mix. This amount is expected to double by 2020, according to a report in the People's Daily. Russia and China signed an agreement in 2006 to build two natural gas pipelines. Russia would then send 70 billion cubic meters annually to China. In 2011, despite numerous positive remarks by both Chinese and Russian officials, there is no pipeline construction.

Denis Borisov, an oil analyst at the Bank of Moscow, believes that Russia badly needs a gas deal with China, to diversity its exports away from saturated European gas markets. "Talks may last long but the gas deal won't be sacrificed..I think gas cooperation is a top priority for Russia," he told Reuters. This optimism was echoed by a Chinese source close to the Chinese-Russian talks,. "Our positions have gotten closer," he said about the possibility of a Chinese loan to build the pipeline.

In April, Chinese President Hu Jintao met with Dmitry Medvedev in the Chinese resort town of Sanya. The leaders announced they would pursue cooperation on major energy projects, such as the west natural gas pipeline from West Siberia to China, according to the Xinhua news agency. Despite the positive pronouncements, Interfax China reported that Gazprom and CNPC were involved in tough negotiations over price that did not appear to be progressing.

Everything looked better in May. Russian Deputy Prime Minister Igor Sechin reported that, after many years of fruitless negotiations, Russia and China had coordinated the key terms of a long-term gas contract. "We are considering two gas supply routes for the next 30 years. The western route will provide China with 30 bcm of gas, the eastern one with 38 billion,' he said. He also said there would be no problem with financing, according to the Voice of Russia. Sechin cautioned, however, that the two sides had not reached a final agreement on price--leaving that detail to Gazprom and CNPC, according to Russiaprofile.org. Chinese Assistant Foreign Minister Cheng Guoping was pleased: "Personally, I'm confident that if progress is smooth, then it's quite likely that in the near future..both sides will achieve a major breakthrough in cooperating over natural gas," he told a news conference. Xing Guangcheng, an expert on Russian studies at the Chinese Academy of Social Sciences, commented, "The deal is not an ordinary project between just two companies. It is a project of bilateral strategic importance, and it needs the determination of the leadership from both sides," according to China Daily.

It was not to be. President Medvedev announced that documents were being finalized, and Premier Hu Juntao said both sides ere willing to push forward, but price remained a stumbling block. "We are not going to sign anything this time," Medvedev concluded the negotiations, according to New Europe. Russian Energy Minister Sergei Shmatko commented, "This is not some simple bazaar deal; we can't hurry on this."

The disagreement was outlined in China Daily. Andrew Neff, an analyst who specializes in Russia and the Commonwealth of Independent States at IHS Global Insight, explained the Russian position: "Gazprom is focused on achieving a price agreement in line with that of its long-term, oil-indexed contracts for pipeline supplies to its European customers." But China disagreed. Pang Changwei, Director of the Institute for International Oil Politics at China University of Petroleum said it was unrealistic to base the price on the European market because the distance between China and Russia was much less than that between Russia and Western Europe. He reasoned that because transportation costs should be lower, so should the price. It was the same Chinese argument that disrupted oil deliveries through ESPO.

Some analysts believe that Russia has no intention to actually build a gas line, and that the lengthy negotiations are a ruse. RusEnergy partner Mikhail Krutikhin opined that clearly no gas agreement would be reached. "Russia is trying to scare Europe with threats of redirecting its gas to China, but China is not ready to pay $220-$230 per 1,000 cubic meters," he said according to Nezavisimaya Gazeta. Robert Cutler cited a Chinese press leak that the two sides were as much as $100 per thousand cubic meters apart on price.

In the end, price differences could be negotiated, but the heart of the matter is a lack of trust between the two sides. "China looks very seductive, but" said former Russian deputy energy minister Vladimir Milov. "there is a deep lack of trust behind the facade," quoted the Washington Post. This lack of trust could be generated by geopolitical rivalry between the two sides, according to analyst Alexandros Petersen. The Chinese officially reject such an analysis as an "inaccurate Western perspective," but Petersen quotes a Sinopec analyst saying, "Our interests and the interests of our government are to see stable governments in the region...The result is soft geopolitical competition between China and Russia. And it is spreading."

All that's left is to see what is more important: access to energy, price or geopolitics.

BP-Rosneft Deal a Victim of Russian Presidential Politics

Russian presidential politics may have been directly responsible for the collapse of the joint venture between British Petroleum and Rosneft. The deal, which was launched in January 2011 with great fanfare and the blessing of Russian Prime Minister Vladimir Putin, was allowed to die quietly at midnight on May 16. Members of the Alfa, Access and Renova Group (AAR) who are supporters of President Demitri Medvedev, placed insurmountable obstacles before the deal. These oligarchs, who included billionaires Viktor Vekselberg, German Khan, Len Blavatnik and Mikhail Fridman, stood to gain $32 billion if the deal were completed--and yet they refused to grant their blessing.

What happened? In January, BP CEO Robert Dudley inked a deal with his Russian counterpart, Rosneft CEO and Deputy Prime Minister Igor Sechin. Sechin is a Putin protoge. The deal proposed a stock swap: 5% of BP would go to Rosneft; and, in return, 9.5% of Rosneft would go to BP. The deal, valued between $16 billion and $18 billion, was designed to give the Russians access to BP's artic driling technology. In return, BP would have a production sharing agreement for access to the oil. At the conclusion of the ceremony, Putin told a press conference that the BP-Rosneft partnership "may become large-scale and have a serious impact on the global oil and gas industry." Later, when things turned nasty, Putin would distance himself from the project stating the government would not intervene in the controversy--but the prime minister's fingerprints were all over the deal.

It didn't work out. BP was already in Russia, in a 50-50 partnership, called TNK-BP, with the AAR oligarchs. As the former president of this partnership, Dudley should have been aware of the details governing the cooperation between the shareholders, including the granting of exclusivity for BP operations in Russia to TNK-BP. When the BP-Rosneft deal was announced, the AAR consortium promptly filed in a London court to stop the merger. According to sources close to TNK-BP, the oligarchs sought and received Prime Minister Medvedev's support for the legal defense of their interests. One of the oligarchs (Viktor Vekselberg) was involved in an innovatin hub near Moscow that was the result of a Medvedev policy initiative. Medvedev further signaled his displeasure by ordering Sechin (and other government officials) to give up corporate posts to stay in the administration. The battle over the merger became a battle between forces loyal to the Prime Minister, and forces loyal to the President.

The issue ended in an arbitration court that issued a consent order permitting the share swap to proceed, but only with the approval of TNK-BP. Without that approval, the rights to drill in the Artic would devolve onto TNK-BP (and not the parent BP corporation), with the approval of Rosneft. Rosneft officials, however, did not want to work with the AAR partners. Efforts began to purchase AAR's 50% share of the partnership. Bidding rose from $27 billion to $32 billion, but to no avail. The Financial Times quoted one observer as saying, "The feeling is they (AAR) did not want to do a deal at all. They were forwarding conditions that they knew ahead of time that BP and Rosneft could not accept."

The blame game has already begun. According to Bloomberg, President Putin blamed BP's Dudley, stating the CEO had left him "completely unaware" of a potential dispute with AAR. Medvedev, by contrast, blamed Putin protoge Sechin and the entire Putin-led government. "Those who prepared the deal should have paid more attention to the nuances of the shareholder agreement. They should have had better due diligence inside the government," he said.

How could BP have ignored its responsibilities under the TNK-BP partnership agreement? According to the managing partner of Goltsblat BLP, Andrey Goltsblat, the problem lay in the informal nature of the Russian legal and business systems. As published in Business RT, Goltsblat said, "I do believe that lawyers knew about that clause and lawyers informed BP, but unfortunately sometimes in Russia more people rely on relations with the government or with the other level of officials, rather than on the law...BP probably thought that the clause is not that important, yet, as they are dealing with the government they are told that the deal is blessed by the Prime Minister and that there shouldn't be problems to overcome that clause."

The issue now moves to the courts. The Moscow Times provided an analysis of the situation from Russian attorney Vsevolod Miller (Yukov, Khrenov & Partners). According to Miller, there would be a guarantee warranty clause in the Rosneft-BP deal, and BP would be in breach because of its probable failure to disclose the TNK-BP shareholder agreement. "Rosneft will sue BP for breach of warranty--they will sue for direct damages, which are likely to run into the millions," he said. Miller added that there were no grounds for a case against AAR (presumably because AAR was only defending its legal rights). Reuters reports that according to a source close to TNK-BP, the company is considering suing for damages of up to $10 billion.

It is still a couple of years until the Presidential contests but, if one considers this skirmish as the first Presidential primary, Medvedev has emerged in the lead.

Exxon follows BP into Russian Exploration

The World Economic Forum in Davos was the location where ExxonMobil announced its joint venture with Rosneft to explore the Black Sea for oil. The two energy giants are combining forces to explore a deepwater trough off the coast of Krasnodar. During the exploratory stage, the two companies will split the costs 50-50, but Exxon will pay 66 percent during the development stage. The geologic formation, known as the Tuapse Trough, is estimated to hold 7.2 billion barrels of oil or its equivalent. http://www.themoscowtimes.com/business/article/exxon-rosneft-sink-1bln-in-black-sea/429894.html Exxon has committed itself to drilling two wells in the area, according to Hurriyet. ExxonMobil has been in Russia a number of years, as 30% owner of the consortium that has developed the Sakhalin-1 project.

The $1 billion deal was signed on January 27. Russian Deputy Prime Minister and Rosneft Chairman Igor Sechin remarked, "Cooperation with ExxonMobil once again underscores our commitment to the principles of transparency and vision of the Russian energy industry as a part of an integrated market place." The St. Petersburg Times reports that the consensus is that Sechin is sincere; Rosneft is looking to a global future, and to achieve that goal requires Western partners.

Rosneft has now signed deals with both BP and ExxonMobil, and Shell's CEO Peter Voser says that he is also in talks with company concerning a possible partnership. Energy analyst Matthew Hulbert writes in European Energy Review that such deals represent the start of a mergers & aquisitions frenzy in the upsteam sector in Russia and other countries, as a result of the Exxon oil spill in the Gulf. Traditionally "safe" locales such as the United States have been demonstrated to carry large, potential financial risks. This is forcing the majors to look at other locations that were previously rejected because of the political risk.

Dr. James J. Coyle is available to speak to your organization or at your event. Please contact him at jimcoyle@verizon.net.

Battle of the Billionaires

The BP-Rosneft share swap that opens up a large swath of the Artic for oil exploration is under judicial challenge. BP's non-Rosneft partner in Russia is the joint enterprise TNK-BP. Major shareholders in the latter company are in a consortium, known as AAR, and they include Alpha Group's Mikhail Fridman as well as fellow oligarchs German Khan, Viktor Vekselberg and Leonard Blavatnik. These shareholders claim that the BP-Rosneft deal is in violation of the TNK-BP agreement that gives the partnership the right of first offer for any BP projects in Russia. AAR has filed a lawsuit in the High Court of Justice in London, who issued an injunction against the deal until March while the court examines the facts of the case.

Analysts do not believe that the oligarchs want to halt the Rosneft deal, especially since it has the blessing of the highest levels of Kremlin leadership. Instead, the legal challenge is designed to obtain concessions from the company or the government. Chris Weafer, chief strategist at UralSib, said either TNK-BP wants access to the new production, or AAR wants the government to buy their shares of TNK-BP. http://www.themoscowtimes.com/business/article/billionaires-take-bp-deal-to-court/429896.html

TNK-BP's legal counsel has notified David Peattie, one of BP's representatives on the TNK-BP board, that he was in breach of his duties because he had participated in the negotiations with Rosneft. TNK-BP said if Mr. Peattie did not refrain from future talks, that TNK-BP would begin legal action against him. In the meantime, the partners have announced that they will block the final dividend payment to BP if the controversy is not resolved. http://www.theaustralian.com.au/business/news/aars-russian-billionaires-consider-stopping-18bn-dividend-payout/story-e6frg90o-1225997210246

The stakes involved in the controversy are huge. Russian Deputy Prime Minister and Chairman of Rosneft, Igor Sechin, estimates that the initial blocs Rosneft-BP will explore may hold 35 billion barrels of oil and 10 trillion cubic meters of gas (equivalent to 63 billion barrels of gas). http://www.europeanenergyreview.eu/index.php?id=2731 If these estimates are correct, the field holds roughly one third more oil and gas than the North Sea, and would increase Russian gas reserves by 25%.

Dr. James J. Coyle is available to speak to your organization or at your event. Please contact him at jimcoyle@verizon.net.

BP Commits to Russia

British Petroleum has been pursuing a long-term strategy of expanding its operations in Russia. Beginning in 1997, BP acquired a 10% stake in the Russian oil company, Sidanco. This company was created by the privatization of some of Rossneft's assets. After a number of lawsuits and other maneuvers, in 2003 BP merged its Russian and Ukrainian assets with another Russian firm, TNK. The result, TNK-BP, was led by BP's current chair, Robert Dudley, until he was forced to flee the country in 2008 in a power struggle for control of the company. BP still owns 50% of the joint venture, but the company now has stronger Russian management. http://www.themoscowtimes.com/opinion/article/twice-burned-BP-not-shy/428953.html

In 2008, the BP Group Vice President for Russia and Kazakhstan, David Peattie, told US Ambassador John R. Beyrle that BP was in Russia for the long haul, and that the company was actively pursuing options with Gazprom and Rosneft for the future. Peattie said BP plans to be in Russia "for the next 50 years." He considered BP's one percent stake in Rosneft as the potential long-term foundation of BP's involvement in Russia. To pursue this strategy, the company planned to sell its share of the Caspian Pipeline Consortium and divest its interests in Kazakhstan. http://www.guardian.co.uk/world/us-embassy-cables-documents/179810.html.

This month, the long-term strategy of cooperation with Rosneft took a major step forward. BP is giving Rosneft 5 percent of its shares, in return for 9.5% of Rosneft--a company that is 75% owned by the Russian government.

BP and Rosneft both gain tremendously. The two companies have agreed to jointly develop three licensed block in the southern Kara Sea, an area of approximately 125,000 square kilometers (over 48,000 square miles). The area has a forbidding, Artic climate covered most of the year by ice and snow. BP is able to add to its reserves, and Rosneft gains access to BP's artic technology. Russian experts estimate the Kara Sea blocks may hold up to 36 billion barrels of oil and 10 trillion cubic meters of gas. Rosneft Vice President Peter O'Brien said exploration of the tracts will begin soon, and the company plans to begin drilling in 2016. http://www.oilandgaseurasia.com/news/p/0/news/10352.

Critics of the deal include Congressman Edward Markey, the Democratic minority leader of the House Natural Resources Committee. He raised concerns that Russian control of BP shares might compromise US economic security (as a reminder to readers on the West Coast, BP owns Arco). He scoffed that "BP once stood for British Petroleum. With this deal, it now stands for Bolshoi Petroleum." http://themoscowtimes.com/business/article/bp-rosneft-in-landmark-swap/428957.html. Other critics are concerned about the rule of law. Rosneft obtained many of its assets from Yukos Oil, which the Kremlin broke up and sold when it threw Putin rival Mikhail Khodorkovsy into prison. The legality of the breakup is under question. Recently, a court in Sweden ordered the Russian government to pay compensation to a Yukos shareholder who had brought suit over these actions. Kremlin critic and former Russian deputy prime minister Boris Nemtsov said that Russian Prime Minister Vladimir Putin was hopeful that BP's ownership of Rosneft shares would blunt western criticism of Moscow's treatment of the former oligarch Khodorkovsky. He said that the deal ignored human rights and property rights. BP spokesman Jeremy Huck tried to duck the issue in an interview with Radio Ekho Moskvy by pointing out the proposed projects were sanctioned by the Russian government: "The question about where those assets are from, that's better asked of Rosneft or the government." http://oilprice.com/Energy/Energy-General/Does-BPs-Deal-with-Rosneft-Legitimze-the-Kremlins-Takeover-of-the-Countrys-Oil-Industry.html.

BP has cast its lot with the Russian bear, for better or for worse.

Dr. James J. Coyle is available to speak to your organization or at your event. Please contact him at jimcoyle@verizon.net.