The Future of Russian Gas? Not In China but Europe?
Should Russian gas strategists be focusing on Europe or China for future growth? At first sight the answer looks obvious. There is no choice between fast growing China v. feeble debt ridden Europe. In addition, the Europeans are diverting rapidly away from gas, and Russian gas in particular. However on closer examination lower Chinese economic growth combined with a shift away from fossil fuels is likely to significantly reduce the size of the market for Russian gas. Meanwhile there are opportunities to grow the European gas market as the EU redesigns its climate change and supply security policies.
At first sight it looks like the Russian government made the right call in negotiating the Power of Siberia deal with Beijing. The costs are heavy. The costs of building this 3600 kilometre pipeline which would bring 38bcm of gas annually into China would be at least $20 billion. This is on top of a second Altai pipeline running from existing Siberian fields would bring 30bcm over 1420 kilometres into China at an additional estimated cost of $14 billion These heavy costs stem from the need to invest in new fields in Eastern Siberia and lengthy pipeline system required for both routes. Gazprom’s underlying assumption however is that there is a huge energy hungry Chinese market which can take Russia’s gas.
However, that assumption may not be as credible as it once was. The slide in oil prices over the last year was in part about rising shale oil production in the US. It was though also about falling Chinese demand. Chinese economic growth fell from its once robust 12% to around 7%. Even the 7% figure may well be an over-estimate. There is real concern that in order to prop up these figures China has been bringing forward demand. The most startling example of this practice is the recent relevation that between 2011 and 2014 China consumed 6.6 gigatonnes of concrete. By contrast in the whole of the 20th Century the United States only consumed 4.5 gigatonnes. Because of the need to build modern cities to house a huge once-rural population these figures do not necessarily mean that what we are witnessing is the largest capital mis-allocation in world history. However, it is at least a matter of bringing forward significant future demand. This rate of consumption cannot be sustained over the next decade. This is on top of the massive liquidity injected into the Chinese economy by the Central Bank pushing stock market and property prices higher even as formal growth figures slide.
It is not only a structural fall in demand that is likely to impact significantly on demand for Russian gas. The Chinese state is also taking very seriously the impact of pollution in the cities. Gas switching from coal is occurring which could increase demand, but existing Central Asia gas supplies and cheaper LNG makes Russian gas not necessarily that competitive. Equally, the Chinese investment in solar is paying off as prices slide for solar panels and solar reaches grid parity. It is also clear that despite setbacks the Chinese have not given up on working out how to extract gas from their large shale deposits.
At the very least falling demand and alternative sources of supply may put pressure on the Altai and Power of Siberia projects. Given how expensive the projects are will Gazprom actually be able to sell enough gas at high volumes and high prices into the Chinese market to make significant returns?
At first sight Europe looks like a poor alternative to the Chinese market. The austerity policies of the Eurozone have suppressed demand. Current EU climate change policy and has had the perverse effect of promoting coal and demoting gas, which combined with carbon leakage has the overall effect of increasing Europe’s C02 emissions. Worse still because of the Ukraine dispute, Europeans are seeking to rapidly diverse gas imports away from Russian gas.
However, there are potentially significant silver linings for Russia in European energy policy. First, it is clear that the new Juncker European Commission recognise that EU energy policy needs to promote gas and reduce incentives to use coal. As policy measures are undertaken to reduce reliance on coal the gas market should expand. Ironically, the energy security measures introduced by the EU to physically complete the EU single gas market and ensure EU liberalisation rules are fully applied also helps Gazprom. In a fully integrated single gas market no otherwise dominant energy company can threaten to cut off suppliers as gas will flow in from other parts of an increasingly diversely supplied market. Hence the potential political threat is removed making it increasingly easier for Gazprom and potentially other Russian energy companies to sell gas into the European market.
Furthermore, as part of a peace settlement over Ukraine a big gas deal with Europe could provide the economic underpinning for such a settlement. Russian energy companies could agree to produce much more gas for the European market, essentially switching their business model from a low volume high price model to a high volume low price model. The potential economic gain for Russia would be to generate much greater revenues by selling much larger quantities at lower gas. Ironically, the pipeline wars of the last few years do give Russia the capacity to provide gas in such quantities as all the pipeline capacity, Ukrainian, Nord Stream and a Turk (Turkish) Stream/South Stream option would be deployed. From a Ukrainian perspective full use of its network for transit would generate significant additional transit revenues. From a European perspective cheap gas would allow significant cuts in C02 emissions by switching from coal, while also allowing European industry to more effectively compete against US industry fuelled by cheap shale gas.
Equally, in this context an antitrust deal over the concerns raised by DG Competition could also move toward settlement. The point here is that if Gazprom is going to maximise its access to a deep liquid open European gas market it wants to put the past behind it and settle the antitrust issues. It no longer needs the practices of the past to prosper. In addition it means that senior Gazprom officials need to abandon the protests against reverse flow gas to Ukraine or blocking access to the Ukrainian-Slovak interconnector to allow more gas to flow to Ukraine. In a more integrated market where Gazprom sells much more gas to Europe there is no need for market restrictions.
Essentially because Gazprom already has the largest gas fields, the largest reserves, the pipelines and the customers in Europe it should be the biggest beneficiary of European energy liberalisation. The policies of the past get in the way of making the most of the European market. By contrast, the capital entry costs into the Chinese market, potential range of competitor suppliers and falling demand make the Chinese market much more problematic for Gazprom.
Professor Alan Riley, City Law School, City University, Grays Inn, London.