[Comment] NS 2: You Couldn't Make it Up!

After the latest Angela Merkel-Vladimir Putin meeting August 18 when the Russian president told the German chancellor that keeping some Ukrainian transit as requested by the EU needs to “make economic sense”[1], it is tempting to try to forecast how the Nord Stream 2 (NS 2) saga could unfold.

Predicting the future is very difficult. But as the consensus is often wrong, most analysts can come up with ideas that could later look very smart! So, let’s predict what’s next for NS 2 at a time when the route is still not finalised[2]…

Today’s situation

Gazprom is the sole owner of NS 2 with five European companies – French Engie, Austrian OMV, Anglo-Dutch Shell and German Uniper and Wintershall – that moved from partners in the former JV to financial investors back in 2017[3]. This followed the decision of the Polish office of competition and consumer protection in July 2016 that a JV could restrict competition.

These five European energy companies have committed to provide long-term financing for 50% of the total cost of the project, which is currently estimated to be €9.5bn ($11bn). Each European company will fund up to €950mn. And today, about half of those funds have already been paid to NS 2 (ie €0.5bn by each of those five financial investors).

Following the recent EU-Russia World Trade Organization energy dispute settlement[4], the European Commission (EC) is now in a much stronger position vis-a-vis full unbundling. After 20 years of negotiations with its member states and the gas operators that dragged their feet over unbundling, the EC could now easily go ahead with a new directive proposal, making the case for NS 2 more difficult.

As the 2016 “Quo Vadis” study imagined, the EC could also go for a single EU wide wholesale and tariff system. It could even favour “diversification of supply” smartly[5]… The NS 2 saga could therefore continue well into the 2020s!

The problem

Because of lack of trust, each party is pushing for the fast and full implementation of its own strategy, making it difficult to strike a balanced deal:

• If NS 2 is built, Ukrainian transit for the EU would be severely reduced from 77bn m³/yr in 2017 to less than 20bn m³/yr and neither Putin’s promises nor the EC's infrastructure exemption decision used last time[6] to cap flows would be able to change this…
• If NS 2 is not built, Ukrainian transit would stay at c.80bn m³/yr[7], allowing Ukraine to keep more than $2bn/year of transit fees[8] but the capex spent on NS 2 would need to be impaired…

My prediction

A single string instead of the two actually planned would solve this problem even if it was more expensive on a capacity basis. With a c. €7bn NS 2 – one line only (175 km longer as outside Danish territorial waters), Gazprom would deliver directly 83bn m³/yr to Germany from 2020; the rest will continue to transit via Ukraine, pleasing the EU and US officials. This then leaves Gazprom and Naftogaz to negotiate a c.50bn m³/yr transit agreement… As Gazprom will have some pipes left to lay the second NS 2 line, Naftogaz should offer a fixed $1.5bn/year deal to transit any quantities up to 100bn m³/yr to make this second NS 2 line uneconomical.

The possible scenario

Contrary to consensus, some of those investors are undergoing a radical capital structure change. I would rather split them into three distinct groups:

• Two utilities that, adapting to the energy transition, changed their names and/or corporate structure: Gaz de France Suez, merged in GDF SUEZ is now Engie; and EON demerged its former Ruhrgas assets into Uniper
• Two international companies with EU headquarters: BASF and Shell. BASF is the sole owner of Wintershall, which is itself in the process[9] of merging with DEA into Wintershall DEA, which would then be owned by both BASF (67%) and LetterOne (33%), the latter being a vehicle of Russian billionaire Mikhail Fridman.
• Gazprom’s oldest European customer and long-term ally: OMV, which recently celebrated 50 years of partnership[10].

To start my saga, I will concentrate on the two financial investors that may well lack the willpower if things get tricky:

• Engie has a long-time strategy of… reversing its strategy: buying International Power to then close the coal-fired plants it bought; fighting against EU unbundling requirements and then trying unsuccessfully (via its subsidiary GRTgaz) to participate in the Greek grid operator’s privatisation after the EU made it clear only truly unbundled players could buy Desfa; going upstream and then selling 30% to the Chinese CIC and the remaining 70% to independent Neptune Energy, pulling out of LNG, and so on. Today, Engie’s “new” strategy is to be 100% green[11] by 2050 thanks to biogas and hydrogen. So, even if this is not the company line today – and it told NGW that gas would be essential to its strategy for some decades to come – it is highly possible that someone working there will think that investing in a pipeline bringing Russian gas to EU countries fully powered by biogas makes little sense. The smart question would then be: why invest in this infrastructure if it becomes stranded before its payback period? Gazprom, being a much more long-term oriented company, would see no obstacle for Engie leaving… if NS 2 keeps the money already paid in. And this shouldn’t be a big problem for Engie, which is used to writing down[12] its old choices!
• Uniper is also facing headwinds. Now 47% owned by Fortum, which it opposed from the start, its CEO is being treated for cancer making him less available for day-to-day business. History tells us that in those circumstances, it is highly likely that a new CEO will soon be appointed, and one likely to want to reassess the corporate strategy.  Here again, the rationale of financing Gazprom’s pipe could be questioned after the many arbitrations (and one still ongoing) between the two companies[13]. And here, the solution would be: NS 2 keeps the money already paid and Gazprom provides a slightly better long-term contracted gas price to settle the on-going arbitration. A more competitive contracted price would help Gazprom to further increase its 55% market share in EU-27 biggest gas market.

Then US president Donald Trump steps in. As someone who fiercely defends American interests, it would make sense for him to impose sanctions on BASF and Shell as they have American competitors (respectively DowDuPont and ExxonMobil). A single belligerent tweet will suffice to scare BASF and Shell[14] who cannot afford the loss of dollars financing for their worldwide operations[15]. And between a €0.5bn impairment and a multi-billion-dollar US sanction risk, it is highly possible that both companies will follow the path taken by the two leavers… Gazprom could provide them with compensations such as new upstream deals in Russia (Achimgaz for Wintershall DEA and Sakhalin 2 LNG for Shell) while NS 2 keeps the money already paid in. Alternatively, a fire sale of BASF’s remaining stake in Wintershall DEA[16] to LetterOne would erase this US risk, allowing the then Russian-owned Wintershall DEA to stay as a NS 2 financial investor.

Austrian OMV, with no US assets, would be the most vocal about those sanction risks and would stay as an immune financial investor in this project. It could even offer to contribute more than the 10% share agreed in 2017.

Gazprom would have to cash out only €4.3bn (ie an additional €1.8bn instead of the €2.5bn budgeted), OMV the contracted[17] €0.7bn and the €2bn remaining would have been courtesy of the former four partners. Gazprom and OMV could go ahead with the laying of the pipe as those companies cannot be subject to either US sanctions (no activity there) or EU sanctions (the EU needs Gazprom gas in its mix for the foreseeable future).

In my story, like in old fairy tales, everyone wins: Engie moves green, Uniper manages to increase its dividend (to Fortum) thanks to its Russian gas contracts, Wintershall DEA can further use its production skills demonstrated in Achimgaz, Shell can expand in Sakhalin 2 to stay the LNG leader, Gazprom gets one NS 2 line built and OMV gets a better return thanks to the line fully used without any delays[18], Naftogaz keeps $1.5bn/year transit and officials can all tweet that the best solution has been achieved!

Reality or fiction? The future will tell but remember South Stream was stopped unexpectedly Dec 1, 2014 by Putin… to become later TurkStream.

Remember also that France was instrumental in designing the “snap back” clause in the 2015 Iranian nuclear deal… allowing Trump to easily re-impose sanctions in 2018! Things can change… My scenario can look fictional, but I believe the consensus view of NS 2 being built on time is not the most probable. Stay tuned!

Thierry Bros

21 August 2018

Advisory Board Member of Natural Gas World