Outlook for post-war Russian gas to EU

2022 was an exceptional year for the gas market, with Russian pipe gas to Europe reduced by 55%. There is no way back to “business as usual,” but it would be a mistake to assume 2023 would follow the same trend. We can image four hypothetical scenarios:

1. Until the end of Russia’s war in Ukraine, the Kremlin has the ability to continue to play the uncertainty principle. We could expect Russian pipe flows to stay between 0.9bn m3/month (via TurkStream only as Russia has little incentive to fully cut Europe) to 4.5bn m3/m (via TurkStream and Ukrainian contracted transit). The uncertainty Europe faces coming from Russia alone amounts therefore to 3.6bn m3/m or 43bn m3/yr. This is more than 10% EU demand or 17% of EU storage capacity.

2. In a frozen conflict with no peace and no internationally recognised borders, like in Korea, there would probably be no agreement with Russia on gas. Only a few selected EU countries will continue post-2025 to receive Russian gas via TurkStream.

3. At the request of Ukraine, the war could end with a geographic agreement setting borders. In this case, extra Russian pipe gas via Ukraine (on top of volumes via TurkStream) would be unwelcome in Europe until all arbitrations are finalised.

4. For lasting peace, Europe could also want Russia to financially contribute to Ukrainian reconstruction. Russian commodities and in particular pipe gas that cannot be rerouted easily, could be used as a financial asset in an extended peace agreement. History gives examples of oil flowing under embargoes or sanctions. The Iraqi-oil-for-food programme could be used to draft a Russian-pipe-gas-for-Ukraine-reconstruction; a peace agreement could set the amount of Russian gas Europe could buy with cost+ going back to Russia while rent going to Ukraine. And to avoid Russia fiddling with the market an ad-hoc formula would be set for this gas.

Focusing on the hypothetical last case – to be initiated by Ukraine alone – the extended peace agreement would freeze all pending gas arbitrations and would set both volumes and prices for this long-term Russian gas contract. 

Regarding volume, the EU could be happy with 80bn m3/yr of Russian pipe gas as this is half of former volumes and represents less than 25% of the bloc’s gas demand. Those volumes could be split between the only two lines still operating: Ukraine and TurkStream. With 15bn m3/yr max flowing via TurkStream, this would leave 65bn m3/yr via Ukraine, in line with the 2020 volumes contracted. The split between EU countries would be done on a pro-rata basis after all countries submitted their request to the EU Joint Purchasing Mechanism. It would be a baseload contract with no flexibility. Member states would have to buy the agreed volumes with Russia having to supply them. Upon Russia’s first failure to deliver, all frozen arbitrations could be re-opened by European utilities. This extra gas would boost Europe’s security of supply, with total volumes too low to inflict damage on Europe if Russia decides again to weaponise its gas.

As for prices, they would need to be set with an index Russia cannot temper. As we moved away from oil indexation, the best index available is the US Henry Hub (HH). The fairest way would be to price Russian gas at the cost of US LNG delivered to Europe with a cap. The formula could be 115% HH + $6/mn Btu (to take into account liquefaction, shipping, regasification and inflation) with a HH cap at $11/mn Btu translating into a cap of $18.7/mn Btu for Russian pipe gas delivered to Europe . We would then need to split this between different actors:

1. Gazprom would get a minimum cost-plus production sum and, once HH is above $3/mn Btu, an additional small incentive.

2. Ukraine for 65bn m3/yr would get its increased transit fee directly paid by EU utilities  that would take delivery of the gas at the Russian-Ukrainian border. For the 15bn m3/yr via TurkStream the same transit fee would go to Gazprom, owner of the pipe as the EU utilities would take delivery in their respective states. Gazprom would need to make sure transit via Turkey is guaranteed. If Turkey was to not cooperate, the full 80bn m3/yr would then have to transit via Ukraine.

3. The remaining gas rent would directly go into an escrow account for Ukraine reconstruction.

4. This formula should not dictate TTF prices. If TTF prices are higher than the set formula, EU member states would enjoy both security of supply and reduced costs. If TTF prices are lower, this could be viewed as an indirect EU contribution to Ukraine reconstruction. The average price between the lowest and highest Russian prices is $12.3/mn Btu, below what the European Commission expects in its RePowerEU forecast. And having Russian gas prices cap at $110/barrel oil could also be viewed as a risk-mitigation to avoid further deindustrialisation in Europe.

5. The contract could be for a max of 20-year period allowing full reconstruction of Ukraine without impacting EU Green Deal narrative. 

Russian pipe gas prices in a hypothetical global peace agreement: HH index with a cap

Source: thierrybros.com

Under extremes of this hypothetical scenario:

• if HH below $0/mn Btu, Russian pipe delivery would be at $6/mn Btu, with Ukraine getting $4bn/yr for its reconstruction.

• If HH above $11/mn Btu, Russian pipe delivery would be at $18,7/mn Btu, with Ukraine getting $24bn/yr  for its reconstruction.

And in a more realistic world:

• If HH = $3/mn Btu, Russian pipe delivery would be at $9.5/mn Btu, with Ukraine getting $12bn/yr for its reconstruction.

• If HH = $9/mn Btu, Russian pipe delivery would be at $16.4/mn Btu, with Ukraine getting $21bn/yr for its reconstruction.

With Ukrainian 2021 GDP at $200bn , those reconstruction amounts are material and should not last more than 20 years. The extended peace agreement could even decide to terminate this contract once $200bn has been put into the Ukrainian gas reconstruction escrow account. Russian gas could not only avoid the deindustrialisation of Europe but could also be sold as hydrogen (produced by gas with pyrolysis) to fast-track EU environmental targets.

In its end-of-year speech Gazprom chairman Alexey Miller stated that the company’s 2022 production level  was 413bn m3 (-20% versus 2021). The drop in production (-103bn m3) is even higher than the drop in its EU market (-82bn m3) showing that even the Chinese exports are still not enough to meaningfully impact production data. Gazprom’s drop in production is also higher than global gas consumption decline (-65bn m3), giving de facto a boost to all its competitors. In a year when EU gas prices achieved a record level, Gazprom provided both volume and price opportunities to its competitors. Even if this drop is material, Gazprom still accounts for more than 10% of global production and is more than three times bigger than the second worldwide listed gas producer. This proves that Gazprom has the ability to sustain the above Ukrainian reconstruction program.

2007-2021 evolution of the top gas producers (bn m3), with 2022 added for Gazprom

Source: Company data, thierrybros.com

2022 has been an exceptional year for Gazprom that had to obey Kremlin’s diktats with EU exports down by 55% and with its supply routes not limited.

Gazprom’s European exports by routes (2017-2022)

Source: Gazprom, Entsog, thierrybros.com

The TurkStream line dedicated to Europe has been operating at an average of 80% in 2022.

Gazprom’s European exports by routes in 2022

Source: Gazprom, Entsog, thierrybros.com

Moving back to the December analysis; it has been an uneventful month, very similar to the last three months.

Gazprom’s European monthly exports 

Source: Gazprom, Entsog, thierrybros.com

If we expect  Russian pipe flows to stay between 0.9bn m3/m (TurkStream only as Russia has little incentive to fully cut Europe) to 4.5bn m3/m (TurkStream and Ukrainian contracted transit), we should see a further decrease of Gazprom’s flow to EU in 2023 versus 2022. This could be mitigated by a growth in Chinese exports. Gazprom could also push for a resumption of transit via Belarus to try to disunite EU member states as some would be fiercely against (Poland) while states benefiting from extra Russian volumes could be in favour.

Gazprom yearly exports to Europe

 Source: Gazprom, GTSOU, Entsog, thierrybros.com

Split of Gazprom’s European monthly exports

Source: Gazprom, GTSOU, Entsog, thierrybros.com

In 2022, regasification send-out was a record high 72% above 2021 and 32% above the previous record (2019). Thanks to new regasification infrastructure, we should expect 2023 to see even higher send-out to mitigate the expected further drop from Russian gas.

EU LNG send-out (excluding Malta)

Source: GIE, thierrybros.com

With an exceptionally warm end of December and with demand reduction/destruction taking place for a few months, EU storage moved back to injection mode and ended the year at 83% full. This allows the supply-demand balance to look more relaxed for the remainder of winter and prices moved south to the level not seen since the Ukrainian war. But with prices two times higher than historical pre-COVID era, we should expect further industrial demand destruction in Europe in the months to come.

EU gas storage utilisation

 Source: GIE, thierrybros.com

Dr. Thierry Bros

Professor & energy expert

January 3, 2023