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Article by: Leonhardt van Efferink (October 2010)
Tags: Russian gas Nord South Stream Nabucco pipelines ENI EDF EON Ruhrgas Wintershall Gasunie Azerbaijan Kazakhstan Turkmenistan Uzbekistan
Leonhardt van Efferink
Leonhardt van Efferink is Editor of ExploringGeopolitics, Founding Director of GeoMeans Analytical Skills Development and PhD student at Royal Holloway, University of London.
He holds Master’s degrees in Geopolitics, Territory and Security (King’s College London) and Financial Economics (Erasmus University Rotterdam).
Russia is the largest supplier of gas to the European Union (EU). Its decision to cut off gas deliveries to Ukraine temporarily reduced Russian gas inflows in several EU countries in 2006 and 2009. The inflows had become smaller because Ukraine tapped Russian gas that was supposed to be re-exported to EU countries. The Russian-Ukrainian gas dispute added fresh impetus to the debate on the dependence of the EU on Russia’s gas.
The article attempts to shed light on Russia’s position on the EU gas market. The first part gives a brief overview of gas demand in the EU, followed by a discussion of Russia’s gas production. The next part continues with Russia’s gas strategy and the role of Gazprom in that respect. The third part focuses on the two pipeline projects Nord Stream and South Stream. The last part summarises the first three parts and wraps up the article.
The EU gas market
In the past 20 years, the energy markets of EU countries were subject to privatisation and deregulation. Governments were focused on neither the political and strategic importance of energy nor the creation of a common EU energy market. Furthermore, the difficulty of transporting and storing gas and, more importantly, lack of political support impeded the creation of an internal EU gas market. Currently, the European Commission is responsible for energy guidelines regarding intra-EU and inter-EU trade, the environment and market competition, while EU countries manage their national energy imports and investments. As a result, the EU gas market has remained fragmented along national borders, with most national markets being dominated by a few companies.
The EU heavily relies on foreign gas, reflected by its position as a net gas importer. A majority of its member states depend on foreign supplies for more than 90% of their national gas needs, partially explaining why energy security is a key concern of the EU. Two factors largely explain this strategic weakness. First, the cumulative gas reserves of the EU states are relatively small. Second, gas plays an essential part in the EU economies and accounts for nearly one-quarter of its energy consumption.
Not surprisingly given the difference between their gas reserves, Russia (in the form of The Soviet Union) started to deliver gas to Western Europe through a pipeline to Austria in 1968. Despite the ‘Cold War’ and its significant share in EU gas imports, the Soviet Union was a reliable source of gas for Western Europe and never gave the impression to link gas deliveries to political issues. During the past three decades, Russia’s dominance of the EU gas market has diminished substantially from a statistical point of view. Its share in EU gas imports came down from 80% in 1980 (including non-Russian Soviet republics) to 40% in 2007.
The share of Russia’s gas in total gas imports differs widely among EU countries, from 0% for countries such as Spain and the UK to 100% for countries such as Bulgaria and Lithuania. The fragmented EU gas market means that particularly smaller EU countries with a strong dependence on Russian gas, such as the latter two, lack any real bargaining power vis-à-vis Russia. The downward trend of Russia’s share in EU gas imports and the fact that Russian gas accounts for a mere 7% of the EU energy supply incorrectly suggest, as this analysis will show, that Russia’s dominance of the EU gas market is diminishing and limited.
Looking ahead, EU demand for Russian gas will become increasingly dependent on gas consumption due to the declining EU gas production. The EU expects that Russia will account for around half of its gas imports by 2020. Some analysts expect that the EU gas consumption will rise due to EU efforts to reduce carbon emissions. Sherr (2009) however suggests that a decrease in gas consumption and imports will be possible when the EU countries improve the energy efficiency of their economies, expand their storage capacity and connect more gas transmission systems of different countries with one another. Umbach (2010) notes that EU policies will be critical in structurally reducing gas demand in its member states.
Russian gas exports
The performance of the oil and gas industry has a significant effect on Russia’s economy and government finances due to Russia’s failed attempts to diversify its economy. Four factors explain why Russia is the world´s largest exporter of gas (share of almost 20% in global gas exports). First, the country has the world’s largest proven gas reserves, equal to nearly one-quarter of global reserves (see Appendix 1 for map of oil and gas reserves and pipelines). Second, Russia has the world’s highest gas production, accounting for one-fifth of global production. Third, domestic demand leaves room for gas exports, with Russia’s home market absorbing around 70% of the national gas production . Fourth, Russia’s pipeline network enables it to re-export imported gas from Central Asia.
Two features of Russia’s gas exports stand out: they have used one means of transport (pipeline) and have been destined to one region, Europe (including countries that used to belong to Soviet Union), since the 1940s . During the previous decade, Russia’s gas production was more or less stable as the increased production of one major gas field and some smaller ones compensated for the declining production of three major, but old fields . The central question for this decade is when new major gas fields on the Yamal Peninsula (see Appendix 1) can be brought into production. In 2009, it became clear that the expected production start of the large Bovanenko gas field had been postponed by one year until 2012. Stern (2009) notes the global economic crisis that started in 2008 reduced the likelihood of gas shortages in Russia in the short-term due to its dampening effect on Russian and European gas demand.
In the longer run, the investment prospects for the gas sector are bleak, making it uncertain whether Russia will be able to honour its gas commitments. Gazprom’s recent track record is disappointing in terms of both level and composition (less than half of investment concerned gas production related activities). The company’s announcement in 2009 to reduce its investment by 22% does not bode well for the future. Another factor that structurally weighs down on the investment level is Gazprom’s effective monopoly on gas exports. This position forms a major disincentive for other Russian companies to invest in new exploration. Finally, Russia’s ambiguous stance towards foreign participation in energy related projects, to be discussed in the next section, further depresses the gas investment potential.
Russian gas strategy
Russia’s current political elite considers the abundant national oil and gas reserves a powerful tool to exercise power abroad, with an impact comparable to the nuclear weapons of the Soviet Union. Supported by high world market prices for gas, the state took a firm grip on the natural resources industries during the 2000-2008 presidency of Vladimir Putin. Foreign companies are still considered to be instrumental in the development of new gas fields because of their expertise and capital.
Nevertheless, the new energy strategy severely restricts their room to operate in Russia. Consequently, Shell and BP were forced to give up their controlling stakes in two gas fields in respectively 2006 and 2007. According to Finon and Locatelli (2008, p. 425), these events show that in Russia “[n]either market rules nor international law will guarantee foreign investment.” Another priority concerns the exploitation of the gas fields in east Russia to gain market access in East Asia and North America.
Russia’s refusal to ratify the Energy Charter Treaty, signed by Russia and all EU countries in 1994, is in line with the government’s gas strategy. The treaty aims to improve energy security by making energy markets more competitive and transparent, without eroding the sovereignty of countries over their resources. Russia’s refusal to ratify stems from its reluctance to apply the market rules that the EU prefers in its foreign investment policies and gas export contracts.
Regarding the latter, Gazprom concluded contracts with a duration of up to 30 years with major EU gas companies in 2006. The company prefers long-term contracts as they provide security of demand. Nonetheless, the EU has pressed for a shortening of contract durations to foster competition on the EU gas market. The treaty further imposes restrictions on Russian acquisitions in the EU energy sector, which Russia opposes. In addition, the multilateral character of the treaty runs counter to Russia’s preference for doing business with the governments of larger EU countries and the leading companies in national gas sectors.
The strategy further focuses on increasing Russia’s control of gas flows to Europe, including those from Central Asia. Another aim is the reduction of Russia’s dependence on two crucial transition countries, Ukraine (its pipelines transport around 80% of Russian gas flows to Europe) and Belarus (accounting for 20% of aforementioned flows) . Russia recently had gas disputes with both countries because of its intention to gradually increase gas export prices to world market levels for countries that were once part of the Soviet Union.
The implementation of Russia’s gas strategy in the EU is largely the responsibility of Gazprom, the country’s major gas company. The state acquired a controlling 51% stake in Gazprom in 2000 and installed a new board comprising allies of Putin in 2001. On its home market, Gazprom dominates gas exploitation and sales, while it manages the gas transmission networks. The company is further active in the oil and electricity sectors, as well as in non-energy related industries and services. Regulated domestic prices below world market prices mean the company has few profitable business opportunities on its home market.
The government does however facilitate Gazprom’s foreign activities that bring the company the lion’s share of its profits. In fact, Pirani et al. (2009) argue that the Russian-Ukrainian gas dispute in January 2009 made clear that the government has considerable influence on Gazprom’s strategy. Fernandez (2009) adds that the strategic interests of Gazprom and the government regarding international affairs largely coincide. Gazprom’s effective monopoly on Russian gas exports is instrumental in its aspiration to dominate the global gas market.
In this regard, the company aims to broaden its scope in terms of both countries and activities. Gazprom’s new initiatives in other gas producing countries such as Libya and Venezuela could make it harder for the EU to find new gas suppliers that are not subject to Russian influence. For the time being, however, these initiatives will likely have a small impact on the EU as they lack substance. A telling example is the 2007 agreement between Gazprom and the Algerian state oil company Sonatrach that concerned cooperation on relatively small projects.
Next to its dominant position in gas production (‘upstream activities’), the company aims to create controlling stakes in the distribution and sales of gas (‘downstream activities’). Gazprom became active in downstream activities in the EU during the 1990s, when it created the joint venture WINGAS with the German company BASF-Wintershall to distribute and sell gas to final consumers. Gazprom is further active in downstream activities in countries such as Austria (gas transmission) and Italy (gas sales) and the Baltic States (energy companies).
A possible threat to Russia’s position in the EU is Gazprom’s considerable debt. The recent experiences of the American bank Lehman Brothers and the construction company Dubai World are a case in point. Both companies made enormous profits, while borrowing heavily, with activities that were not completely scrutinized by financial markets and independent monitoring agencies. Eventually, both companies could not completely re-finance their outstanding debt, resulting in bankruptcy in the case of Lehman Brothers and a liquidity crisis in the case of Dubai World (ended by substantial capital injections of the government). If financial problems were to occur and the government response were inadequate, Gazprom could be compelled to sell some of its foreign assets.
Nord Stream pipeline
The Nord Stream project fits neatly within Russia’s strategy to consolidate its position in the EU. In 2005, Gazprom signed an ‘in-principle’ agreement to develop the Nord Stream pipeline. The other signatories were the two German companies Wintershall and EON Ruhrgas, later joined by the Dutch gas company Gasunie.
The Nord Stream pipeline will be built on the seabed between Vyborg (Russia) and Greifswald (Germany), enabling the transport of Russian gas directly to its largest EU market. Accordingly, the Nord Stream pipeline will end the transit monopoly of Ukraine and Belarus on Russian gas flows to the EU. The realisation of Nord Stream pipeline has become very likely, as nearly all required conditions have been fulfilled. The pipeline is expected to become operational in 2011 . The costs of building the Nord Stream pipeline are considerable. Initially estimated at USD 5bn by the project management, analysts currently expect an amount of around USD 12bn.
Claims of EU officials that Nord Stream will improve EU energy security by precluding the possibility of interruptions in transit countries miss this point. Nord Stream would after all not make a difference for the EU in terms of supplier diversification.
A completely different claim was made by the Polish minister of Foreign Affairs Radek Sikorski in 2009. He argued that the Nord Stream pipeline deal was comparable to the 1939 Molotov-Ribbentrop Pact. With this agreement, Germany and Russia intended among other things to create two spheres of influence in Central Europe and Eastern Europe.
At first sight, this comparison seems far-fetched. Nowadays, most countries are members of the European Union and NATO, while countries in this region lacked strong institutional ties with Western Europe or the US in the 1930s. However, bearing in mind that Eastern European countries form relatively small markets for Gazprom compared to countries such as Germany and France, the economic costs for Russia of a gas delivery cut-off to these countries is relatively small. Moreover, the de-linking of gas deliveries to Western and Eastern Europe also reduces the political costs of such a move. Combined with the relatively heavy dependence of the Eastern European countries on Russian gas, the Nord Stream gas pipeline would make gas flows a more effective tool for Russia to influence the political process in EU countries in Eastern Europe. Particularly since the perceived threat of interrupting gas deliveries already provides Russia with political leverage in the countries concerned, even before Gazprom would actually stop the gas flows.
South Stream pipeline
The South Stream pipeline is another result of Russia’s gas strategy towards the EU. In 2008, Gazprom signed an agreement with Italian energy company ENI for the development of second new pipeline to EU, coined South Stream. This pipeline would transport gas from Russia through the seabed of the Black Sea to Bulgaria. From there, the gas would continue in two directions: to Austria, crossing Serbia and Hungary, and to Italy, crossing Greece and the seabed of the Adriatic Sea. In May 2009, Russia signed an agreement to conduct South Stream feasibility studies with the governments of four involved countries, Italy, Bulgaria, Greece and Serbia. The pipeline is expected to cost USD 25bn and to be completed by 2015.
A brief analysis of both pipeline projects makes clear that Russia likely has political and strategic reasons for building the new pipelines. To start, Russia effectively controls the Nord Stream and South Stream projects thanks to Gazprom’s 51% share. This position is in stark contrast with the pipelines that cross Ukraine, which Russia has sought to acquire to no avail for years. Gazprom has stated that it would welcome the expected participation of the French utility company EDF in the South Stream project, but insists on keeping its decisive vote and majority ownership. Another telling observation is that the estimated transportation costs for gas of the new pipelines will substantially exceed the transit fees that Russia currently pays to Ukraine and Belarus. Furthermore, Russia never expressed any doubt about the projects after the global economic crisis began (2008) and the gas prices declined sharply (2009) . Finally, recent gas market forecasts imply that existing pipelines between Russia and the EU have sufficient capacity to facilitate Russia’s gas exports to the EU until 2030.
Many analysts, including Paszyk (2010), claim that South Stream is a deliberate attempt of Russia to prevent the building of the Nabucco pipeline. This pipeline would run from Turkey across Bulgaria, Romania and Hungary to Austria. Its estimated development costs are less than half of those of the South Stream pipeline and the planned completion year is 2013. The project has been troubled by financial problems and a lack of consensus among the involved countries. The Nabucco project is part of EU efforts to find opportunities to import gas without Russian interference.
The South Stream project seems poised to have a negative impact on the Nabucco project as it aggravates the latter’s most serious problem: the supply of sufficient gas to transport through the pipeline. Suggested options to secure gas flows include connections between pipelines in eastern Turkey and those in either Azerbaijan or Iraq. While the second option is not possible for the time being due to political problems in Iraq, the first one is attractive as Azerbaijan, Kazakhstan, Turkmenistan and Uzbekistan have earlier expressed interest in delivering gas to the EU without interference of Russia. So far, the countries concerned have however only guaranteed 20% of the required gas flows, making it highly unlikely that eventually sufficient gas will be available for the Nabucco pipeline. The ability of Azerbaijan, Kazakhstan, Turkmenistan and Uzbekistan to deliver gas to the EU through the Nabucco pipeline is compromised by committed gas sales to Russia, export opportunities to China and strong domestic demand.
The long-term prospects of the Nabucco project, and thus of the EU’s ambition to become less dependent on Russia for its gas imports, were further clouded by Gazprom’s acquisition in 2008 of a 50% share in the large gas transmission centre at Baumgarten in Austria. With this transaction, Gazprom created an influential position towards the Nabucco pipeline, as the EU had designated the centre as the final destination of the Nabucco pipeline. Officials of the Austrian government and the Nabucco project have recently suggested using the Nabucco pipeline to transport Russian gas as well or to merge its European (non-Turkish) route with that of the South Stream pipeline . These suggestions make clear that the initial rationale behind the Nabucco pipeline, excluding Russia from part of the gas flows to the EU, seems nothing but a ‘pipe dream’.
Although Russia’s share in EU gas imports has recently diminished considerably, the country has been actively engaged in consolidating its position on the EU gas market. First, Russia has recently been effectively countering the EU’s attempts to diversify its gas sources. The country has positioned itself well to purchase a large part of the future gas production of Central Asian countries. Contrary to this development, Gazprom’s activities in some other gas producing countries will likely have a small impact on Russia’s position vis-à-vis the EU for the time being. Second, Russia plans to build two new pipelines, Nord Stream and South Stream, to reduce its dependency on Belarus and Ukraine. Both countries currently function as transit route for all its exports to the EU. For the EU as a whole, this simply means continued dependence on Russian gas. Nevertheless, the projects have raised fears in Central and Eastern European (EU) countries that Russia would become more inclined to cut off gas flows to this region for political reasons. Third, Gazprom is gradually becoming more active in downstream activities in the EU such as gas storage, transmission and sales. Its majority share in the Nord Stream and South Stream pipelines and its acquisition of half of the shares in a large Austrian gas transmission centre underline Gazprom’s increasingly powerful position on the EU gas market. In this respect, the position of EU companies in Russia pales in comparison, as they are denied controlling stakes in upstream gas projects.
Looking ahead, an insufficient Russian gas production or a financial crisis at Gazprom, making the company sell some of its foreign assets, could (temporarily) weaken Russia’s position on the EU gas market. If these events do not occur, then Russia seems poised to consolidate this position the coming decade. This is the consequence of the EU’s inability to create one internal EU gas market. This inability stems from a lack of political willingness and constraints related to the difficulty of transporting and storing gas. National governments of the larger and powerful EU states still consider energy security a national interest, not be delegated to a supranational body. The EU gas market seems likely to remain fragmented, providing Gazprom the opportunity to continue implementing its strategy on national gas markets. Smaller EU countries with a strong dependence on Russian gas will especially lack any real bargaining power vis-à-vis Gazprom.
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