Workshop Review: Tatiana Mitrova – Russian Gas Export Strategy

By Nicholas Watt and Maurizio Recordati

On December 9, 2013, the ENERPO program welcomed Russian energy specialist Dr. Tatiana Mitrova to European University at St. Petersburg. Her nearly four hour presentation in our university’s Golden Hall consisted of two parts – Russia’s gas export strategy and the future of world energy markets.

With a professional background that includes work with Russian majors like Gazprom and Rosneft, an advisory role in Deputy Prime Minister Arkady Dvorkovich’s “Government Commission on the Fuel and Energy Complex”, and head of Global Energy Department at Skolkovo’s Energy Center, Dr. Mitrova is one of the foremost experts on Russian energy issues. Her diverse experience and depth of knowledge – with 7 books and over 110 publications to her name – has made her one of the most frequently quoted Russian energy experts in the media. As the current head of the Oil and Gas department, a title held since 2011, at the Energy Research Institute of the Russian Academy of Sciences (ERI RAS), Dr. Mitrova continues to build upon her 16 years of experience in Russia’s hydrocarbon industry. Previously, starting in 2006, she was the head of the Center of International Energy Markets Studies, also at the ERI RAS.

Dr. Mitrova studied economics at Lomonosov Moscow State University, where she received her bachelor’s degree in 1995. In 2004, she got her PhD from the Gubkin Oil and Gas University, where she is now also an assistant professor.

Additionally, Dr. Mitrova is a member of the Valdai Discussion Club, which holds annual meetings attended by the foremost experts on Russia and has been attended by Russian President Vladimir Putin and Prime Minister Dmitri Medvedev.

With a professional background that includes work with Russian majors like Gazprom and Rosneft, an advisory role in Deputy Prime Minister Arkady Dvorkovich’s “Government Commission on the Fuel and Energy Complex”, and head of Global Energy Department at Skolkovo’s Energy Center, Dr. Mitrova is one of the foremost experts on Russian energy issues.

This report on her presentation will first provide a condensed version of her analysis of Russia’s gas export strategy and second, an edited transcription of the subsequent question and answer session with the ENERPO students and faculty.

Why Gas Export is So Important to the Russian State

Energy – natural gas, crude oil, and oil products – comprises nearly 70% of all Russian exports. 45% of all incomes of the state budget come from oil and gas, with the bulk of these coming from oil, and only 8-10% coming from gas. But it has not always been this way. If you look back at the early 2000s, oil and gas provided less than 10% of budget incomes. It is only recently, as oil prices started to rise and gas prices were obviously following this trajectory, that the Russian government began to rely so heavily on these.

This means that the Russian government’s military expenditure, social programs, or any ambitious plan will come from this money. The problem is that any additional taxation of oil production will lead to declining oil output. It is heavily over-taxed: out of $100 per barrel, the government takes about $75. For those producing in Western Siberia with operating costs of $8 to $10 per barrel, it is still profitable. However, any new enhancement or greenfield project is far from lucrative, especially in the promising Eastern Siberian and Arctic regions. Enhanced oil recovery costs approximately $50 to $60 per barrel; in the Arctic this figure jumps to $110 to $130 per barrel; and for the Bazhenov it is approaching $200 per barrel. Under current taxation regime, the math simply doesn’t add up – that is why the government introduced tax breaks for Arctic and Bazhenov. For Russia to sustain current production levels of approximately 10 million barrels per day, it is critical not to increase oil taxes any more. The government is left with only one more source of income…gas. Only gas taxes can provide some substantial, additional revenues. This is important because later in this presentation we will see the government has a particular strategy with gas exports. But in trying to understand this strategy, we should understand the dependence on gas revenues for the state budget.

Naturally Maturing European Gas Markets

Russian gas exports started in the late 1960s. Throughout the Cold War, it was quite successful and without conflict. There was the famous Gas-for-Pipes deal when Germany, Italy, and France provided pipelines for compressor stations, and the Soviet Union in turn provided quite cheap gas. Both sides were satisfied: European countries found a huge market for their steel production and got cheap energy resources, while the Soviet Union received much needed hard currency and with a new, extensive pipeline system, was able to gasify the European part of Russia.

European gas market was constantly growing, but recently this growth has since leveled off. These mature markets are introducing energy efficiency measures and have either steady or declining population. Their industrial production is moving primarily to non-OECD countries so they don’t need much additional gas. All the growth is concentrated in non-OECD countries like China and other developing countries. These markets stopped growing a few years before the crisis, but nobody mentioned it. All the experts thought it was just a seasonal problem, but if you look back at the statistics the markets stopping growing somewhere between 2006 and 2007.

For Russia to sustain current production levels of approximately 10 million barrels per day, it is critical not to increase oil taxes any more. The government is left with only one more source of income…gas.

On the supply side, additional gas supplies will be mainly covered by new conventional fields all over the world. We’ll see that this club of gas-producing countries, which was limited, is now expanding with the entrance of a number of new players to the market.

The Closed North American Gas Market

In 2004, there were special road shows organized by the US Department of Energy, which traveled to all of the gas producing countries and those with LNG, with tales of a looming US gas crisis: “Prices have jumped from $2 per BTU up to $8 -10 per BTU and there is a gas deficit. We will be importing 120 -180 bcma of LNG by 2020.” Qatar and Nigeria, for example, were targeting their LNG projects on the US market. The Shtokman project was also initially targeting this market, but then in 2007-2009, it started to become more and more obvious that the shale gas revolution was not an accident, but a real game-changer. Shale gas production in the US reached 260 bcma in 2012. North America will probably be net gas exporters by 2020, possibly even earlier. The first LNG export terminal projects have gotten permission to start exporting by 2016. By 2016 – 2018, there will be US LNG reaching European and Asian markets. This market is now full; and Russia – which was very seriously considering this market for its gas – had to postpone Shtokman and Baltika (which was being planned in cooperation with Petro-Canada).

Stagnant Demand on the European Gas Market

We are observing now increasing competition together with very slowly growing, possibly even declining demand. Of course, however, European domestic gas production is falling. Every year, the Northern Sea – main source of gas for Europe – is losing 20-25 bcm. Though there will be an increasing need for import, a number of different players are targeting this attractive market, with its high prices and large demand. Gas – either LNG or piped – will be coming from Africa, the Middle East, South/Central America, and North America. Piped gas, coming from Russia and the CIS, is probably the most expensive on the market. The market niche for newcomers is not increasing significantly. While this market is not declining, it is at the same time not growing as it was supposed to according to Russian strategic documents. If you look back at the Energy Strategy of the Russian Federation in 2009, you’ll see that Russia was planning to supply 220 bcma of gas to Europe by 2020. Currently, we are supplying 140 bcma. All the expectations – in the domestic gas sector and in budget revenue estimations – were made on the basis of this 220 bcma. It is not a catastrophe because Russia did not lose the market. We are supplying the same volumes as we did before the crisis, but they are not growing, which is already a problem for the budget.

When oil prices rise, people do not stop fueling their cars, because there is no substitute. With gas it’s different; gas is always facing a tough interfuel competition. When gas prices become unfavorable, it is replaced in the fuel mix. 

A few more words about the European gas market, if someone ten years ago would have tried to develop the most catastrophic scenario for gas exports to Europe, I think he wouldn’t have imagined such an unpleasant and unfavorable coincidence of different factors. First, we have weak demand. The demand is lower than contracted volumes, so Europe is over-contracted. IEA analysts predict that European gas demand will recover by 2020 at the earliest. The situation with the euro zone is really bad: no growth in industry, no growth in electricity or in the residential sector. There are currently no drivers for demand.

More Coal, Less Gas in the European Power Sector

90% of the power plants in the previous two decades were built for gas powered electricity generation, but now gas is facing stronger inter-fuel competition. The first competitor is renewables. Without counting hydropower, they used to account for 9% in 2000 and are now approaching 16%. They have feed-in tariffs, subsidies, and, once completed, low marginal costs. The second is coal; and gas is losing this competition. If you compare operational efficiency between coal generated power and gas generated power, they used to be quite comparable. Over the last four years, gas has become more expensive and coal has become cheaper as a result of oversupply and the weak economic situation globally. Lots of coal came from the US because the shale gas revolution dropped gas prices in the US and started to squeeze coal out. Nobody there wants to close coal mines. They are currently working with zero margin, and have doubled their exports to Europe. This additional supply of North American coal has led to much lower coal prices. Oil demand is inelastic. When oil prices rise, people do not stop fueling their cars, because there is no substitute. With gas it’s different; gas is always facing a tough inter-fuel competition. When gas prices become unfavorable, it is replaced in the fuel mix. This is increasingly the case as gas has been replaced by renewables and coal. Many of the recently built gas fueled plants have closed, and old, dirty coal plants are being used. This phenomenon has nothing to do with EU’s plans for emissions cuts. Since the crisis, people have been driven more by pragmatic considerations. The power generators are doing this to avoid going bankrupt. They don’t have much choice as electricity prices are really quite low. Additionally, industrial output has dropped. The price for CO2 allowances has dropped as well. The prices, which used to be 30 euro per ton before the crisis, are now just 5 euro per ton. This tool, that was meant to make gas more attractive than coal, is not working anymore. The IEA has said the price per ton has to be increased to 80 euro to make gas competitive with coal. No country is willing to increase the price this much. Gas has to become 40% cheaper or it’ll continue to lose its market. Additionally, strict regulation on coal fired plants is lacking. However, there are some countries, like the UK that are introducing measures that effectively kill coal plants that were built before 1973. These measures come into force sometime this year. It remains to be seen what else will be done administratively to help gas’s competitiveness.

Many of the recently built gas fueled plants have closed, and old, dirty coal plants are being used. This phenomenon has nothing to do with EU’s plans for emissions cuts. Since the crisis, people have been driven more by pragmatic considerations.

It would seem the silver lining for Russia is that its coal could be sent to Europe, but it actually is not competitive there. Coal is primarily produced in Russia’s East and railroad tariffs are too high. Additionally, despite a market opening up in Germany following its policy of closing nuclear reactors, the country has chosen renewables instead of gas to replace this capacity.

At the moment, the markets do not favor gas. It does not have many stakeholders lobbying for it. There are no more gas companies in Europe. Energy companies are generating electricity and are more concerned about optimizing their portfolio, which is their priority. For the European Commission, more gas means more dependence on Russia. All official documents of the European Commission state that there should be more diversification. With the exception EuroGas, nobody is trying to promote gas as a fuel of choice in the Europe, as it was 10 to 15 years ago. Now, it is a fuel of conflict and high prices.

Unfavorable and Uncertain European Gas Regulation is Not Helping Russia

For Russia’s gas export prospects, the demand story is not even as bad as the regulation story. First of all, we have the third energy package (TEP) and unbundling. Starting from 2002 when Miller and his team came to Gazprom, they were immediately instructed by the president to cut out the intermediaries by building a vertically integrated chain, and thus become more profitable. Once Gazprom built everything, bought the companies, invested in the pipelines and underground storage, they found out that they cannot use it as a vertically integrated chain.

The majority of EU stakeholders have decided they want spot indexation. It is not necessarily a rational choice. If you look back, there were periods when oil linked prices were lower than the spot price.

This is not the whole story. There is question of whether Gazprom would have an exemption from the TEP. These pipelines are enormous. Just imagine building Nord Stream – costing about 15 billion euros – and then not being able to use it at full capacity, only half capacity. 7.5 billion euros just gone to waste. Similar threats are facing South Stream as there is a very complicated legal dispute, which I think has only just started. The Russian Ministry of Energy pretends that these intergovernmental agreements for the onshore part of South Stream were signed before the TEP came into force. That is why according to the Vienna convention it has priority over this regulation. I think it’ll take a lot of time and effort from different lawyers to settle this dispute. Meanwhile, there is this legal grey zone and nobody knows how it will function, so the risk is very high. This risk in financial terms is billions of euros. On top of this, you have the Gas Target Model, which is the next step in the implementation of the TEP, and which, though still under development, describes how the gas market will work in the future. The main idea is to move deliveries from the national borders to the virtual hubs. The question revolves around the future of Russia’s long-term contracts which are all made at the national borders. In addition to these regulatory risks, there is the EU Commission’s investigation against Gazprom, claiming that Gazprom abuses its market power. You can see that the situation is extremely unfavorable. The uncertainty is huge – as the regulatory measures are changing every few years – and even with the Gas Target Model, which has to come into force in 2014. We still don’t know what is inside.

Before 2017, there will be no more LNG available on the market. 

The next problematic area is pricing. Spot lobbies are increasing very quickly. Before 2009, the share of spot indexed gas did not exceed 20%, which was almost all in the UK. Over the last four years, the share of spot indexed prices has raised to about 50%. The other 50% are still supplied under the “Groningen formula”, tied to oil prices. This is unsustainable: you have two different prices for the same market and the same good. The majority of EU stakeholders have decided they want spot indexation. It is not necessarily a rational choice. If you look back, there were periods when oil linked prices were lower than the spot price. It’s a question of preferences. EU companies and working consumers prefer spot-based. They believe it to be more fair. The EU Commission, importantly, also thinks it is more fair even though the name of this long term oil indexation kind of pricing – Groningen – comes from the Netherlands, which was developed for the Groningen field back in the 1950s.

EU Gas Supply: Tight Now, Glut Later

You cannot say that supply is expanding, but that it is expected to expand. New energy producers are coming to the market and there will be a diversification of pipeline sources like the Southern Corridor and maybe some from North Africa or Middle East. It is important to separate gas market conditions for the next three, four, five years from the longer term. It is not widely discussed, but the market is tight: there was a 25% drop of EU LNG imports in 2012, all of this was redirected to Asia. According to LNG contracts, companies can redirect them if it is more profitable. Before 2017, there will be no more LNG available on the market. North American LNG will come on stream in 2017, and Australian in 2017. There are no new projects currently available. I would expect that until the end of this decade, Europe will remain a deficit market.

It is true that after 2020 there will be other options, but now the only option is to increase Russian gas supplies. This is the reason for Gazprom’s price behavior.

Norway, for example, cannot supply any more. Last year, they had more exports than Gazprom, but it was not without consequence. Sustaining such a high production volume is a problem, as these are also depleting fields. It is true that Norway has made some new discoveries located between its own territory and that of Russia, but it will take some time before production can begin on these fields. Norway is expected to maintain current volumes, but no more than that.

Algeria can hardly fulfill its export obligations. Egypt’s growing domestic market does not allow them to export. If you look at all the suppliers that Europe can rely on, you’ll see that there is little available other than Russian gas. It is true that after 2020 there will be other options, but now the only option is to increase Russian gas supplies. This is the reason for Gazprom’s price behavior.

Gazprom Has Chosen Higher Prices over More Sales

Gazprom will hold on to high oil-indexed prices because when there is no competition, your customer has no choice but to buy your product. Given this situation, Gazprom understandably prefers higher prices. When the goal is revenue maximization, you should understand this strategy as not only Gazprom’s, but that of the Russian state. The state cannot afford to give discounts, though Gazprom has given some. The differential between contractual prices and spot prices is decreasing. This is because Gazprom is very slowly and painfully providing some price discounts for individual customers. They have gone through about 4 or 5 rounds of these price renegotiations over the last four years. Sometimes these price discounts, like 15-20%, are organized as a retroactive payment; sometimes it is changing the coefficient in the formulas. There are different mechanisms, but the main message is that although Gazprom will provide discounts, it will continue the oil-linked pricing mechanisms in the contracts. Once the economy recovers, Gazprom will still have oil-linked prices. This is a principal position of the Russian government.

Demand for Russian Gas in Asia

Asian gas demand, especially in China, is growing. Gazprom would like to sell gas there but there are some obstacles. If you look at the Chinese market, it is already over contracted. Until 2020, China has contracted more than they need. Only by 2025, will there be some market niche. It could be one pipeline from Russia; it could be around five gas terminals, as China is building regasification terminals very quickly. China will have a choice between taking pipeline or LNG gas from Russia. China is, however, trying to exploit its own shale gas reserves, an endeavor, which so far has not been very inspiring. There have been problems with geological formations and with available water for hydro fracturing. But it is still the early days. China is not in a hurry to get Russian gas. Central Asian gas is crossing near to Afghanistan’s borders – not a very secure region. LNG could be controlled by US fleets. Russian pipeline gas without transit countries seems perfect from this point of view – but at the same time, not at any price. Only a cheap proposal from Russia is acceptable to China, which from Russia’s point of view is impossible. Unlike the Western Siberian fields, the eastern fields – Chayanda and Kovykta – and even Sakhalin gas are quite expensive. Also, these fields have a high quantity of helium, which despite being very difficult to store, must be stored according to Russian law. This means that before this eastern gas is put into pipelines, gas processing plants that would extract these liquids and helium must be built, requiring significant investment in the upstream and mid-stream. Russia has not built any gas processing plants in over two decades and their cost is similar to that of oil refineries. Once the gas has been processed, you’d have to transport it via pipeline. The average cost of pipeline construction in Europe is 3 million dollars per kilometer – Gazprom is showing 7 million. If you put all this together – expensive upstream and midstream, and expensive pipeline – the price that Gazprom would deliver at the Chinese border is high. China does not need expensive gas from Russia and this is why these negotiations have been going on for 10 years. China wants equity in the upstream, but Gazprom is against this. The situation is not desperate from the Russian side, but they would like to complete a deal as soon as possible.

American suppliers have already signed contracts of up to 60 million tons, whereas Russia has managed to contract only 7 million tons of new LNG.

Another market that seems to be very attractive is OECD Asia – Japan and South Korea – where the highest prices are, and currently stand at around $16 – 18 per BTU. Demand is slightly rising, with the nuclear phase-out of Japan, and supply is declining, as Malaysia and Indonesia are now becoming net importers. The problem is they are already contracting their LNG. American LNG is very attractive for Japan and Korea. Buying from the US is good for Japan, because it would also mean increased protection. Russia, on the other hand, still does not even have a peace agreement. American suppliers have already signed contracts of up to 60 million tons, whereas Russia has managed to contract only 7 million tons of new LNG. Cheniere, which has tied its prices to the Henry Hub market, was the first in America.

Currently, [Gazprom’s] market positioning is swing producer with price maximization, though it is not articulated clearly.

Gazprom’s Pricing Policy and Market Positioning

Gazprom’s rationale for getting as much revenue as possible now is that later on it will be much more difficult and the competition more hefty. There is a lot of gas around the world that could be produced economically, but this is long-term. The prices in Europe will drop by 2020 because of the coming oversupply. There is not a lot of hope for increasing revenue from gas for the Russian budget. A lot will depend on the Chinese, who could theoretically buy 40 bcma. When Alexei Miller came in 2002, Gazprom switched from price dampening, which allowed them to increase market share, to price maximization strategy. It was quite successful because of the growing prices and markets at the time. It was like an endless show, but the show has stopped. The strategy has been adjusted to allow for some small price discounts.

Russia is like the Saudi Arabia of gas. The difference is that Saudi Arabia has very low costs of production, while Russia has entered into expensive proects like South Stream, Nord Stream, and Bovanenkovo. I’m not sure for how long this strategy can be sustained without creating problems for the balance sheet. Currently, our market positioning is swing producer with price maximization, though it is not articulated clearly. Just as an illustration to the thesis I have already promoted – Europe has no options for gas supply alternatives available for the next three or four years – nothing can be delivered in such a short time frame. There are high expectations in Europe concerning North American LNG, but the Americans are unsure about supplying gas to Europe; for them, the Asian market is much more attractive. The situation is similar for East African LNG.

The problem is if you have this price-oriented strategy instead of a volume-oriented strategy, then the question arises: why would you build so much transportation capacity?

Gazprom’s contract portfolio is a factor that should not be neglected. Europe has been offtaking about 75% of the contractual supplies, the very minimal amount without breaking the take or pay clause. They will offtake gas they don’t use and sell it on the spot market, ironically pushing prices there down. If you look at all of Gazprom’s current contracts, they are guaranteed to sell at least 120 bcma to Europe until 2020, about what they sell currently. Also, Gazprom sells about 20 bcma on the spot market – in Belgium and in the UK. Plus, if we assume there will be some deficit on the market, it means that Gazprom will be in a position to increase supplies. Gazprom’s preliminary results estimate that 160 bcm was sold in 2013. In the third and fourth quarters, sales increased a lot.

There are arguments for Gazprom in favor of both oil indexation pricing and spot pricing. Plus, it is hard to say what is fair pricing. To a large extent, it’s a question of your faith. For Gazprom, oil-indexation will be much more attractive than spot indexation for the next several years. This does not mean Gazprom will always refuse spot indexation. Probably by 2020, Gazprom will have to adjust, but not now. It’s a good strategy actually, the probem is if you have this price-oriented strategy instead of a volume-oriented strategy, then the question arises: why would you build so much transportation capacity? The capacities of Nord Stream and South Stream will exceed annual contraction quantities by two times. With minimal contractual quantities, it’ll be even less. There is a major inconsistency – profit maximization makes sense and is a reasonable strategy, but don’t invest in large pipeline projects. There is a single explanation for these investments: to bypass Ukraine. I think the current situation will be used as proof that it’s necessary to bypass Ukraine. But still, it seems there could be other solutions to this transit issue.

Summing up, Gazprom is protecting its oil-indexation policy in Europe. In Asia, Russia is in negotiations with the Chinese for a gas deal that is critical for the government. The pipeline to China would run from Chayanda and Kovykta with one leg branching off to Vladivostok to the liquefaction plant. This leg would make it so Russia is not so dependent on the gas to China.

Changes Moving Forward in the Russian Gas Industry

The recent LNG liberalization law was quite a historic event for the Russian gas industry. For the first time, non-Gazprom producers will be able to export gas outside of Russia. The government realizes that Gazprom, which is dealing with pipelines, Bovanenkovo, and the domestic market, is overburdened by carrying out so many projects simultaneously. This is partially why Novatek and Rosneft got this exemption for their projects in Yamal and Sakhalin. I have to stress this is not a complete export liberalization. It’s not that easy to get an export license, but at least it’s not just Gazprom now. There are at the same time at least two LNG projects by Gazprom: Baltic LNG, and Vladivostok LNG, and probably a Sakhalin 2 expansion, which would probably be the fastest and most reasonable but since it’s not 100% Russia, it is not very welcome. Despite harsh conditions, these Russian LNG projects are more or less competitive, at least at first glance. If they manage to control costs properly, then these projects are more or less economically viable – at least not more expensive than US or Australian LNG, though not as cheap as LNG from Qatar.

The three pillars of the Russian gas strategy: price reviews with minimal adjustments of oil-indexation framework, Eastern Development including a gas deal with China, and LNG development with non-Gazprom players’ projects.

Summing up, here are the three pillars of the Russian gas strategy: price reviews with minimal adjustments of oil-indexation framework, Eastern Development including a gas deal with China, and LNG development with non-Gazprom players’ projects. It seems that for Russian gas, there are still many opportunities on the market, but realizing these opportunities is accompanied by huge challenges, which have already started to change the institutional structure of the industry and will likely bring more changes both domestically and in the export strategy.

Question and Answer Section

Question: This year Statoil is planning to switch all of its contracts to spot market pricing. My question is what effect do you think this will have on the European spot market, and what will it do to Gazprom’s export strategy?

I think Statoil made this decision at the right time. If they’d done it two years ago they would have lost a lot of money, but now if you look at the spot prices, they are going up. From market fundamentals, if you have a tight market without many supply options available even with a stagnant demand, prices will go up. In winter, prices for gas will be at least in the range of oil indexed prices. So, Statoil is not losing anything by switching but is acquiring an image of a flexible market oriented player that takes into account the needs of the customer, something Gazprom is lacking. It is a good way for Statoil to enhance its own positioning on the market. I don’t think it will affect Gazprom’s strategy, as this strategy, as I have tried to explain, has a very serious basis behind it. It’s not Gazprom being so nasty and/or reluctant to any changes; they just see what would be more profitable for them now.

Question: In your presentation you mentioned many potential export markets for Gazprom. My question is what are Gazprom’s prospects on Russia’s domestic market?

For a period of time it was popular [for Gazprom] to say, if the foreign customers don’t like us, we will switch to the domestic market. After the crisis, however, the domestic market stopped growing. It has been stagnant since 2009. You know what has happened with Russia’s economic performance? In 2013, we will be happy to have 1.4% GDP growth with nearly zero industrial output growth. There is no gas demand with the economy in stagnation; it’s similar to the EU situation.

[Russia’s] domestic gas suppliers are supposed to be like normal competitors but it’s more like an oligopoly, where they are dividing their markets.

Additionally, there is increasing competition on the domestic market. We used to have just Gazprom and a little bit of Novatek. Now, we have an ambitious Novatek, aiming to bump its production to 100 bcma, and an equally ambitious Rosneft with the same production target. With Novatek, this growth is coming from the natural development of new fields. With Rosneft, it is to a large extent the result of mergers and acquisitions. We see Gazprom losing its market share. In the good old days, they had 85%, now it’s less than 74%. This figure will further decline because these new market players are very influential, active, and aggressive, providing gas discounts. In the last couple of years, Novatek and Rosneft have been cherry picking the best of Gazprom’s domestic customers – large industrial customers that pay the highest prices. Novatek and Rosneft agreed to sell their gas at a discount: the regulated price minus 5 – 10%. The domestic gas suppliers are supposed to be like normal competitors but it’s more like an oligopoly, where they are dividing their markets. The problem for the producers is that on the stagnant market it is very difficult to justify a price increase. Actually, domestic Russian prices have already reached the level of the USA. In the 1990s and early 2000s, there were cheap prices but that is no longer the case. Currently, they pay around $130 or $140 per 1000 cubic meters, with industry screaming that any further price increase would lead to negative industrial output growth. The government has decided to freeze gas prices for 2014. Most likely, we will see a period of much lower annual gas price increases, probably following the rate of inflation. Historically, it was 25% increases starting from 2007 to 2011, which later dropped to 15% per annual growth. Now, it will be about 5% per annum.

Question: What is Gazprom doing to market its brand? What is it doing in terms of PR and lobbying in different countries?

Gazprom has several contracts with major PR companies. They are financing football clubs, what else? [laughs] They are putting forth a lot of expensive effort to promote themselves, but I am afraid that the negative image, which is to a large extent a result of people regarding them not as a commercial company, but as a political tool, is very hard to overcome. It’s difficult to explain their side of the Ukrainian gas crisis of 2009, namely, that if you were supplying gas to somebody that does not want to pay, the logical decision would be to switch them off. But the other side would disagree, saying it was Russia applying pressure to Ukraine. I would not say that it’s a problem with Gazprom but a problem with the image of the Russian Federation.

Question: You have spoken a lot about Russia’s relationship with the EU. I was wondering if you could spare some words on a different gas customer: Turkey. How does the Blue Stream pipeline fit in to Russia’s relationship with Turkey?

Blue Stream was a fantastic story. I believe they started construction in 2002. The first problem Gazprom faced was that demand in Turkey was overestimated, just as in Europe nowadays. The price formula was wrong and there was then a long dispute trying to settle prices. As a result, Gazprom had to give a good discount. But then this pipeline had remained underutilized until very recently. It was utilized roughly at 8 bcma whereas its capacity is 16 bcma. From time to time, when Iran was failing to supply contracted volumes to Turkey, Gazprom was asked to compensate for that and the utilization was increasing. These were quite short periods of time though. I wouldn’t say Blue Stream is an example of the most efficient project I’ve ever seen. There were many corruption scandals that erupted both in Russia and in Turkey. Until recently and for the last decade, Turkey’s gas consumption has been rising fast, providing for the highest growth rates of gas consumption in Europe. Turkey, however, in its own energy strategy, wants diversify both its energy mix and suppliers portfolio, in which it refers to this mysterious dominant single supplier.

I think both sides will go to courts and in a couple of years the problem will be settled, and meanwhile Gazprom will just build South Stream.

There have been some very painful price disputes: in 2011, Turkey stopped two contracts and refused to resign them because Russia did not concede price discounts. These contracts were terminated for half a year. The following contracts involved not Turkish state company BOTAS, but other companies, as Turkey was undergoing market liberalization and there were new entrants into the market. What makes it harder for Gazprom is Turkey is keen on diversifying its options. It’s not only gas from Azerbaijan, but also potential suppliers from Iran, Iraq, and those using the Arabian pipeline are possibilities. Turkey is trying to position itself as a South European gas hub. More important, Turkey was trying to become an intermediary, buying gas on its border and selling it to the EU – something Gazprom just hates. It has not been an easy relationship, but Gazprom was very happy when Turkey gave permission for the construction of the South Stream on its territorial waters, and Gazprom was very interested in the construction of gas storages and gas fired power plants in Turkey. There are problems with a nuclear power plant construction, an element which is also affecting Russo-Turkish energy relations and gas deals as well. Finally, not everything is rosy with many different complex factors, but they are and will be working together because it’s in both parties’ interest.

Question: Last week the EU Commission announced that Russia’s bilateral agreements with EU Member states regarding South Stream were illegal and had to be reformulated. How do you see this progressing? What is Gazprom’s next move? And the European Commission’s?

I think the Russian Ministry of Energy stated the Russian Government will appeal to the European Court and the European Commission will do something similar, so it will move this legal issue to the priority of different agreements — what is more important: an intergovernmental agreement between Russia and every single country or European legislation, super-national regulation. There is no straightforward answer, it has to be worked out in courts. I think both sides will go to courts and in a couple of years the problem will be settled, and meanwhile Gazprom will just build South Stream.

In the worst case scenario, there could be just two lines of South Stream ending in the Balkans, not stretching further. Hence, some TPA wouldn’t mean any significant losses for Gazprom in this case.

Question: What do you think will happen with the EU Commission’s case against Gazprom, will it be settled at courts?

Maybe it will sound cynical [smiles], but when you’re facing winter time and you do not have any supplier capable of delivering gas, you will be quite cautious to fine Gazprom with 10% of its turnover. I think it will be settled. There will be some evidence showing that Gazprom has applied different prices to different consumers, but then it will just be forced to correct its contracts. At least at the current stage that’s how I think it will develop.

Question: If South Stream fails to get an exemption from the 3rd energy package, which seems likely, then other suppliers, such as the Shah Deniz Consortium could, through the third party access clause, use Gazprom’s pipeline. How is Gazprom dealing with this possible scenario?

Gazprom is still working on its South Stream strategy, because they still do not know for sure how far the European Commission will go and what the courts’ decisions will be on this issue. In the worst case scenario, there could be just two lines of South Stream ending in the Balkans, not stretching further. Hence, some TPA wouldn’t mean any significant losses for Gazprom in this case. I think they will simply adjust to the situation.

It’s becoming more and more obvious that Novatek and Rosneft are interested in the Ukrainian market. This could be a solution to these dead-end negotiations. For Rosneft and Novatek, $170 per 1000 cubic meters is a good price, and $220 is just perfect.

Question: As a follow-up question, do you think fear of projecting weakness is one of the reasons Gazprom is refusing to allow TPA?

It could be. You know, when it comes to these exchanges of statements there is so much of policy inside and just a little bit of economics [smiles], so it’s difficult for me to comment on that. Of course there is a part of political, just political, pressure on the other side. On the other hand, some TPA could be theoretically acceptable – very unpleasant, but acceptable. Gazprom will resist, of course, for as long as possible.

Question: One part of Gazprom’s strategy, as you have mentioned earlier, is to develop Russia’s Far East. Can you speak to the effectiveness of this strategy? What is the state of its development?

One of the rationales behind the Eastern Gas Strategy is that it’s not just providing gas for exports but also developing gas for local industrial production, providing employment for locals and the gasification of the region as well as for gas fired power plants. The problem is that it’s expensive gas and so far we have an example of gas supplied to this region through the Sakhalin-Khabarovsk-Vladivostok pipeline. Consumers have been quite skeptical about this gas and only after the federal government has provided special and significant subsidies it had started to work. In the local inter-fuel competition, local coal is much more competitive than Sakhalin gas. The government can apply these subsidies, if they think they are justified, but I’m not sure that it’s the best way to develop energy supplies from remote and locked regions. I think that to a certain extent it is exaggerated, this impact, this multiplication effect of gas supplies in the region. With the industrial consumers, the Eastern Strategy was developed in 2006 when there were high GDP growth rates and Russia was a little bit different a country than it is now. There were a number of industrial projects in the Far East which could have used this gas, but they are now postponed and there is no such gas demand.

Question: Russian Ukrainian gas relations are poor at the moment, yet Ukraine is still reliant on Russian gas. How do you see gas negotiations between the two countries going forward?

It will depend partially on the market players that supply gas to Ukraine. It’s becoming more and more obvious that Novatek and Rosneft are interested in the Ukrainian market. This could be a solution to these dead-end negotiations. For Rosneft and Novatek, $170 per 1000 cubic meters is a good price, and $220 is just perfect. For instance, now Rosneft, not Gazprom, is negotiating some Russian exports to Belarus.

Nicholas Watt is an alumnus of the ENERPO program and the editor-in-chief of the ENERPO Journal. Maurizio Recordati is the executive director of the ENERPO program.

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