Stalled Negotiations on South Stream – Addressing Fears of More Russian Gas

by Nicholas Watt

As the European Union heralds in new leadership with Jean-Claude Juncker replacing former Commissioner Jose Barroso, it is an appropriate time to review the considerations from the EU and US that have gone into halting progress of Russia’s South Stream pipeline, as well as to highlight developments in Europe’s gas market that should allay Western fears of the Russian pipeline’s potential implementation.

The faulty premise is that Gazprom holds a monopoly in Europe and that South Stream will reinforce it.

Gazprom’s roughly $40 billion dollar project involves a pipeline that will cross Turkey’s section of the Black Sea and provide gas to Bulgaria, Serbia, Hungary, Slovenia, and Austria, where it will terminate at this country’s Baumgarten gas hub. Though construction officially started in late 2012, little actual pipeline building has occurred. The project’s resumption is based on the adherence to bilateral agreements between Russia and those four countries that (with the exemption of that with Serbia, which is not yet in the EU) the Commission has deemed illegal, as the project does not conform to a piece of EU legislation called the Third Energy Package. Direct negotiation between Russia and the EU on this issue has since been halted as a result of Russia’s involvement in Ukraine. “In the current situation, with civil warlike conditions in eastern Ukraine and without Moscow’s recognition of the government Kiev, we will certainly not arrive at a political conclusion of our negotiations [on South Stream],” Gunther Oettinger, the EU’s energy commissioner, said during an interview in June 2014 to a Frankfurt newspaper. Bulgaria, the EU country where South Stream is planned to come onshore, stopped work on the pipeline following a meeting between the country’s leadership and US senators, including John McCain, who declared bluntly after the meeting, “We want less Russian involvement in South Stream.” This admission reveals a broader truth, which is that the EU Commission, with pressure from the US, does not want South Stream to go forward because they think its success will enhance Russia’s ability to use gas as a weapon – either by completely shutting off supplies to Russia’s perceived adversaries or by adjusting prices to squeeze political concessions out of them. Moreover, in the event of the pipeline’s implementation, its success would be portrayed in the Western media (and by opportunistic politicians) as another in a long line of continued European dependence on Russian gas and that by allowing this pipeline to be built, Europe is making itself more vulnerable to perceived Russian aggression, as Europe’s room for maneuvering would be handicapped by an even higher energy dependence on Russia. However, such a portrayal would be misleading.

Addressing Concerns of Those Afraid of Russian Gas

Putin deciding to shut off the gas to the EU because of the conflict in Ukraine is an unlikely scenario. The idea is that this drastic measure would be taken against the EU because of its support of Ukraine’s central leadership – much as the Arab countries in the Middle East did with oil against Western supporters of Israel during the Yom Kippur war in 1973. Indeed, Gazprom stopped selling to Ukraine in June of 2014, but has used the quite compelling argument that Ukraine hadn’t paid its $5 billion debt for gas already consumed. If Gazprom were to cut the gas to all of its EU customers over the Ukraine conflict, then the EU would surely suffer – but cope – by having to turn to limited stored gas and imports from other sources such as LNG, and by reverting to coal for power generation. In the longer term, a gas war would accelerate its efforts to diversify away from Russian gas, thus depriving the Russian state of future revenues upon which its solvency depends. Moreover, if such a drastic measure were taken by the Russian side, the West would likely counter with an embargo of Russian oil that would devastate the Russian economy even more than the loss of gas revenues would. Putin, as the primary decision-maker of the Russian state, would not take such a gamble. And the implementation of South Stream would not change the variables enough to make such a gamble more reasonable from the Russian side.

The increasingly competitive [European gas] market will force Gazprom to continue to make pricing concessions.

The most obvious example of gas prices being used to achieve political ends is in Ukraine, where Russia’s gas discounts persuaded former president Yanukovych to opt out of the EU Association Agreement in late 2013, a decision which sparked protests that led to the former Ukrainian president’s ousting. This pricing adjustment was the latest in a long history dating back to the breakup of the Soviet Union of price reductions for Ukrainian political concessions. So, countries dependent on Russian gas do have some reason to be wary.

South Stream route: Turkey’s EEZ, Bulgaria, Serbia, Hungary, Austria, and possible offshoots. South-stream.info 2014.

Western fears that South Stream would facilitate the Kremlin’s tactic of using gas prices to squeeze political concessions out of European countries are slightly more justified than the fear of the full use of the “gas weapon”, but are still overblown. This is not because the Russian state is above such a policy – it has used it (quite unsuccessfully with Ukraine) – but because it overstates the position of Gazprom on European gas markets. The faulty premise is that Gazprom holds a monopoly in Europe and that South Stream will reinforce it. And, the reasoning goes, the absence of competition allows Gazprom to set the price so high that the European gas importers, generally state-owned companies, are obliged to seek a price cut, which Gazprom, under Putin’s direction, will only grant in exchange for political concessions. But the problem with this is that there is a coming gas glut in Europe that will prevent Gazprom from acting in this way. The increasingly competitive market will force Gazprom to continue to make pricing concessions, as it has done in some cases already.

Especially since the $40 billion South Stream is so expensive, Gazprom will need to remain competitive in the gas markets the pipeline will feed in order to recoup its investment. Building a pipeline, as opposed to expanding LNG export capacity, carries its own particular risk in that the seller is confined to marketing its gas along that pipeline infrastructure, and this requires maintaining market share.

It is helpful to refer to Gazprom’s recent behavior to find clues of what may happen in the future. All across Europe, including Ukraine, Russian gas prices were rising in 2011, despite weak demand. This increase in the Russian price was not a tactic meant to squeeze political concessions out of European countries, but the result of Gazprom’s contracts being tied to the price of oil, which from 2011 until recently remained over $100 a barrel. Because of the disparity between Gazprom’s prices and European spot prices, Gazprom was compelled to provide billions of dollars in rebates and discounts to some of its largest customers in Poland’s PGNiG and RWE in the Czech Republic. This was not the behavior of a company that is trying to use gas prices for political concessions, but rather that of a company striving to retain its share of an increasingly competitive, but still lucrative, market. It is important to keep in mind too that Gazprom acting in its commercial interests serves Putin’s political goals as well – the Russian state needs the money. This case of Gazprom’s discounts was a signal of its diminishing dominance on the European market, and what is more, it established an important precedent that Gazprom will be loath to copy, but will be required to as gas competition tightens further.

Gazprom needs to retain market share because it is a company on which the Kremlin, which is arguably even more dependent on Gazprom’s customers than the other way around, is increasingly reliant. And especially since the $40 billion South Stream is so expensive, Gazprom will need to remain competitive in the gas markets the pipeline will feed in order to recoup its investment. Building a pipeline, as opposed to expanding LNG export capacity, carries its own particular risk in that the seller is confined to marketing its gas along that pipeline infrastructure, and this requires maintaining market share. If the prices were to remain unreasonably high for gas, then many of these countries would continue to switch to the use of coal, instead of gas, in electricity production, or raise imports from other sources. Gazprom, from a commercial point of view, will want to maintain market share because the massive investment in South Stream needs recouping. What this means is Gazprom will need to adopt a more flexible pricing policy toward its customers in the short-term if it wants to remain competitive long-term, when it is literally banking on higher gas demand, and European gas revenues. In this way, one could reasonably argue that South Stream represents a greater risk for Russia than for the EU.

Southeastern Europe’s Gas Infrastructure and Prospects for Diversification

I have been referring to a future European gas glut, which is correct in that there will be more gas in Europe, but it will not be uniformly distributed. Unlike the oil market, the gas market is not mature, at least in Europe. The EU’s Third Energy Package is a piece of legislation that is meant to speed up this process, a process which others – such as Gazprom – argue should happen naturally, almost ironically, by market forces. While oil is priced based on two benchmarks that follow each other closely, gas prices are currently based on various kinds of benchmarks and models. What this also means is that prices vary significantly from region to region, which also reflects the multiplicity of stages of gas infrastructure development. In Bulgaria, Serbia, Hungary, and Austria, an understanding of the current state of these gas markets is necessary, in particular the gas projects that will allow for more consumption of nonRussian gas, to understand the extent to which South Stream will make them vulnerable to Russian influence.

Like Bulgaria, Serbia consumes around 3bcm and takes almost all of its gas from Russia (80%), but will benefit from a planned 5bcm per year Croatian LNG import terminal, which Angela Merkel announced could be co-financed by the Commission, due to be operational in 2019, given the interconnector between the two countries is built as planned.

The first major relevant gas infrastructure project in the region is the TAP pipeline, which will take gas from Azerbaijan through southeastern Europe to Italy. Bulgaria, which currently takes 90% of its 3bcm annual gas demand from a Russian pipe that transits Ukraine, is contracted to receive 1bcm per year from the TAP pipeline via a planned interconnector with Greece. Moreover, Greece is poised to become a gas hub, with already one operational LNG import facility, Revythousa LNG (planned to have 7bcm capacity by 2016), and another planned for the Greek city of Kavala. As long as the interconnector between Greece and Bulgaria is built, this additional capacity would put downward pressure on Russian gas prices in Bulgaria.

The main reason the EU Commission has stopped negotiating approval of the pipeline is not necessarily because of the Ukrainian crisis, as it has stated, but because some of these infrastructure projects are still hypotheticals.

Like Bulgaria, Serbia consumes around 3bcm and takes almost all of its gas from Russia (80%), but will benefit from a planned 5bcm per year Croatian LNG import terminal, which Angela Merkel announced could be co-financed by the Commission, due to be operational in 2019, given the interconnector between the two countries is built as planned.

Hungary is similarly dependent on Russian gas (60%), but has a much higher gas demand, roughly 10bcm per year, and has significant gas storage capacity. The country already has interconnectors with Romania and Austria, and has one with Croatia, whose planned LNG could potentially flow to Hungary, just as it could to Serbia. Important too, is a link with Hungary’s northern neighbor Slovakia, which would conceivably allow Hungary to receive gas from Poland’s LNG terminal, which will be completed next year. Austria, where South Stream will terminate, is already a major gas hub, and thus multiple gas supply options. With an interconnector with Italy, Austria could make use of its southern neighbor’s LNG import terminals.

The main reason the EU Commission has stopped negotiating approval of the pipeline is not necessarily because of the Ukrainian crisis, as it has stated, but because some of these infrastructure projects are still hypotheticals. The Commission has offered to co-finance the LNG project in Croatia, understanding it as strategically important vis-à-vis Russian dependence. The EU faces the problem of incentivizing investment in these interconnectors that will link non-Russian gas to the markets that need it. These interconnectors are not cheap and the economic return may not be justified, so private investors are understandably hesitant. However, the Commission itself, it seems, will contribute funds to these interconnectors. A note from the Commission in July 2014 declared that 38 billion euro would be available for “low-carbon economy investments under the European Structural and Investment Funds from 2014-2020.” Given the strategic importance placed on diversifying away from Russian gas, a sizable portion of available funds from the Commission will likely be used to subsidize interconnectors.

What should the EU do? First, it should somehow secure a guarantee that some of these key gas projects in southeastern Europe will go forward.

Another question is where will the LNG come from? The market is relatively tight right now, as usual producers Qatar, Norway (mostly piped gas), and Algeria are producing at capacity, but in five or so years, there will be more suppliers, with likely exports from the US, Canada, Australia, Mozambique, Iran, and the eastern Mediterranean region. And there is also the possibility of some European shale gas reaching markets in a few years.

Conclusion: EU Commission Should Be More Willing to Use South Stream as Bargaining Chip

Finally, South Stream should not be considered a major security risk for the EU. Though its implementation would be seen as a major “coup” for the Russian state, such a perception would not reflect the reality. Truly, South Stream’s implementation would perpetuate Gazprom’s delusory image of itself as a mighty gas monopoly able to set gas prices at will, but why should the EU (and the US) be concerned with Gazprom’s inflated self-confidence when an increasingly competitive European gas market, which will be achieved by the political resolve of the Commission, paints a more realistic picture? If Gazprom wants to make a dubious $40 billion investment (which will benefit EU member states and the primarily Russian firms contracted for construction), why should the EU be particularly worried in light of these gas infrastructure developments? What is more, South Stream will have the positive effect of eliminating the risk that Ukraine poses, a result that is in everyone’s interest except Ukraine’s. If the Commission delays too long and the Ukrainian risk, which South Stream is meant to eliminate, becomes a reality and alternate non-Russian sources of gas are not in place, then those most afflicted – Bulgaria, Serbia, and Hungary – would have more reason to blame the Commission than Gazprom.

So what should the EU do? First, it should somehow secure a guarantee that some of these key gas projects in southeastern Europe will go forward. Once this happens, since South Stream will only slightly increase Russian political influence in Europe, and since it is Gazprom taking on the bulk of the financial risk, the Commission should gradually (and very quietly) make some concessions on the issue of South Stream’s legality; such an agreement could have the effect of making Putin more willing to compromise in Ukraine. Perhaps a deal could be struck such that the Commission approves a version of South Stream that may not be 100% compliant with the Third Energy Package, but closer, in exchange for something that it wants the Russian state to do (or not do) in Ukraine.

Perhaps a deal could be struck such that the Commission approves a version of South Stream that may not be 100% compliant with the Third Energy Package, but closer, in exchange for something that it wants the Russian state to do (or not do) in Ukraine.

Putin has been supporting South Stream since the idea’s inception in 2006, and has been the pipeline’s most powerful cheerleader. As the project lagged, Putin constantly called for work to be hastened, thus the “ahead of schedule” 2012 construction launch. The reason he did this was not necessarily because he wanted South Stream built, but because he wanted to put pressure on Ukraine to give up its pipeline system to Russia. The trick was to make South Stream seem like it would be built. Continuing to transit Russian gas through Ukraine to the countries that South Stream would supply was (and still is) by far the more economical decision, and was thus favorable to the Russian state. As South Stream appeared closer to realization, the pressure on Ukraine (which would be deprived of sizeable transit revenue in the billions of dollars per year) would rise for the former Soviet state to relinquish its major moneymaker and powerful political bargaining chip. Though South Stream was successful in causing its rival Nabucco to flounder, it has been highly unsuccessful in achieving its goals vis-à-vis Ukraine, which still controls the massive gas transit system. Now, as the state of the Russian economy grows more precarious and Gazprom’s financial resources become increasingly focused on the Power of Siberia and potentially another gas pipeline to China (the so-called “western route”), Putin’s national champion is left with an arguably superfluous $40 billion pipeline project. So what should the new EU commissioner Jean-Claude Juncker do? He should understand this dynamic, and gradually and quietly allow South Stream to go forward, with the knowledge that it is a greater risk for Russia, in exchange for a concession from the Russian state. Ironically, one could say that giving South Stream the green light could have the same effect as the sanctions have had – weakening the Russian economy.

Nicholas Watt is the editor-in-chief of the ENERPO Journal and a graduate of the ENERPO program at European University at St. Petersburg.

Sources

European Energy Programme for Recovery map ob-tained from European Commission official website. http://ec.europa.eu/energy/eepr/projects/#!/gas-interconnections-and-reverse-flow/

Johnson, Keith. “The Looming Gas Glut.” Foreign Poli-cy. Oct. 21, 2014. [Accessed October 2014]http://www.foreignpolicy.com/articles/2014/10/21/the_looming_gas_glut_LNG_australia_canada_china_japan

Milekic, Sven. “ÉU to Back Croatian Gas Project in Krk.” Balkan Insight. Jul. 23, 2014. [Accessed October 2014] http://www.balkaninsight.com/en/article/eu-to-back-croatian-gas-project-on-krk

“Oettinger: EU help in resolving South Stream’s legal problems is conditional.” Euractiv.com. Jun. 2, 2014. [Accessed October 2014] http://www.euractiv.com/sections/energy/oettinger-eu-help-resolving-south-streams-legal-problems-conditional-302527

Pirani, Simon, Chris Weafer, Tatiana Mitrova, et al. “Forum”. Oxford Institute for Energy Studies. Issue 97. August 2014. [Accessed October 2014]. http://www.oxfordenergy.org/wpcms/wp-content/uploads/2014/09/OEF-97.pdf

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