From illusions to lasting values

February 21, 2011

Defining mutual priorities in strategic development of the Russian and European gas industry, assessing the Third Energy Package impact, searching for new approaches to blue fuel pricing. According to Alexey Miller, these are among the relevant issues to be discussed during the EU-Russia summit. The gas market players and experts addressed these issues beforehand during the Topical European Energy Issues round table discussion held at the Gazprom headquarters on February 21, 2011.

Topical European Energy Issues round table discussion
Topical European Energy Issues round table discussion

Topical European Energy Issues round table discussion

Gas is not potatoes

Long-term contracts ensured sustainable gas supplies to Europe over the decades. Due to the crisis, however, natural gas prices in the European market abruptly went down triggering an animated discussion in the European Union about potential changes in the time-proven pricing principle.

Is it possible to abandon the long-term contracts and create a natural gas spot market similar to the oil one?

Long-term contracts historically proved their efficiency but, according to Christoph Weber, professor of the Duisburg University (Germany), spot contracts allow for faster response to volatile market conditions.

However, as Konstantin Simonov, Director General of the National Energy Security Fund noted, many people equate the spot market with a cheap gas market. “However, one should understand that spot pricing is just another pricing principle that is not to say that gas will be cheaper in this case,” the expert stressed. He reminded that in February some European spot trading platforms had recorded higher gas prices versus long-term contract prices. Meanwhile, gas was merely a few dollars cheaper in Baumgarten at the moment if compared to gas delivered under long-term contracts.

Anatoly Dmitrievsky, Director of the Oil and Gas Research Institute under the Russian Academy of Sciences looked back at how the EU attitude towards long-term contracts had been changing over time. Thus, the European Parliament and the Council of Europe adopted the First Gas Directive in 1998 proclaiming refusal of long-term contracts. However, 5 years later Europe got back to an understanding that the gas market was inoperative without the prior system and in 2003 the Second Gas Directive declared the long-term contracts validity once again. And the 2004 Directive confirmed this principle. So, what is the reason for such a turnaround? According to Anatoly Dmitrievsky, the authors of the First Gas Directive considered gas as a regular commodity – cucumbers, tomatoes or potatoes. “But gas is not potatoes, as gas transmission requires trunklines to be constructed,” pointed out Anatoly Dmitrievsky. “One can’t build gas pipelines just in case, waiting for a consumer in the spot market,” the expert added.

Alexey Miller, Chairman of the Gazprom Management Committee believes that spot market volatility is highly insecure for a consumer as predictability and reliability of deliveries are most important to him.

According to Alexey Miller, the share of gas traded at spot prices in Europe will not exceed 15 per cent in future. As he noted, “Unlike oil, gas is not a classic exchange commodity. Gas has no prospects for becoming a classic exchange commodity due to its physical properties and supply terms”. Gazprom CEO reminded that in winter, when the spot gas prices exceeded those under the Company’s long-term contracts, the representatives from Gazprom during negotiations with one of its European consumers suggested signing the terms of transfer to spot prices. But the consumer refused. “Everybody brings up the issue when the spot price is well below the long-term contract price. Once the spot price approaches or exceeds it, the issue is held back right away”, Alexey Miller said.

From left to right: Nikolai Nikitin, Alexander Medvedev, Alexey Miller, Evgeny Kopatko
From left to right: Nikolai Nikitin, Alexander Medvedev, Alexey Miller, Evgeny Kopatko

From left to right: Nikolai Nikitin, Alexander Medvedev, Alexey Miller, Evgeny Kopatko

Outdated regulations

In addition to accepting the priority of long-term contracts, the 2003 EU Gas Directive approved gas companies’ exemption from the principle of third-party access to the gas pipeline system. Anatoly Dmitrievsky pointed out that the decision was caused by the fact that gas mains construction was suspended for several years after the first document had been adopted.

The Third Energy Package endorsed in 2009 unbundled gas pipeline management operations from the business related to gas production and supply. Thus, according to Anatoly Dmitrievsky, the document authors intended to maintain competition in the gas market. At the same time, he believes the document provisions violate a key competition principle – effective return on investment. Creation of independent companies managing gas transmission capacities brings up a question: how efficiently will they manage these facilities?

As Alexey Miller pointed out, the Third Energy Package, which is ideologically aimed at supporting the renewable energy sources, has become outdated in the current post-crisis period. “While a few years ago the EU could afford abundant subsidizing of renewables, the situation is now somewhat different with the amount of subsidies cut down,” he said.

Gazprom CEO also noticed that the Third Energy Package implementation will reduce the attractiveness of investment in gas transmission facilities.

Vladimir Feigin, Director of the Institute for Energy and Finance believes the Third Energy Package represents an extremely complex set of documents. “This is not an immediately applicable document. There is still much to do to implement this very complex reorganization system,” he supposes. Vladimir Feigin mentioned that it will take at least 4 to 5 years to endorse the solutions package according to most optimistic forecasts.

Есть ли надежда на сланцевый газ?

In recent years, shale gas has become another issue of discussion in the gas market. Based on the US track record, the EU comes to an optimistic conclusion with regard to a potential decline in the pipeline gas demand. “There are illusions hard to get rid of,” noted in this respect Sergey Komlev (Head of the Contract Structuring and Pricing Directorate of Gazprom export), and shale gas to his mind was another illusion of the kind.

He says over the recent 5 years the prime cost of shale gas has been in excess of USD 200 per thousand cubic meters, or some USD 6 per million BTUs which is up USD 2 per million BTUs versus the current gas price at the Henry Hub. At this rate shale gas producers rely on hedging mechanisms in order to survive. “However, the analysis of financial statements by shale gas producers and the situation in the forward market show that fewer companies can afford using this instrument,” he stressed. In this regard, Sergey Komlev made a conclusion that, “The shale gas bubble is likely to burst before long.” At the same time, he mentioned that Ukrainian shale gas reserves evaluated at 2 trillion cubic meters include only resources but not proven reserves. Thus, shale gas may become a sheet anchor for Ukraine helping to get rid of the so-called dependence on the Russian Federation.

Konstantin Simonov also underlined that Europe’s wish to get cheap natural gas and simultaneously initiate shale gas production is quite delusive since considerable investment in shale gas production started as early as in late 2005 when the gas price at the Henry Hub was at USD 500 per thousand cubic meters. According to the expert, one should understand that production of shale gas, akin to renewables, requires immense investment. “The question is whether or not the EU is ready to make investment when the financial environment is complex and euro is not doing so well,” he noted.

The experts note that an inconsistent vision of the supply and demand behavior in the gas market accentuates the issue. “The forecasts are not just updated – they are replaced like in Wikipedia,” Konstantin Simonov said.

Vladimir Feigin explains that energy business representatives and independent consultants feel realistic or optimistic about the increasing role of gas in the European energy mix. At the same time, the official EU bodies forecast a future drop in the EU gas consumption along with rapidly growing efficiency of renewables utilization. In the meantime, the IEA is planning to publish from May to June a special review on the golden age of gas.

Konstantin Simonov believes that in the context of swiftly changing gas market development scenarios, the Europeans that currently stand for new pricing principles in a few years may realize that they have been too hasty.

Dmitry Vydrin, an independent Ukrainian political analyst compared the expert forecast of gas consumption with the one in the alcohol market. He mentioned that every year European experts forecast a drop in alcohol consumption. But whisky producers steadily build up their production. “We can see the same situation with gas forecasts – every year they forecast a decline in gas demand. It seems to me that alcohol and gas consumption forecasts are compiled by the same guys,” he joked.

Looking for a happiness formula

Building relationship between Russia and Ukraine is another issue addressed by the round table discussion participants. How should Russia and Ukraine build their relationship in the new economic environment? What is the happiness formula that would be acceptable for every party of the triangle: Russia, Ukraine and the EU?

According to Catherine Locatelli (Research Fellow of the Laboratory for Economic Aspects of International Integration of the Center for Social and Economic Research under the French National Center for Scientific Research), Russia and Ukraine will remain important players ensuring sustained gas supplies to Europe regardless of various gas market development scenarios and gas demand forecasts. “Therefore, it is necessary to work out the relationship scheme that would allow ensuring flexibility, competition and security at the same time,” she believes. The expert thinks that asset swap deals could allow raising the relationship of the EU, Russia and Ukraine to a new level

As Dmitry Vydrin noted, to build mutually beneficial relations between Russia and Ukraine it is necessary to make the latter an ally of Russia. The expert believes that Ukraine, therefore, has to become Russia’s partner in the upstream sector.

According to Anatoly Podmyshalsky (Head of the FSU Relations Directorate, Gas and Liquid Hydrocarbons Marketing and Processing Department of Gazprom, Director General of Gazprom sbyt Ukraine), Russia and Ukraine are self-sufficient in energy supplies – Ukraine remains an important transit state ensuring Russian gas export to Europe and it is a large gas importer at the same time. Meanwhile, Ukraine needs large-scale investment to reconstruct its gas transmission system.

Alexey Miller, in his turn, noticed that a merger between Gazprom and NAK Naftogaz Ukrainy could be a mutually acceptable form of cooperation between Russia and Ukraine. In this case the Russian Company will ensure maximum loading of the Ukrainian gas transmission capacities, thus increasing budget revenue.

The current loading of the Ukrainian gas transmission system is at 95 billion cubic meters. In case a certain amount of funds is channeled for the system reconstruction and upgrade, the capacity could be increased to 120–125 billion cubic meters, and in case of large-scale investment in compressor stations and loopings construction, the capacity could even grow to 140 billion cubic meters, Alexey Miller stressed.

Round table discussion Topical European Energy Issues
Round table discussion Topical European Energy Issues

Round table discussion Topical European Energy Issues

Alexey Miller is convinced that implementation of projects for new gas transmission facilities construction will see no underloading problems. Indeed, gas consumption in Europe may grow to 130–140 billion cubic meters by 2020. Thus, Gazprom is objectively Ukraine’s priority partner, Alexey Miller noted. The key point is not to make potential cooperation a matter of politics, but to regard it from the point of economic and social benefits.

The experts haven’t worked out a unified happiness formula during the round table discussion. But they all hold to the key point that Russia and Ukraine need each other as well as Europe needs them both. Alexey Miller feels sure that the EU-Russia summit will give another opportunity to search for a mutually acceptable cooperation algorithm for the three countries. According to him, in the course of the event Russia and the EU could sign a gas Roadmap until 2050, the document that will symbolize movement towards each other in understanding key issues.