Can Russia Play Its Trump Card Gas To Beat EU Sanctions?

Mar 5 2014, 9:19am CST | by

Vladimir Putin’s aggressive moves in Ukraine raise concerns about whether he will use natural gas as a weapon against the European Union should it decide to intervene. Putin has used Gazprom for this purpose in the past, but oil and gas exports are also Russia’s key sources of foreign currency. I recently met a Yale student who wrote his thesis on the economic and geopolitical calculations behind the European gas trade, and invited him to write about the current situation in Ukraine. Andrey Semenov is a specialist in international trade and energy, concentrating on Europe and Russia. He is deeply familiar with the political and economic dynamics of the region, having focused on it during his master’s degree studies at Yale. While at Yale he researched the EU-Russia gas trade, language policies in Ukraine and the Balkans, shortcomings of the European Monetary Union, and NAFTA implications for Mexico, among other things. He has prior experience with trade organizations and undergraduate training in finance.

By Andrey Semenov

As Russian saber-rattling continues in Ukraine, markets in the region catch fever over the uncertainty of the highly explosive geopolitical situation. Putin seems to be ready to bear the brunt of economic consequences of his reckless gamble in Crimea. While the Russian ruble tests record lows against dollar and euro, world markets react predictably to political uncertainty, with oil and gas prices rising on supply risk. Some 30% of European Union gas comes from Russia, and half of it flows through Ukraine. Unfortunately, creating a truly free market for the European gas trade has still a very long way to come, and despite some setbacks for Gazprom, Europeans have not been decisively successful in diversifying their supply.

Conversations about trade sanctions against Russia, should the conflict in Ukraine escalate, bring the EU energy supply situation under fire. European and Ukrainian officials report that they have gas in storage to cover European demand for 1-3 months should Russia shut off gas to apply geopolitical pressure. Despite this proclaimed capacity to sustain themselves with ample gas storage, is it really a viable solution for Europeans to put the continent’s energy security at stake? There has been a lot of buzz about the advent of spot trading on hubs and the increase in LNG capacity as two factors that are bound to deliver a mortal blow to Russia’s dominance on the European gas market. Is it truly so?

Five years ago Russia enjoyed what seemed an unshakeable dominance on the European gas market, until its position shattered in 2011 with Qatari LNG flooding European markets. In Europe LNG was traded on hubs at market, or “spot,” prices. This free-market model, where many small suppliers can bid directly in a volatile environment, is a sharp contrast to the long-term contract (LTC) model employed by Gazprom. Hubs with their free-market spirit quickly got the attention of European politicians who were eager to break the dominance of Gazprom which, in its turn, was breaking the backs of consumers with unreasonably high prices and draconian clauses included in the LTCs. Gazprom lost 10% of market share in 2012 due to its inflexible pricing mechanisms.

As much as LNG and spot trading were promoted to the public, policymakers’ enthusiasm was premature. LNG supply to Europe dipped sharply after peaking in 2011. Asian markets offered much more attractive prices to the suppliers of $17.2/MMBtu (Japan) and $16.6 /MMBtu (Korea), compared to $9.8/MMBtu for the EU average. As a result of this price discrepancy, given the flexibility of LNG supply allowing tankers to be easily redirected globally, exporters shifted their focus to the Asian markets.

Hubs, where LNG is traded, were growing rapidly over the past years and were thought of as a backbone of the new European gas trade architecture. Even though hubs likely do present the best route to creating a competitive trading platform for natural gas — similar to the one for oil — currently they are plagued by fundamental problems such as low liquidity and the inadequacy of forward pricing. Liquidity is measured by the “churn ratio,” or the ratio of traded volume to physical throughput. So far, of all European hubs only UK’s National Balancing Point (NBP) has achieved the ratio of around 15%, which experts consider the lowest acceptable level. Continental European hubs, especially in Central and Eastern Europe, which is the most dependent on gas delivered from Russia, face liquidity problems and inadequate interconnectors between countries.

Second, it must be noted that while market for oil is competitive and long-term-contracts (LTCs) with draconian clauses are not an issue for customers (unlike Gazprom’s LTCs), oil trade is futures-based. Only a futures-based market that resembles the market for oil can provide pan-European benchmarks for gas. Spot prices, which are prevalent at the hubs, are insufficient for that purpose, and the EU futures trade in gas has a long way to go.

If Europe imposes sanctions in the name of forcing Russia to retreat from Ukraine, what alternative suppliers could pitch in? Norway is a big player and it eroded the Russian position substantially in 2012. In 2013, however, the situation reversed, and Norwegian exports fell by 5% while Russian supplies to Europe rose 16%. Even if LNG from the U.S. is to reach the EU in sizable quantities, it will still never be able to substitute for the Russian supply; besides European hub architecture is not mature enough to effectively satisfy demand, especially in Central and Eastern Europe.

Considering all of the above, sanctions against Russia can have a dire effect on European energy security, exposing European economies to substantial supply risk. Other economic consequences of trade sanctions of course include loss of the Russian market, which is the fifth largest in the world. For the U.S. it may be a significant consideration, but not a critical one, as Russia is not even in the Top 15 of their trading partners, while for the EU Russia ranks third according to total turnover of goods. It will be extremely difficult for European companies to re-establish themselves later in Russia, as the market already will be lost to competitors. From a pure energy perspective, notwithstanding other economic risks, it is abundantly clear that trade sanctions against Russia would represent a gamble on the part of European policymakers, bringing Europe’s energy security at risk.

There is an alternative, should EU policymakers and Gazprom go along. The optimal trading model would be a mix of hub-traded gas and long-term contracts (LTCs). Europe will not be able to completely abandon Gazprom’s LTCs, even in the long run, as this can seriously harm suppliers. LTC duration, however, should shorten and stabilize at the length of time necessary for the suppliers to hedge for new investments and develop new fields. It will not go beyond that, as market forces will push it down.

Ideally, the mixed hub/LTC model should benefit both suppliers and buyers. The latter will receive a more flexible market with easier entry; more supply options, and more participants, albeit at the cost of greater volatility and higher overall uncertainly of supply, through the system of hubs. At the same time, the baseline needs will be guaranteed with LTCs, bolstering European security of supply. Gazprom, if it chooses to adapt, will still enjoy a large share of the market due to its significant reserves and extensive pipeline infrastructure in place. Increased competition in Europe would foster more effective corporate governance, more focused on the financial bottom line than on geopolitical considerations. Even though this seems like a long shot today, with turmoil in Ukraine, both partners must look at the long-term perspective, where economic interests not only of Europe but also Russia might as well be best served by de-politisation of Gazprom.

Source: Forbes Business


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