Russian gas keeps Europe warm…for now

The European Commission and the EU member states have been seriously misled by the January 2006 Ukrainian gas cut-offs. The real problem with Russian gas is not the threat of politically motivated cut-offs but the prospect of a significant gas deficit opening up. Former Russian Energy Minister Vladimir Milov estimates that the deficit could be at least 126 billion cubic metres (bcm) by 2010. To put that in context in 2004 non-former Soviet Europe received 150bcm.

At first sight it seems inexplicable that Russia the holder of the world’s largest proven gas reserves of 47 trillion cubic metres (tcm) could possibly run short of gas. However, the compound impact of the depletion of existing fields, lack of investment in new fields and infrastructure, restrictions on foreign investment, a loose approach to property rights and the maintenance of a closed and increasingly vertically integrated gas market now threaten the flow of Russian gas to EU markets. The potential consequences of a significant gas shortage are likely to have a serious impact on Russia, the Central and Eastern European member states and Germany.

The immediate reason for the shortage is the running off of the three major Soviet era gas supergiant fields in the Nadym Pur Taz (NPT) region. As only one other supergiant field, Zapolyarnoye, has come on stream since the end of the Soviet era and will itself soon begin to plateau a gas crunch is becoming a serious threat.

Gazprom should have put investment into new gas fields and infrastructure to ensure continued gas supply. But while Gazprom has been investing, as the International Energy Agency (IEA) recently pointed out, its investment has been in export infrastructure such as the North European Pipeline (NEP) and foreign acquisitions, not domestic investment to ensure continued gas supply. Worse still, restrictions on foreign shareholdings in the energy sector, combined with an unwillingness to protect property rights undermine the willingness of foreign holders of capital to advance the enormous sums required to develop the new supergiant fields. For example, the lifetime cost of developing Yamal, a significant proportion of which is upfront, amounts to $70 billion (€56bn). This unwillingness has been reinforced recently by the threat to the Sakhalin Production Sharing Agreement (PSA) between the Russian government and Shell. When the PSA was signed in the early 1990s the energy price was low and the PSA was a good deal for Russia.

Now energy prices are high and Russia wants significantly to alter, if not tear up, the deal. While investors still may be willing to loan low-billion amounts in consortia such behaviour from the Kremlin both increases the cost of capital and shrinks the available capital resources.

The threat to gas supplies is enhanced by the Soviet approach to the running of the gas market.

Gazprom controls all the pipelines. Third party access can only be achieved with difficulty and only for low-priced domestic supplies. The incentive for Russian independent gas producers to develop their fields is limited by Gazprom’s total control of exports. Increasingly vertically integrated with no serious competition, Gazprom does not face the market challenges to improve performance the way most energy majors do.

At first sight there are two possible ways out of the threat to gas supplies. The first is for the Russian gas independents to be given greater access to Gazprom’s pipelines, which would incentivise the independents to increase production as they get access to European markets. But the willingness of Gazprom to provide significant third party access to its pipelines is open to question. Second, the recent announcement that the Shtokman field is to be used as a resource for the NEP could potentially provide a means to close the deficit. Unfortunately, Shtokman is unlikely to come on stream before 2016. There are also questions as to where Gazprom is going to obtain the technology and capital to deliver this capital intensive and cutting edge technology project.

The consequences of a significant gas deficit pose serious threats to the Russian economy. Gas is both a source of foreign exchange and tax revenue. A significant gas shortage would threaten economic stability and the social gains made since the 1998 crash. Most central and eastern European member states are heavily dependent on Russian gas and would face both economic and social disruption if gas supplies were reduced.

But it is Germany, increasingly dependent on Russian gas, which is in the most vulnerable position. It is highly unlikely that the NEP will be in operation in time to provide Germany with an alternative source of supply. Plus, as the most heavily dependent westerly EU member state, it is in a uniquely vulnerable position against any shortage. Whatever the contractual relationships, the likelihood is that if the gas supply to foreign customers is reduced Germany will be hit first and hardest.

It would be possible to minimise the gas deficit if action is taken rapidly. Structurally measures are required to liberalise EU and Russian markets and enforce the Energy Charter Treaty to encourage inward investment. In the short term energy efficiency and refurbishment investment is required. In the medium to longer term very significant capital injections are required to bring on new gas supplies.

• Alan Riley is reader in private law at City Law School, City University, and associate research fellow, Centre for European Policy Studies (CEPS), Brussels. His new paper The Coming of the Russian Gas Deficit: Consequences and Solutions will be published this week by CEPS.

The European Commission and the EU member states have been seriously misled by the January 2006 Ukrainian gas cut-offs. The real problem with Russian gas is not the threat of politically motivated cut-offs but the prospect of a significant gas deficit opening up. Former Russian Energy Minister Vladimir Milov estimates that the deficit could be at least 126 billion cubic metres (bcm) by 2010. To put that in context in 2004 non-former Soviet Europe received 150bcm.