5/2/15: Gazprom's Nord and South Streams: Lessons Learned, Strategy Changed

An interesting paper from Oxford Institute for Energy Studies, titled "Does the cancellation of South Stream signal a fundamental reorientation of Russian gas export policy?" (January 2015: http://www.oxfordenergy.org/wpcms/wp-content/uploads/2015/01/Does-cancellation-of-South-Stream-signal-a-fundamental-reorientation-of-Russian-gas-export-policy-GPC-5.pdf).

It is a very insightful and interesting paper worth a read. Here are some extensive quotes, occasionally with my own comment.


In 2006, Gazprom and the Italian company ENI, subsequently joined by the French EdF and German Wintershall, announced South Stream project – two gas "pipelines, each 930 km in length to be laid from Anapa on the Russian Black Sea coast to Varna in Bulgaria in water depths of up to 2,250 metres." Note the timeline: 2006. Following January 2009 Russia-Ukraine gas dispute/crisis, the project was doubled from 2 lines to 4 lines and capacity of 63 Bcm/year. First line was scheduled to come into production in Q4 2015, second line by the end of 2017 and all four lines by 2020. Note: doubling of the pipeline, in theory, allowed for a partial offset for gas flows currently transiting Ukraine. Permitting for growth in the Turkish market (supplied via link via Bulgaria) and for expected growth in demand for Russian gas across Europe, South Stream at full capacity could have reduced Russian gas transit via Ukraine by around 40-50%.

Per paper, "From 2008-10, Russia signed intergovernmental agreements with seven European countries… The total cost of South Stream …was estimated at around $40 billion in mid-2014, comprising: $17 billion for the Russian Southern corridor; $14 billion for the offshore section and $9.5 billion for the onshore European sections." In other words, Russia agreed modalities and permissions for construction with all EU member states involved. Some estimates put the cost at EUR50 billion (see here: http://www.eegas.com/S-Stream_cost_en.htm) once feed-in pipelines were to be included, of which EUR 40 billion was supposed to be Gazprom own share, large portion of which would have been unrecoverable (sunk) cost if South Stream were to proceed to on-shore landing at Varna.

In the end, Gazprom held 50% of South Stream shares (excluding feed-in pipes), Eni owned 20%, and Wintershall Holding and EDF had each 15% shares. These only broadly corresponded to the final cost breakdown as well, with the Russian side was required to supply in excess of USD20 billion worth of own funding to the project, raised predominantly via debt to be assumed by Gazprom. No participant to the project required any access to the pipeline for any other party or for project shareholders, other than Gazprom. The pipeline was conceived, planned and funded absent any other suppliers than Gazprom and no participant in the project objected to this.

So what happened from the date of enthusiastic European engagement with Gazprom till the day of its cancelation of the entire project in early December 2014?

Well, a lot. The key change was regulatory volatility induced by the EU. The Oxford paper is straight on that: "The regulatory environment worsened dramatically for Gazprom, following the introduction in 2011 of the EU’s Third Energy Package (TEP).The TEP mandated regulated third party access (TPA) to pipeline capacity …unless an exemption from these rules is granted by an [National Regulatory Authority] NRA and approved by the European Commission (EC). Thus the TEP created major problems for Russian gas exports to EU countries in terms of compliance with the changing regulatory environment both in respect of existing and new pipeline capacity."

Recount that: five years after the initiation of the project, EU unilaterally demolishes the regulatory basis for the project. This, in Brussels' view, is how one does business involving decades-long capital commitments. Proceeding with South Stream, therefore, post-2011 meant that Gazprom would sink tens of billion into infrastructure to supply own gas, based on several decades of expected revenues, and EU could hold a stick of barring Gazprom access to its own infrastructure, built on its own money, at a whim.

You think I am exaggerating? Oxford paper describes another case where Gazprom fell a victim of the EU regulatory caprices: the OPAL line. In the OPAL case, as Oxford study details, EU agreements were not worth the paper they are written on, and EU National Regulators have been found to hold no power to even exercise the power legally granted to them by the EU. All of this was already in play before the Ukrainian crisis.

Similar happened in the case of the South Stream pipeline. But as an even bigger farce. EU Commission argued that national-level agreements signed by Gazprom with member states violated TEP. Here's what Oxford paper says on that: "The TEP (in)compatibility argument, which was the main reason for the South Stream cancellation, is somewhat flawed as the TEP in its current form does not contain any rules for construction and utilisation of new pipeline capacity, but only rules for existing pipeline capacity."

Yep, Russians made a major mistake. "Given this regulatory void in respect of new capacity, which would not be filled until the second half of the 2010s, Gazprom and the Russian government should have recognised and acknowledged much earlier in the process that South Stream could not proceed on its original timetable." In other words, Moscow should have canned South Stream back in 2011-2012 and opted for the Turkey Stream instead (but see more on this latter bit below).

Only after all this TEP brandishing as a lethal sabre in front of Gazprom does the Ukrainian crisis enter the frame: "…following the Ukraine crisis and Crimean annexation, relations between the EU and Russia on all gas issues were “frozen”, creating great difficulty in even scheduling meetings between the two sides. …The inability of the parties to even negotiate, let alone reach a compromise, on regulatory issues ultimately led to the South Stream cancellation."

Was Ukrainian crisis a convenient excuse for the EU to bully Gazprom? Was, at the same time, arbitrariness of the EU regulatory process applied to Gazprom as the means for assuring that Russian gas deliveries to Europe remain subject to control by Ukraine? Is Gazprom transit being treated by the EU as a direct subsidy to Ukraine? I don't know nor do I want to speculate - the powder keg of Ukrainian conflict geopolitics makes any rational discussion impossible, given the proliferation of policy trolls and the vitriolic pseudo-intellectual debate being promoted by all sides to the conflict. But are these questions legitimate, given the timing and nature of events pre-dating Ukrainian conflict? Should they be asked?

There are many examples of absurdity of the EU position, were one to be tempted to explain it from the rational / logical point of view:

• One: EU aims to secure Russian gas deliveries without interruptions. Would this objective not be best served by cutting out middle men from the transaction and allowing delivery via more pipelines than less? In finance, South Stream completion would have been equivalent to portfolio diversification. 
• Two: What happens when the majority shareholder in Gazprom and the CEO of Gazprom simultaneously announce a strategy change? "On December 1, 2014, …president Putin and Gazprom CEO Alexey Miller announced that South Stream had been cancelled due to the combined failure of the Bulgarian government to provide assurances that the pipelines could be laid; and the European Commission to provide assurances that gas would be allowed to flow through them." What does the EU Commission do in response? It "notes" the “currently unofficial nature of this announcement”. Unofficial announcement? By the President of the country that owns Gazprom and Russian gas? By the CEO of the company itself? How more official can it get? Clarify what? Do the EU Commission boffins know the word "No"?

Meanwhile, Russia was left nursing serious losses and had to redeploy allocated funding to a different route.

Again, from Oxford paper: "While one strand of opinion was that the real reason for the cancellation was a recognition from the Russian side that, due to economic problems stemming from sanctions and a falling oil price, the project could no longer be afforded, this seems unlikely… By the time the project was cancelled, Gazprom had already spent $4.7 billion on the offshore and European sections, most of which would have been for the offshore pipe and the charter of the barge; and a similar amount on pipe and compressors for the Russian Southern Corridor. This represented approximately 40% of the $20 billion of capital investment required for the first two lines (approximately 30 Bcm/year of capacity). … once the pipe was on the seabed, then the Russian side would be completely dependent on Bulgarian and EU decisions to monetise its considerable investment. Hence ...the timing of the decision was crucial." In other words, the costs were about to become 'sunken' or, rather, full hostage to the EU meddling with the project, and by extension, to the Ukrainian geopolitics of the EU.

Turkey Stream announcement allows Gazprom to recover much of the capital already allocated. And, according to the Oxford paper, Turkey Stream replacement for South Stream makes business sense. For all parties concerned, not just Gazprom. "The cancellation of South Stream and adoption of new pipelines arriving in a non-EU member state remove a major problem in EU-Russia gas relations..."

However, the sticky point is, you guessed it - Ukraine. "…as a result of the events of 2014, the EU political agenda expanded to include maintaining a gas transit role for Ukraine, and this is also important for maintaining reverse flows to Ukraine…" In other words, forget the Energy Security blabber and the rest of the EU agendas. The core objective is to retain Gazprom capture by the Ukrainian transit system. Chain that bear!

Here is the take on the Russian-Ukrainian game of energy poker: "The Ukrainian government led by Arseny Yatseniuk has expressed a determination to phase out Russian gas imports (replacing them with LNG and pipeline gas from other sources), but a willingness to continue transit. On the Russian side, …Alexey Miller reiterated the claim that transit of Russian gas across Ukraine would be phased out, but a willingness to continue supplying the country. The positions of the two countries on supply and transit are fundamentally in conflict, and appear equally unrealistic."

The problem, folks, is that it is Russian gas, not Ukrainian. It's up to Russia to say who it sells it to and to agree terms on which it is sold. Not Ukraine's. Ukraine has a right, under existent contracts, to receive gas it pays for. And it has the right to negotiate its terms for receiving this gas. It also has a right to refuse buying Russian (or anyone else's) gas. But it has no right to demand Russian transit via its territory.

More crucially, however, is the overall change in Gazprom business strategy that underlies the Turkey Stream announcement and other developments in Russian-European gas markets.

Again, as Oxford paper states, "All of this is consistent with the announcement by Alexey Miller that the company is abandoning its long held strategy of direct sales to European end-users: “The principle of our strategy in relation to the European market is changing. The decision on stopping South Stream is the beginning of an end to our operation model of the market within which we oriented ourselves towards supplying [gas] to the end consumer… But you can’t win love by force. If the buyer doesn’t want the purchase to be delivered home, well then perhaps he needs to get dressed and go to the store, and if it happens in winter, get dressed warmer. Well he could also take some package… which can well be the Third Energy Package, but what counts most is that it should not be empty. In our case the store is certainly the delivery point on the Turkish-Greek border.”"

In other words, if a grocery store is not allowed to deliver directly to consumers' homes, consumers will have to go to the grocery store, where it is located.

Per Oxford analysis: "This firmly closes the door on any possibility of a `strategic partnership’ between Russia and Europe on gas, and places the trade at the level of a `commercial partnership’ i.e. if Russia has gas to sell and Europe wants to buy then trade will take place, but there will be no deeper economic or political commitment to facilitate trade." Question is, is Europe Europe ready to engage in commerce instead of political 'partnership' games that are designed to assure a 'revenue cut' for the Ukraine? Time will tell…

Is "an ironic result of the 2014 crisis - a much more logical commercial strategy for Russian gas exports?" ask the Oxford analysts. And their answer (and I agree with it) is 'Yes'. "US and EU sanctions, limiting the availability of finance for Russian energy companies and threatening the possibility of an embargo on LNG technology, have accelerated both a move into the Asian market by Russian companies and a shift away from Russian LNG to pipeline gas projects. ...Abandoning South Stream, which looked very complicated from a regulatory point of view, in favour of direct undersea pipelines to Turkey, prioritises Gazprom’s second biggest market, and its only European market with major expansion possibilities over the next decade. Refocussing on pipeline gas – where Gazprom has decades of experience, compared with LNG where it has very little - looks like an entirely sensible strategic move."

Do note the LNG threat. If Russia was allowed to develop LNG capabilities, it could have serviced some of the European markets (e.g. Italy) via LNG supplies. By threatening this capacity, the US and EU are de facto forcing Russia to push gas via pipelines. Coupled with the EU opposition to South Stream, it means that the US and EU were forcing Russia straight into the monopoly hands of Ukraine as transit route. Does this make any sense? No. Instead of diversifying supply routes, it retains them at the point of highly volatile geopolitics and domestic Ukrainian politics. Why, someone should ask, would EU want this outcome?

"…an irony of the post-Ukrainian crisis period may be that a combination of western sanctions, EU regulation and the breakdown in EU-Russia relations, may have pushed Russia and Gazprom into a much more logical commercial strategy for gas exports." And delivered to China long term strategic partnership-based access to gas and oil from Russia.  Congratulations, Brussels.