Big Politics Driven by Gas

Osip Shor

Width 250px 035 pau764744 02 fmt

After nearly two decades of gas export negotiations with China that have yielded little result, Russia is coming closer than ever to sealing the coveted deal. However, for this dream to come true and to capitalize on the prospects offered by the Chinese gas market, Moscow will have to take a political decision and agree to sell gas to its eastern neighbor at a below-cost price.

If your first visit to Beijing happened to take place late last year, you were most likely struck by what you saw: city streets, parks and buildings barely visible behind a thick milky fog; cars slowly crawling along, their headlights unable to penetrate the murky haze; the people in the street – pedestrians, bicyclists, waste collectors, or local residents caught in the midst of their Wushu practice – their faces covered by gauze masks and bearing a look of intense concentration.

No, you guessed wrong, the Chinese capital had not been the target of a terrorist attack or suffered a massive chemical explosion. Mother Nature simply played a mean practical joke on Beijing. In December the weather is damp and windless in more than thirty cities across the north and east, and for several weeks one third of the country’s territory ends up covered by smog. By mid-January this year air pollution in Beijing had reached the fifth (and penultimate) severity level, and the level of the tiny pollution particles known as PM2.5 came close to 1000 micrograms per cubic meter – 40 times higher than the norm. Local hospitals were unable to cope with the influx of patients with respiratory and heart problems.

“To add insult to injury, as if the smog is not enough, we have a sand storm coming. I can’t even open my eyes or my mouth,” a local resident was quoted as saying by Reuters in early February. “I am already used to seeing the smog where the sky is supposed to be, but now with the sand storm on its way I get the feeling that the situation is getting from bad to worse.”

At that time the city administration had to step in and take decisive measures to alleviate the dire environmental situation. All industrial facilities located inside the city limits were told to reduce their atmospheric emissions by a third. At the same time the official mass media were doing their best to calm a perturbed public: they said that the ‘fog’ (the word ‘smog’ was banned at the time) was not caused by human activity, but was rather a result of a natural anomaly which was quite common in other countries.

Regardless of what the official Chinese propaganda might say, the sheer scale and extent of the environmental problems faced by China have long been an open secret. Suffice it to recall that in 2008, one week prior to the official opening of the Olympic Games in Beijing, the authorities had to shut down all industrial facilities in the city to improve the air quality.

It is well accepted that China is paying this heavy cost as a result of its colossal industrial development successes in the last two decades, and of a fuel consumption heavily dominated by coal.

Not All Quiet on the Gas Front

According to the Russian Institute of Energy Strategy (IES), coal accounts for 68% of China’s total energy mix, with environmentally friendlier gas hovering at around 4.5%, compared to 25.6% in EU countries and 27.2% in the United States. This imbalance seems to persist regardless of China’s efforts throughout the last decade to quickly increase gas production levels. According to China’s National Development and Reform Commission, in 2000 the country produced as little as 27 billion cubic meters of gas, but in 2012 production levels jumped to 107.7 billion cubic meters (up 6.5% compared to the previous year). Given the country’s aggregate consumption of 147.1 billion cubic meters (+13%), China had to import 42.5 billion cubic meters of gas (including liquefied natural gas) – 31.1% more than the year before.

The lion’s share of gas was imported from Turkmenistan. Beijing and Ashkhabad signed a 30-year contract to export 30 billion cubic meters of Turkmen gas per year as early as 2006, in addition to some 10 billion cubic meters imported under contracts with Uzbekistan and Kazakhstan. China even financed the construction of a $20 billion pipeline commissioned in late 2009 to transport gas from Turkmenistan. In November 2011 China reached an agreement to increase imports through the pipeline by an additional 25 billion cubic meters per year.

It is an open secret that, all this time, Moscow has been watching with envy the fruitful cooperation between Ashkhabad and Beijing in the gas sector. After all, Russia has been trying unsuccessfully for a long time to seal the deal and penetrate the lucrative gas market in China, which according to a number of experts is expected to reach 350 billion cubic meters per year by 2035. (1, 2)

Gazprom began to ‘put out feelers’ and look into shipping gas to China through a pipeline as early as 2004, when the company signed an agreement on strategic cooperation with the China National Petroleum Corporation (CNPC). In October 2009 Gazprom signed a framework agreement spelling out the key terms and conditions of gas exports, whereby up to 68 billion cubic meters of Russian pipeline gas could be shipped to China on a yearly basis. However, the new-found partners never managed to translate any of these agreements into concrete action.

In particular, the parties could never reach an accommodation as to which route should be used to transport Russian gas – the western ‘Altai’ pipeline, or the ‘Eastern’ (‘Power of Siberia’) pipeline, from Yakutia to Vladivostok – but most importantly they could not agree on the price.

“China wants to buy Russian gas as cheap as possible – their estimated asking price ranges from $150 to $250 per one thousand cubic meters,” explains Alexei Belogoriev, Head of the Expert and Analysis Department at the IES. “Russia would prefer to sell its gas at the ‘European’ price – that is, between $350 and $400 per thousand cubic meters.”

It was only in early 2013 that the two partners finally managed to achieve some semblance of success in their gas negotiations. In late March – as soon as the smog over Beijing had dissipated – representatives of Gazprom and CNPC signed in Moscow yet another memorandum of understanding and cooperation in the gas sector.

“The recently signed document is strategic and long-term in nature. It sets out parameters for shipping Russian natural gas to China along the ‘Eastern’ route and lays the foundation for a 30-year contract to export gas from Russia to PRC,” said Alexey Miller, Gazprom CEO, commenting on the document in question.

According to the man at the helm of the Russian monopoly, the deal on the table was to potentially start shipping up to 38 billion cubic meters’ worth of Russian gas through the ‘Power of Siberia’ pipeline as early as 2018, and subsequently increase the volume to 60 billion cubic meters per year. Under this agreement all legally binding documents are to be signed in June. The partners are even planning to seal a long-term gas export deal by the end of the year. Gazprom hopes that by that time the issue of the baseline price will finally be resolved. Miller added that Gazprom’s Chinese counterparts were even willing to prepay future gas shipments and commit to co-financing the construction of a new gas pipeline estimated at $25 billion.

Gas Instead of Coal

It seemed that the celebratory coverage of the agreements reached in March left no doubt as to how this event should be regarded: the protracted bilateral gas negotiations were about to culminate in a long-awaited deal. However, it may well be another case of wishful thinking on the part of the Russian negotiators.

“The signing of the Moscow memorandum was presented in Russia as if it were the final agreement, but CNPC did not even report this event on its official website,” Mikhail Kroutikhin, a partner in the RusEnergy consulting agency, tells BRICS Business Magazine. “To put it in other words, the Chinese understand very well that this is yet another declaration of intent that is not binding in any way is unlikely to lead to any tangible result in the future.”

There is an easy explanation for this skepticism that is fully shared by the expert community: despite reaching an agreement on the transportation route for Russian gas, there is little prospect of resolving the main issue – agreeing on the price. After all, the figure that Gazprom has in mind is still roughly three times higher than that expected by CNPC.

Both sides can resort to objective economic reasoning to back their respective positions. Due to the fact that the net cost of gas production and transportation along the agreed route (Yakutia – Khabarovsk – Vladivostok) remains high, Gazprom is unable to offer China much of a discount without exporting gas to its Chinese neighbors at a loss.

“Theoretically, Gazprom could sell gas to China at a profit if the product came from the company’s Sakhalin projects. In that case Gazprom would be able to ship gas to the Chinese border and still bank a small margin,” explains Kroutikhin. “However, if they choose to transport gas to China all the way from Yakutia along the agreed ‘Eastern’ route, its net cost is likely to reach $360 per one thousand cubic meters, according to current estimates. This price would be too high for China – they would not agree to pay that much for gas.”

In fact, as it stands today, Beijing has no shortage of gas and can certainly afford to put the negotiations with Gazprom on a slower track. Moreover, time is on their side.

“Some five years ago Beijing was much more amenable to reaching a compromise on the price. However, much has changed since then,” says Maria Belova, Senior Analyst at the Skolkovo Business School Energy Centre.

“In the first place,” she explains, “Beijing has alternative sources of gas. Apart from the relatively inexpensive Turkmen option, China may well import up to 13 billion cubic meters of gas from Myanmar through a new pipeline completed just last spring, which is slated to reach its full operational capacity in 2016. Another option may come in the form of liquefied natural gas that Chinese companies buy today under various contracts at a price significantly lower than that offered by Gazprom – that is, starting at $100 per thousand cubic meters.”

Secondly, China would always have its coal to fall back on to replace the more expensive imported blue-burning fuel.

“Considering the extent to which the state controls the economy in China, if gas becomes de facto too expensive to import, the government may simply legislatively put a stop to domestic consumption growth despite the environmental concerns. This in turn would most likely lead to gas import restrictions,” Belova notes.

According to Belova, data coming directly from Chinese companies confirms the premise that expectations of rapid gas consumption growth in China, resulting in increased imports, may never be fulfilled:

“In forecasting their gas consumption for the next twenty years they operate based on widely varying indicators, ranging from 390 to 500 billion cubic meters. However, they also presume that the share of imported gas would remain stable and would not exceed 200 billion cubic meters per year.” (3)

Following in America’s Footsteps

With the largest shale gas reserves in the world – estimated at 36 billion cubic meters – China is about to embark upon its own shale gas revolution. In accordance with the 12th Five-Year Plan (2011-2015), by the middle of the next decade shale gas production in the PRC should reach 6.5 billion cubic meters. To achieve this objective the country plans to drill some 50 exploration wells and 150 production wells within that period.

The first auction, selling exploration licenses for four blocks, was held in summer 2011 for Chinese companies only – with Sinopec and Henan CBM ending up as the successful bidders. In autumn 2012, the rights to explore 19 additional blocks were sold to 16 corporations whose aggregate investments into these projects were expected to reach $2 billion.

It was reported that the first exploration well, Qianye-1, completed by Sinopec in early 2012, showed a high production yield. By spring 2013 a total of 39 wells had been completed in China, however only nine of them demonstrated sufficient gas influx. Moreover, the development of shale deposits was reported to be lagging significantly behind the original schedule.

In March 2012, in his address to the 12th Session of the National People’s Congress, China’s then Premier, Wen Jiabao, virtually admitted to having encountered difficulties, promising that the Chinese government “would take more proactive steps to address key issues relating to shale gas exploration and production.”

Be that as it may, experts still believe that the prospects of a shale gas revolution in China are real. In its January report BP predicted that by 2030 the People’s Republic of China would become the most successful country besides North America in developing shale gas deposits.

The main driver of domestic market growth should come in the form of increased production of unconventional shale gas: China’s shale gas reserves are estimated to be the largest in the world, reaching nearly 36 trillion cubic meters.

“Gas demand in China will be predicated on the country’s ability to produce unconventional fuel,” Belova argues.

Given a favorable combination of circumstances, in the next twenty years it may rise from 50 to 150 billion cubic meters. Last year, China’s Ministry of Land and Resources held its first auctions for the rights to explore shale deposits. The data obtained from exploratory drilling shows that these expectations are likely to be met.

“The recently published flow rate data for various wells gives us plenty of reasons to hope that production volumes would be high,” Mikhail Korchemkin tells BRICS Business Magazine. Korchemkin is Manag­ing Director of East European Gas Analysis, an in­dependent US-based energy consultancy.

A Political Decision

The likely growth of domestic production is not the only factor that in the long run may drastically reduce the imported share of gas in China. There is another aspect that is clearly underestimated by potential exporters blinded by the Chinese gas market growth dynamics of recent years: the Chinese government is increasingly weary of the economy’s growing dependency on imported energy resources.

“The fast-developing gas demand in China that we saw over the last decade was not dictated by an economic necessity – to a greater extent it came as a function of politically-driven efforts to diversify the country’s fuel and energy portfolio,” notes Alex­ei Belogoriev from IES. “Therefore, it would be strange to presume that in the future political considerations would play a less significant role in determining the gas demand dynamics than they do today. From the political perspective, one of the key threats to China’s economic development in the future is the rapidly growing share of imports in the domestic consumption.”

According to Belogoriev, by 2020 China is likely to reach the so-called ‘resource pause’ phase, when the rate of energy consumption growth is expected to slow down drastically. As a result, by the beginning of the next decade, China may no longer need Russian gas at all.

All of these developments mean that Gazprom has very little time left to reach an agreement. The experts are certain that to do that the Russian company would have to find a way to reduce the cost of its gas but that, at the end of the day, it does have a certain leeway to be able to do this.

“For example, a major breakthrough could be achieved in the gas negotiations if the Russian side would hire Chinese contractors to build the Yakutia – Khabarovsk – Vladivostok pipeline. After all, they charge three times less per one kilometer of pipeline than Gazprom’s Russian partners. Furthermore, the Russian government may well exempt the gas exported to China from any taxes and duties. In that case the price of gas shipped from Yakutia to the Chinese border could become acceptable,” suggests Korchemkin.

However, not all experts believe that this more ‘economical’ option is viable. For instance, Mikhail Kroutikhin from RusEnergy is convinced that the contracts to build the ‘Eastern’ pipeline will be awarded to Gazprom’s Russian partners. Given this scenario, the real cost of the pipeline could reach $60 billion at a minimum – a figure that is 2.5 times higher than the current official estimate.

According to Kroutikhin, the only realistic option to sell Russian gas to China is to agree to reduce the price to the ‘Chinese’ level – that is, to sell it below cost.

“It would be an embarrassment for Russia. However, it may well be the case that a political decision will be taken to address this issue,” he notes.

Maria Belova believes that the Russian government may indeed take such a political decision.

“Today the Russian government’s perception is that if we are about to lose the European gas market, where exports have been falling in recent years, we need to find a way to commit ourselves to shipping gas to Asia,” she says. “We need to commit to the Chinese market, which in this case certainly appears to be the lesser evil, even if we initially would have to export at a loss. There is a certain rationale behind this position, after all. Therefore, I would not go as far as saying that should such a political decision be taken it would necessarily be bad. However, I do hope that it would not come to that.”

There is yet another development that may well force Russia’s hand in making concessions to China. In late November 2012 Gazprom took the final decision to invest in the development of the Chayandinskoye field and build the ‘Eastern’ cross-country gas pipeline from Yakutia, via Khabarovsk, to Vladivostok. The Russian gas monopoly really has nowhere else to retreat.

It is still an open question as to when the long-awaited agreement will be signed. However, when it happens, both Russia and China will undoubtedly feel relieved. Moscow will finally be able to ‘take a breather,’ and Beijing too will be able to breathe more freely.

Official partners

Logo nkibrics en Logo dm arct Logo fond gh Logo palata Logo palatarb Logo rc Logo mkr Logo mp Logo rdb