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NEWS & COMMENTARY 2008 SPEAKERS 2007 2006 2005

Thursday, May 25, 2006

Russia defies EU on energy security

FROM THE ECONOMIST INTELLIGENCE UNIT

Energy will be a prominent issue at the EU-Russia summit, with the EU delegation eager to ensure stability of supply for Europe and to avoid destabilising sharp rises in prices for former Soviet states too. All signs point to further sharp rises for former Soviet states, to bring their prices into line with those for Western Europe. A number of these economies thus seem set to face more gas price shocks in the coming years, depending on the length of the transition to EU prices. Although this promises to be benefit Russia, already it is having to pay more for Central Asian gas—and prices will probably have to rise further if it is to maintain its stranglehold on Central Asian gas.

Charter fight

Ahead of the EU-Russia summit that begins on May 25th, the two sides’ respective positions have become clear. The EU, concerned about the disruption of Russian gas supplies in early January as a result of a Russia-Ukraine price dispute, is eager to extract Russian guarantees—or, better still, to establish mechanisms to ensure—that supplies in future are stable. The EU’s principal objective is to ensure that Russia ratifies the European Energy Charter and its transit protocol, which would oblige Russia to liberalise access to its gas pipeline system. At present, Russian gas pipelines are owned by the state-controlled gas monopoly, Gazprom, which places strict limits on third-party access and refuses to allow Russian independents or CIS producers access to the lucrative EU market.

Russia’s response to this is already clear. President Vladimir Putin’s coordinator on EU relations, Sergei Yastrzhembsky, said on May 23rd that Russia would not sign the Energy Charter because it imposed unequal conditions on the EU and Russia. This is entirely consistent with Russian policy in the last few years, which has refused to countenance any reform of Gazprom or dilution of its control over the gas market. Because it controls the pipeline network, Gazprom has enormous leverage over independent producers and is able to purchase gas from them very cheaply. In a separate interview, Kremlin aide Igor Shuvalov suggested that Russia may eventually liberalise access to the domestic pipeline network, but that the government would never consent to breaking Gazprom’s export monopoly.

Shock proofing

Partly for reasons of enlightened self-interest, the EU is also eager to ensure that there are no future shocks on gas prices or supplies to Russia’s neighbours. This is a direct result of Russia’s behaviour at the end of 2005, when it doubled gas prices for Georgia, Armenia and Azerbaijan to US$110 per 1,000 cubic metres, insisted that Moldova pay US$160 per 1,000 cu metres and demanded that Ukraine pay US$230 per 1,000 cu metres from the start of 2006, compared with a notional price of US$50 per 1,000 cu metres in 2005. The failure of Ukraine and Russia to agree a deal before the year-end led to supply disruptions that had an impact across Europe, before a hastily-negotiated and still partly opaque agreement was reached in early January.

The EU’s focus on ensuring no shocks in gas pricing for former Soviet states is probably shrewd, for it is based on acceptance that gas prices for Russia’s neighbours will rise considerably within the next few years—the main question is how quickly this will happen. A transition period of several years would at least muffle the shock and enable the affected countries to adapt accordingly.

All signs point to further large rises in the price of gas for the CIS and Baltic states in the next few years. Russia’s move sharply to raise prices last year had a political aspect—punishing those CIS states (Ukraine, Georgia and Moldova) that had adopted pro-Western policies at what was perceived to be Russia’s expense—but it was primarily directed towards increasing Gazprom’s revenue. CIS prices have for years been fixed, at rates that were lower than the price paid by West European customers. Within the last 1-2 years, however, the spread increased considerably as West European gas prices followed oil prices to historically vaunted levels. By the second half of 2005, Gazprom made clear that it was no longer willing to assume the opportunity cost of supplying so much cheap gas to neighbouring states. The fact that the government finally agreed to lift the so-called ring fence on Gazprom stock, allowing foreign investors to own more of the company, was a sign that Mr Putin wanted to push the company in a more commercial direction.

No more favours for neighbours

Developments within the last two months confirm that prices for the former Soviet states will soon rise once again. In early April Gazprom concluded a deal with Armenia—which after Belarus is the CIS gas customer most closely aligned with Russia—to fix the price at US$110 per 1,000 cu metres until the end of 2008. To win this deal, Armenia conceded to Gazprom majority control of the joint venture, ArmRosgazprom, and agreed to transfer to the venture ownership of a section of the existing gas pipeline from Iran, as well as the right to build a new pipeline link with Iran. Armenia also gave to Gazprom the fifth block of the Razdan power station, which is already mostly owned by Russian interests. The clear implication of this deal is that CIS gas prices will rise sharply above US$110 per 1,000 cu metres in the next few years; Armenia has sought to exclude itself from this process by allowing Gazprom to satisfy one of its strategic objectives—to gain ownership over gas export infrastructure beyond Russian territory. Control of the Iranian pipeline will enable Gazprom to regulate future Iranian gas exports to the southern Caucasus.

The prospect of higher gas prices for all CIS states was confirmed days after the deal with Armenia, when Gazprom deputy head Alexander Ryazanov said that the price paid by Belarus should be “at least three times as high” as the current US$47 per 1,000 cu metres. It is possible that Gazprom is adopting this position to force Belarus to make further concessions on the ownership of energy infrastructure, but this does not rule out the possibility of Gazprom doubling prices to Belarus as well as gaining more control over the Belarusian pipeline system.

The first CIS state to experience a gas price hike could be Ukraine. According to most accounts of the January gas agreement, prices for Ukraine were to be set at US$95 per 1,000 cu metres for the first six months of 2006—after which rises were possible. Although the agreement set the price for Ukraine of Russian gas at US$230 per 1,000 cu metres, the Gazprom-Ukrainian joint venture RosUkrEnergo agreed to supply Ukraine with its gas import needs at US$95 per 1,000 cu metres by buying gas from Turkmenistan, Kazakhstan and Uzbekistan. On May 22nd, Mr Ryazanov announced that the price for Ukraine would have to rise to US$130 because Russia had agreed with Kazakhstan that the price of Kazakh gas would rise from US$50 per 1,000 cu metres to US$130.

The clearest signal to date that CIS prices will soon rise much further came on May 23rd, when the Russian minister for economic development and trade, German Gref, said that all prices for all Gazprom’s foreign customers would rise to “world levels”. He added that Russian domestic prices, which are currently less than a fifth of the West European level, would rise more gradually—so that Russia would maintain a competitive advantage in the form of cheap energy for many years.

Higher prices

There are several implications arising from these developments. For the CIS and Baltic states, there is an appreciable risk that gas prices—which for many have already doubled in the space of six months—will rise sharply once more from the start of 2007. The Georgian gas company, for instance, is concerned that Gazprom will insist on a price of US$200 per 1,000 cu metres within a year or two. A quadrupling of gas prices within the space of two years would pose enormous challenges for energy-dependent enterprises across the CIS. It would also cause strain on municipal heating systems, which are highly inefficient consumers of gas and might be less able financially to introduce energy-saving technology. Kryvorizhstal, the giant Ukrainian steel mill owned by Mittal Steel, has been able to reduce gas use by half through greater use of coking coal as a feedstock. For Ukraine’s municipalities, a switch to co-generation is likely to take years even under the most optimistic set of assumptions.

For Gazprom, the rise in prices will offer a boost to its bottom line. Last year, according to Gazprom data, the company exported 16.7bn cu metres of gas to CIS and Baltic customers at an average price of around US$55 per 1,000 cu metres. Although the Ukrainian market is, in effect, subcontracted to Central Asian producers, the price rises this year should deliver a revenue gain of around US$55m. A rise to an average price of US$200 per 1,000 cu metres would add nearly as much again to Gazprom’s bottom line. Just as importantly, by extricating itself from the Ukrainian market (to which it supplied over 8bn cu metres in 2005), Gazprom will free up sizeable volumes of gas for export to Western Europe.

The Central Asian gas race begins

For Gazprom, there are downsides to the rise in gas prices, however. The push to increase the cost of gas in Ukraine in the second half of this year is mainly because Central Asian gas producers are hiking their prices too, taking their cue from Gazprom’s own pricing policy. Until now, Gazprom has enjoyed a stranglehold over Central Asian gas exports, acting as a monopsony. This is very useful for Gazprom, given that demand for its gas is rising at home and abroad while its own output is rising only modestly—and will come under pressure in the next few years, as its giant fields begin to decline before new production can be brought online. On some projections, Russia will be unable to meet its obligations in the next few years without drawing on Central Asian gas.

This alone gives Central Asian states, particularly Kazakhstan that has little need to export gas, leverage over Gazprom. And unfortunately for Gazprom, it can no longer rely on retaining its monopsony over Central Asian gas exports. Very high prices for gas and renewed fears over supply security have reignited Western interest in gaining direct access to Central Asian gas supplies—US Vice-President Dick Cheney recently urged the Kazakh government to commit to a gas export pipeline that would bypass Russia, and that could deliver Kazakh, Turkmen and Uzbek gas to Europe. China and India, two countries that are set to experience rapid gas demand growth in the next few years, have also shown an interest in Central Asian gas. This month, India’s parliament voted to approve the construction of a pipeline via Afghanistan and Pakistan by which the country could receive Turkmen gas.

Although financing for these projects remains highly uncertain, increasingly it is becoming clear that Russia can no longer take for granted that its stranglehold over Central Asian gas will endure. The rise in the price of gas for CIS states to near-European levels, and the prospect that European prices will remain elevated for some time, is likely to spark a more determined race among the states abutting Central Asia for access to the region’s gas. To stay ahead of its rivals, Gazprom will have little choice but to pay considerably higher prices for gas that it can ill afford to do without.

Source: ViewsWire Eastern Europe
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