Russia's gas deal with China: Business is business

Russia's gas deal with China: Business is business

Insight
Ian Bond, Rem Korteweg
25 June 2014

Does Russia’s agreement to sell China gas worth $400 billion (€294 billion) over the next 30 years foreshadow a Sino-Russian special relationship, and a geopolitical earthquake that could threaten European gas imports from Russia? Or has Russian president Vladimir Putin mortgaged Russia’s future to China’s goodwill? Gazprom CEO Aleksei Miller called it an “epoch-making event”, but former Russian deputy minister of energy Vladimir Milov said the terms of the deal are “an insulting lesson for Putin”. Two things seem certain: the China deal will give renewed impetus to EU efforts to reduce gas dependency on Russia; and the biggest winners from the contracts signed during Putin’s visit to China on May 20th-21st will be his friends in the energy and construction sectors.

For China, the deal brings mostly advantages. To help tackle its huge pollution problem, China wants to burn more gas and less coal. It also needs to meet growing energy demand. China’s current gas consumption is forecast to more than double by 2020; from 170 billion cubic meters (bcm) to more than 400 bcm. Beijing is developing significant domestic shale gas reserves (BP expects these to supply 22 per cent of total Chinese demand by 2030), but this will not be enough. So China must rely more on imports. It is investing in liquefied natural gas (LNG) terminals (nine are under construction or have been approved), building new pipelines across Central Asia and eyeing offshore fields in contested areas of the South and East China Seas. If international sanctions on Iran are lifted, China will also be first in line to sign gas contracts with Tehran (Iran has the second largest natural gas reserves in the world – after Russia). Russia has now agreed to supply almost 10 per cent of Chinese demand from 2018, and could increase this later to around 15 per cent.

China has driven a hard bargain. It negotiated with Russia for more than ten years before getting the deal it wanted. The exact price remains a commercial secret, but Russian energy minister Aleksandr Novak said that $350 per thousand cubic metres was “close to” the figure. This is below the European average ($380) and well below the average price in East Asia: Japan currently pays $538 for its LNG. The price is above the $280 per thousand cubic metres which China pays for Turkmen gas. But given the pipelines and other infrastructure that still need to be built, and in comparison with Japan’s soaring gas bills, China has negotiated a hefty discount.

On the negative side for China, gas will not flow for at least four years. Meanwhile, China has agreed to pre-pay $25 billion to help fund construction of the pipeline in Russia. Beijing has also accepted a gas price linked to the oil price. This link is being broken elsewhere by downward pressure on global gas prices as a result of increased LNG availability (due to the US shale gas revolution and new production in East Africa, Indonesia and Australia). So Beijing could possibly have held out for an even better deal.

For the Russian government, the pluses and minuses are more finely balanced. On the one hand, Gazprom diversifies its clients: currently 76 per cent of its gas is sold to EU member-states, many of whose economies are still smaller than before the financial crisis. Since the contract with China involves exploiting relatively undeveloped fields, the state-owned company will increase its total production and revenue. It will now have a long-term contract with a rapidly growing economy; and the pipeline will give it scope to export to other parts of East Asia over time. It is a “take or pay” contract (of the kind which the EU is trying to outlaw) so Russia would not lose revenue even in the unlikely event that Beijing no longer wanted or needed to take the contracted amount of Russian gas.

The up-front payment from China will partially offset the costs to Russia of new infrastructure required for the deal. Moscow may also feel that having China as a customer gives Russia more leverage vis-à-vis European customers because of the additional revenue, although Europe will remain by far the biggest importer of Russian gas for the foreseeable future.

On the other hand, the deal is expensive for Moscow. It involves developing two new fields, Chayanda and Kovykta, and building a 4,000 km pipeline through difficult, seismically active terrain to China, at a total cost of $55 billion. By contrast, the costs of field development and existing pipelines to Europe were written off long ago. At a conference on energy strategy on June 4th, Putin said that the state might recapitalise Gazprom to cover its investment in the China deal, using Russia’s gold or foreign exchange reserves, or its wealth fund. This fund is supposedly intended to fill shortfalls in the national pension fund, which is already in deficit. Using the wealth fund to help Gazprom would significantly worsen Russia’s problem of unfunded pension liabilities. To compound this, the Russian finance minister, Anton Siluanov, said that Russia might consider exempting gas for China from the mineral extraction tax, which would cost the Russian treasury around $450 million a year.

Overall, Gazprom may not be able to make a profit from the deal; particularly if increasing availability of alternative gas supplies forces it to lower its prices at some stage (as it has had to do with some of its European contracts). Russia has always had the upper hand in its dealings with European countries, because the pre-existing pipeline system and lack of investment in bringing gas from elsewhere to European markets left Russia as a de facto monopoly supplier to some eastern European countries. But this is now changing: a number of EU member-states have been able to negotiate price reductions from Gazprom by investing in alternatives. Lithuania, for instance, negotiated a 20 per cent reduction in May 2014 following its decision to build an LNG terminal on the Baltic coast. With China, Russia could face a monopsony: in the short term, China is likely to be the sole purchaser for gas from Kovykta and Chayanda, but will have a range of other suppliers, from Turkmenistan to Australia, as well as growing domestic gas production – useful levers if world gas prices fall and Beijing wants to get a better price from Russia. China will be a tougher customer to bargain with than many EU member-states.

For the EU, this deal – coming on the heels of Russia’s Crimea annexation and European sanctions – has reinforced the fear that Russia may ‘turn off the taps’ and divert gas to China to punish Europe. This seems unlikely, given Russia’s financial needs and its interest in maintaining the trust of international capital markets. A politically-motivated cut in gas supplies to Europe (as opposed to Ukraine) would tarnish Russia’s image as a reliable partner. Still, European consumers may be the victims of the escalating gas dispute between Russia and Ukraine; one-third of European gas imports transit Ukraine.

The EU should therefore treat both the Ukraine crisis and the China deal as opportunities to stimulate debate on Europe’s energy security and take steps to wean itself off over-reliance on Russia. At present, six EU countries rely completely on Russia for their gas imports. The EU should act vigorously to shield these member-states from the effects of possible Russian supply cuts, by making it easier to move gas around Europe through bi-directional interconnector pipelines, developing more LNG terminals and importing more gas from non-Russian sources. The Commission has already identified projects to fund in pursuit of these objectives. The EU should further liberalise the European gas market through effective enforcement by the Commission of existing rules on unbundling ownership of production, transmission and retail energy operations; and it should encourage energy efficiency and the development of new energy sources.

One question under consideration is whether the EU should take up Polish Prime Minister Donald Tusk’s suggestion that the EU set up an “Energy Union”, including by creating a single purchaser of gas. Although in theory this would increase Europe’s bargaining power, the Polish proposal is unlikely to be accepted in full: the EU would struggle to predict accurately the energy needs of 28 states for years to come; and many states would be wary of giving the Commission the power to negotiate gas contracts on their behalf. But some elements of the Tusk proposal make a lot of sense: if there was full transparency about the deals European companies make with Gazprom, there would be more opportunity for the Commission to act against market-distorting behaviour, and less chance for Russia to divide and rule in the EU. The Commission has also said that it will consider permitting voluntary collective negotiation of gas contracts by interested countries, which would strengthen the purchasing leverage of those currently most vulnerable to pressure from Gazprom.

For one European country, perhaps, the Russia-China gas deal may be worrying. Russian supplies to China will be nearly equivalent to the amount of gas it sells to Ukraine; 38 bcm and 30 bcm per year respectively. Gazprom cut gas exports to Ukraine on June 16th in a dispute over payment arrears, in parallel with Russia’s efforts to destabilise the country. Together with the South Stream pipeline, which would bring Russian gas to Europe without transiting Ukraine, the deal with China would ultimately allow Moscow to leave Ukraine in the cold without greatly affecting Gazprom’s revenue. But this assumes that by 2018 relations with Ukraine are still as bad as today; and that South Stream gets a green light from the Commission, which is currently uncertain. Under pressure from the Commission, Bulgaria has suspended work on its section of South Stream, but during Putin’s visit to Vienna on June 23rd Austria rejected EU criticism and signed a contract with Russia for construction of the Austrian section of the pipeline.

So what is the geostrategic significance of the deal with China? A Russian-Chinese naval exercise took place during Putin’s visit, suggesting the possibility of closer security ties between Moscow and Beijing. But neither military co-operation nor gas supplies will be enough automatically to create a Sino-Russian ‘special relationship’. While the two countries work together in the UN and relations are generally cordial, there are too many divergent interests for them to become brothers-in-arms. Bilaterally, there is still mistrust in Moscow about China’s influence and long-term goals in the Russian Far East. Russia is also concerned about China’s forays into Central Asia, which Moscow still considers as part of its traditional backyard; the Russian-led Eurasian Economic Union could hinder China’s trade with the region. In China’s backyard, on the other hand, Russia is building closer ties with Vietnam to gain access to the naval port in Cam Ranh Bay at a time when Chinese-Vietnamese tensions are increasing over energy resources in waters claimed by both sides.

Another sign that the deal is less than a geopolitical game-changer is the currency in which the deal will be settled. Fearing further Western sanctions, Russian firms want to move to renminbi-based contracts; instead, at least initially, the gas deal will operate in US dollars and thus not threaten the global position of the greenback (though it is unclear whether the contract allows for a switch of currency in the future).

Finally, one group of people who are likely to benefit, not only from the Gazprom contract with China, but from the many other deals signed during Putin’s visit, are his friends. Someone has to build a 4,000 kilometre pipeline in Russia, and two of the main options are Stroygazmontazh, described by Russian media as Gazprom’s largest contractor and owned by Arkady and Boris Rotenberg, who are both subject to US sanctions; and Stroytransgaz, controlled by Gennadiy Timchenko (also subject to US sanctions). Timchenko is also a major shareholder in several more companies which signed lucrative contracts with China during Putin’s visit.

For China the gas contract looks like a business deal, pure and simple. For the oligarchs involved, it does too. Not for the first time, those close to Putin are likely to do well by doing good for the Motherland.

Ian Bond is director of foreign policy and Rem Korteweg is senior research fellow at the Centre for European Reform.