The Bear Growls, The EU Grovels: Adventures in the European Gas Market

Among those hoping that global warming is real we should now count the EU.  As winter approaches there is, quelle surprise, the initial hint of yet another gas supply crisis between Russia, Ukraine and Russia’s EU customers.  The problem is that those pesky pipelines have to go through somewhere to reach the market and that somewhere happens to be the Ukraine (unless it’s Poland, more on that later).

Source: US DOE, for better map resolution

All those red lines running Northeast-to-Southwest carry gas from Russia to the EU countries.  There is just no getting around the Ukraine for most of the transits; it is big and (if you are Russian) in the wrong place.

Gas: The Great Green Hope for Europe

As noted previously, gas use in Europe is roughly the same as that of the US, a bit over 20 tcf annually.  Unlike the US, gas production in Europe is falling not rising, with net imports currently at about 10 tcf/year and going up by 0.5-1 tcf annually.  Russia provides about 80% of Europe’s imported gas (about 80%), with the remainder mostly arriving in the EU as LNG.

As coal-fired power plants face increasing environmental opposition, and as a new generation of nuclear plants proves difficult to finance and construct European nations have turned increasingly to gas.  Power generation in the EU currently uses about 6 tcf/y, about the same as the US, and the US Department of Energy expects this to rise to the 6.5-7.5 tcf/y range by 2015-2025.

With falling conventional production and limited import alternatives, Russia looks to maintain its key role in EU gas supplies in coming years.  For all of the touted alternative routes and sources – Nabucco, trans-Med pipelines, LNG – the EU remains wedded to Gazprom.  In fact, Russia has made a play for even greater EU dependence with its Nord Stream (Baltic) and South Stream (Black Sea) pipelines.  Completion of those two lines will permit Gazprom to supply Germany, Austria, Italy and others without transiting Ukraine or Poland.

Energy Security or Energy Hardball – Why spend all that money for half-full pipelines?

Russia will invest more than $40 billion in new pipeline capacity without any substantial increase in its gas exports to Europe.  Why?  One view is that it is all about control:

South Stream will cost upwards of $20bn to build, adding to suspicions this is politically rather than financially motivated project. “The Nord Stream and South Stream pipelines are designed as bypass pipelines without increasing Russian exports or improving the security of gas supply to Europe. On the contrary, these projects are designed to reduce the security of supply to Belarus and the EU member states of Germany, Poland, Hungary, Romania, Bulgaria and Greece. Russia will be able to turn off the gas flow to any of these countries without decreasing other exports,” Mikhail Korchemkin, executive director of East European Gas Analysis.

As for Nord Stream, it will supply Germany and Scandinavia with about 1 tcf/year, but this $20 billion plus project will not result in greater net Russian Exports to Germany.  In fact, field development costs for new Russian supplies are expected to be among the most costly options for new EU gas supplies (Riley, et al page 8).

According to knowledgeable analysis of Russian gas, the key to the viability of the two pipelines is that they permit France and Germany (investors in South and Nord Stream, respectively) to keep their domestic gas markets closed and will insulate them from Russia’s disputes in it “near abroad.”  Without liberalization in those two markets, the impetus of significant alternatives to “High North” (Yamal, Shtokman) gas supplies is limited.

So, what is going on here:  no new gas supplies, lots of spare pipeline capacity, the ability to bypass Eastern European consumers with bad attitudes, and guaranteed consumers for the next round of Arctic gas.  This sounds a lot like market control through vertical integration.  Plus you get to stick it to the Poles and the Ukrainians.

Just in Time for Winter: Russia Practices Invading Poland and Russia Announces “Problems” in Supply Through Ukraine

And right on cue the president of the EU (a Swede, not that “stiff-necked” Vaclav Klaus from the Czech Republic) has promised that he had “followed this issue closely and that we will continue to do so.”  We pretty much know how this play will end – supplies will be cut sometime after Christmas, in a very cold week, perhaps there will be kinetic problems with the pipelines, and then the EU, Russia, Ukraine will come up with a “solution” one that is likely to involve lending Ukraine enough money to pay its disputed bills to Russia.  And we will be happy for another year.

Only Mr. Market Can Face Down the Bear

As U.S. experience with deregulated gas markets and shale gas development have shown, even a small effort to produce energy economically can yield great benefits in the overall energy market.  Europe’s heavy investment in renewables, especially wind, has not produced these kinds of market effects because (1) they replace far less firm energy than predicted; and (2) the cost of energy from these sources is very high, providing cover for high gas prices linked directly to crude oil prices.

The U.S. is now in a strong position vis-à-vis LNG suppliers because the country has another source of energy that is fully substitutable and cheaper.  As we noted in our discussion of shale gas in Europe, “negotiating with Russia for lower gas prices by resorting to more costly forms of alternative energy, [such as offshore wind,] is like shoveling money into a furnace to prove that you have another way to heat your home.  You are not likely to get the best price.” [or a warm house]

In addition to the pricing aspect of limiting supply in gas competition, there is also the political problem that such monopolistic supply can create.  Would we really expect France, Italy or Germany to challenge a restriction in Russian gas supplies to one of the smaller Central European EU member countries if Russia retained the capability to retaliate against any one of these nations individually?  After all, what is all that excess network capacity for (pp 14-15) if not to move gas around to your friends and punish your enemies, all the while maintaining high price levels for gas.  As the noted Russia energy analyst, Anders Aslund, put it in 2006:

Naturally, Gazprom wants to maintain and if possible extend its monopoly over gas pipeline transportation. It wants to take over trunk pipelines in other countries, and it works hard on doing so. Gazprom and thus Russia are dead against the European Energy Charter and its Transit Protocol, because it will reduce Gazprom’s monopoly powers. In this regard, Gazprom and the European Union have contradictory interests. For years, the European Union has demanded that Russia ratify the Energy Charter, but Russia will never do so. (ibid)

Europe’s energy salvation does not lie with stifling competition in the name of “security.”  The EU would gain a lot more from encouraging production of its own shale gas resources, currently estimated at 300-570 tcf, than they would from “security” at a premium price.  With LNG prices low, this is also a good time to build up import and storage capabilities.  In energy markets a little bit goes a long way.  The 1979 price quadrupling was caused by a cutback of less than 5% (Iran) in world oil supplies.  The recent 10% increase in U.S. natural gas production (about 3% of total domestic energy production) has weakened LNG prices worldwide greatly benefiting gas users more than any conceivable alternative energy project.  Small changes at the margin can be significant.

This would be an excellent time for the EU Competition Commission to hold firm in its support for liberalized markets in energy.  If Europe could get 1-2 tcf/year from its shales, 12-25% of what the EU now imports from Russia, another 1-1.5 tcf from Algeria and Libya, and more LNG to balance load then Russia would be forced to negotiate about the economy of its gas, instead of the political economy of its gas.