Will Russia's Gas Deal with China Block Other Suppliers?

• The recent natural gas deal between Russia and China involves volumes comparable to the gas production of the US Gulf of Mexico.
• Barring a major economic slowdown, meeting China's projected growth in gas demand will require this Russian gas, more LNG imports, and China's own shale gas.

 

$400 billion deals aren't announced every week--even by heads of state--although the new natural gas supply agreement between Russia and China had been in the works for some time. However, the crucial element of price apparently wasn't agreed until a negotiating session that lasted until 4:00 AM, Shanghai time. "Our Chinese friends are difficult, hard negotiators," said President Putin. They certainly waited for the right moment, with Russia pressed by sanctions in the aftermath of its annexation of Crimea.

The numbers are all impressive: After investing more than $50 billion in gas field and pipeline development in Eastern Siberia, Russia will sell 38 billion cubic meters (BCM) of gas per year to China for 30 years, and China will reportedly invest $20 billion for gas infrastructure and market development within its borders. Deliveries are set to start in 2018 and could eventually ramp up to 60 BCM/yr.

To put that in perspective, 38 BCM/yr equates to 3.7 billion cubic feet (BCF) per day. That's on par with the entire natural gas production of the Eagle Ford shale formation in south Texas, or the federal waters of the Gulf of Mexico.  Of greater relevance is that it's also nearly twice the output of Australia's Gorgon LNG project, which is expected to begin production in 2015. So from the perspective of the regional gas market and alternative supplies, this is a very significant quantity of gas, especially with a number of new Australian LNG projects under development or consideration.

As of 2012 China's gas market was already the largest in Asia, ahead of Japan, based on BP's annual Statistical Review of World Energy. This deal represents 27% of China's current gas demand, so it's tempting to conclude that squeezing Russian gas into China must come at the expense of other potential suppliers. If China's gas market were mature, such a zero-sum view could not be ignored, particularly by marginal LNG projects in Australia, Indonesia and the US that have not yet begun construction.

Competition with Russian gas could also impede development funding and access to infrastructure for China's nascent shale gas industry. The US Energy Information Administration's 2013 global survey of technically recoverable shale resources found that China could have over a quadrillion cubic feet--1,115 TCF--of shale gas in the ground, or nearly twice as much as the US. Yet China's progress in tapping this resource has been slow, and hardly a week goes by without another article explaining why it will be difficult if not impossible for others to replicate the US shale gas boom any time soon.

The growth of demand will largely shape the competitive environment for gas in China. In 2012 natural gas accounted for less than 5% of the country's total primary energy consumption, compared to 13% for Taiwan, 17% for South Korea and 22% for Japan, none of which are significant gas producers. From 2007-12 China's gas market grew at a compound average rate of 15% per year. In their just-released Medium-Term Gas Market Report, the International Energy Agency (IEA) forecasts China's gas demand growing by 90% by 2019, while their latest World Energy Outlook anticipated it tripling by 2025 and quadrupling by 2035, eventually reaching 11% of energy consumption. Achieving that would require the equivalent of ten gas deals the size of this one.

That outcome isn't a certainty, for many reasons. Having all that gas turn up at the right time poses a massive logistical and capital investment challenge, and China's economy might slow further. Meanwhile, the price implied in the media coverage of the Russia/China deal is around $350 per 1000 cubic meters ($10 per million BTUs) or more than double the current US wellhead price. That's a lot cheaper than most of the LNG delivered to Asia, but it won't outcompete Chinese coal on economics alone, and it won't jump-start new, gas-reliant industries the way the US shale gas revolution is beginning to do.

The scale of market development implicit in the IEA's forecasts for China would require a substantial expansion of gas-fired power generation, which in any case is the logical complement to China's aggressive expansion of wind and solar power installations. It also entails a significant shift from solid and liquid heating and cooking fuels to gas, where at least in the case of liquids, $10 gas would have the edge over products derived from $100 oil. It might even encompass gas-based distributed power generation using fuel cells, which is still in its infancy in the US. Such developments will benefit all potential suppliers, not just Russia.

It's also worth considering what this deal means for Russia. While many reports have suggested it provides a counterweight to Russia's dependence on the European gas market, that's really only true in a financial sense. The deal represents a major growth opportunity for Gazprom, Russia's majority-state-owned natural gas company, but this isn't the same gas that now supplies the EU. It will mainly be production from new gas fields. The potential upside for Russia may depend on its ability to leverage the infrastructure built for this deal into a larger gas network for supplying growth throughout Asia--in competition with US and other LNG projects eyeing that market.

"Milestone" is an over-used term, but it fits this deal. If the parties can iron out all the remaining details and proceed to construction and ultimately delivery, it could prove to be a key step in giving gas a much bigger role in fueling Asia's growth. That would have important environmental benefits, in both mitigating the air pollution in Asia's major cities and reducing carbon emissions, perhaps by enough to bend the curve of the region's greenhouse gas growth.

 

A different version of this posting was previously published on the website of Pacific Energy Development Corporation.

Energy Risks of the Ukraine Crisis

• Russia's intervention in the Crimean Peninsula poses few risks to Europe's energy supplies, but escalation or Western sanctions could change that assessment.
• If the crisis expanded to mainland Ukraine, the integrity of that country's pipelines and the natural gas they carry to EU members would be the most immediate energy concern.

Although Ukraine's energy assets don't appear to be a major focus of Russia's occupation of the Crimean peninsula, any escalation of the crisis could have serious energy consequences, regionally and globally. The initial reaction of energy markets has been cautious, with Monday's jump of around 2% for Brent crude and nearly 10% for European gas futures largely erased in Tuesday's trading. While some of Russia's oil exports to Europe transit through Ukraine, the latter's natural gas pipelines are the bigger worry, especially in light of Russia's past use of the "gas weapon."

It's always dicey commenting on an unfolding event of this magnitude, which various observers have nominated as the most serious geopolitical crisis in post-Cold War Europe. I've spent the last few days following developments, listening to conference calls, and speaking with a Russia expert of my acquaintance. Dismissing the current events as out of tune with the 21st century ignores the complex history of a region that has seen multiple episodes of great-power conflict, just as trying to impose a Western mindset on President Putin's intentions is likely to come up short.

His latest reported comments suggest that he may have achieved his initial goals, at least insofar as giving him, rather than the new government in Kiev, control over Russia's access to the strategic Black Sea naval installations. Any broader goals are unclear at this point, and as a military expert highlighted in a media call hosted by the Council on Foreign Relations, the current confrontation in Crimea runs the risk of "unintended escalation." Wars have started this way.

So what's at stake, in energy terms? An infographic from Business Insider puts the gas situation in perspective. Russia's share of Europe's gas supply has fallen to 22% as EU members diversified their sources of supply in the aftermath of past interruptions in Russian gas deliveries. Still, roughly two-thirds of Russian gas sent to the EU passes through Ukraine's territory, and the pipelines that transit Belarus and the Baltic Sea lack sufficient capacity to reroute the entire volume should Ukraine's pipelines be disrupted.

Whether that occurred as an intentional reaction by Russia to steps that the US and EU are considering in response to its intervention in Crimea, or as a result of armed conflict in mainland Ukraine, natural gas prices in Europe would spike, even with ample gas in storage after a relatively warm winter. That would adversely affect EU economies still recovering from recession and the EU's financial crisis.

European natural gas prices are already much higher than those in the US, and any further increase would ratchet up the pressure on the EU's manufacturing sector. Nor is there nearly as much LNG available globally to make up any shortfall as there will be in just a few years, once US exports gear up and several large Australian LNG projects come onstream. Ironically, Ukraine is building its own LNG import facility to diversity its supplies--luckily not sited in Crimea.

The threat to oil deliveries seems less acute, short of an embargo that would hurt Russia as much as its customers. In 2012 Russia exported around 6 million barrels per day of oil and condensate to European refineries by various routes, including the southern leg of the Druzhba pipeline that crosses Ukraine on its way to the Czech Republic, Hungary and Slovakia. While a disruption of this flow could force refiners in those countries to scramble for alternative supplies, Russian oil would probably still find its way to world markets via other routes, including to the Baltic ports. Ensuing world oil price increases would likelier reflect an overall risk premium than a more localized physical shortfall.

Even if the situation doesn't progress beyond its current state, longer-term energy impacts could still follow. These include a recognition of heightened political risk for investments in Russia and its "near abroad" neighbors, along with the results of any financial sanctions that might be imposed.

If Mr. Putin is satisfied to engineer greater Crimean autonomy or independence from a more EU-oriented government in Kiev, and if the EU/US response is limited to financial measures to prop up that government, then the consequences--similar to those for Russia's ongoing occupation of part of Georgia--could be minimal. The EU can't go any farther than Germany will support, and thanks to the Nordstream gas pipeline led by its former Chancellor, Germany has less at stake in Ukraine than some of its neighbors. It has already distanced itself from suggestions of evicting Russia from the G8 group of nations. In that context, the US administration seems unlikely to sustain a harder line than Brussels.