Russian-Ukraine dispute highlights need for supply diversification

March 20, 2006
The Russian-Ukrainian natural gas dispute provides a reminder that some suppliers are willing to renegotiate contracts forcibly, even to the point of cutting off supplies, if the prices involved justify such actions.

The Russian-Ukrainian natural gas dispute provides a reminder that some suppliers are willing to renegotiate contracts forcibly, even to the point of cutting off supplies, if the prices involved justify such actions. Diversifying sources of supply is key to avoiding being cut short if such events occur.

The settlement reached between the two countries paradoxically reinforces Ukraine’s dependence on OAO Gazprom’s supplies. The European Commission has expressed serious concern regarding regional security of supply and will issue its first paper on European Energy Policy in second-quarter 2006, with final conclusions and proposals due by yearend.

The dispute will likely have a long-term influence on supply strategies, going beyond European frontiers and boosting LNG receiving terminal projects. It will also provide an opportunity to increase LNG flows from Asia to Europe.

The Asia-Pacific region is generally less at risk than Europe to supply disruptions because of the dominant role played by LNG in the region, but the dispute also provides a preview of what Russian price expectations might be in negotiations for natural gas exports from Sakhalin I to China.

Weaknesses exposed

Russia and Ukraine settled their natural gas dispute on Jan. 4, 2006. According to the two 5-year agreements signed on that date, Russia will sell natural gas to Ukraine at a price four times as expensive as the previous contract. Russia will add its volumes to the larger and much cheaper supplies from Turkmenistan, and sold by RosUkrEnergo (owned 50% by OAO Gazprom) to Naftogaz Ukrainy at a common price of $2.60/MMbtu. In return, Russia will increase the transit fee for gas deliveries through Ukraine by 47% and pay in cash instead of gas.

These agreements closed the bitter dispute between the two countries that culminated in Gazprom cutting supplies to Ukraine on Jan. 1, 2006, and led to natural gas shortfalls in many European countries.

Coming 1 year after a similar crisis between Russia and Belarus, the Russo-Ukranian crisis has triggered serious concern in Europe about security of supply. Andris Piebalgs, European Union energy commissioner, and Martin Barenstein, Austrian minister for economy and labor, jointly remarked that European energy security needs to be approached on a European level. The issue is on the agenda of the EU summit, Mar. 23-24, 2006

This crisis highlights two areas of concern for the security of natural gas supply in Europe. The first lies in the region’s infrastructure. Most of the Russian gas bound for Europe moves through the Ukraine. Only two other, more limited-volume, transit routes exist: the Yamal-Europe pipeline through Belarus and the recently inaugurated Blue Stream, crossing the Caspian Sea to link Russia and Turkey. A lack of interconnecting infrastructure, however, prevents natural gas delivered to Turkey moving to northern Europe.

The other concern lies with dependence on a single supplier. Many observers consider the dispute as much a political argument as a business disagreement, tarnishing Gazprom’s reputation as a reliable supplier.

Effect on projects

The effect of the Russian-Ukrainian crisis on main infrastructure projects will vary by product and region.

• Central Europe. Gazprom sees the North European Gas Pipeline as a way to avoid transit across third countries. The 1,200-km pipeline is designed to link Russia and Germany through the Baltic Sea. The NEGP company, created by Gazprom (51%), BASF Corp. and E.ON AG (24.5% each), has appointed former German Chancellor Gerhard Schroeder as chairman, and Gazprom began construction of the onshore segment of the pipeline in December 2005. The pipeline is scheduled to begin operations in 2010, with an initial capacity of 27.5 billion cu m/year (20 million tpy), which could be doubled.

This €4-billion project is moving ahead quickly and enjoys strong political support in both Russia and Germany. But it faces criticism from existing transit countries and will not help reduce Germany’s dependence on Russian natural gas.

The Nabucco pipeline project aims to connect Turkey with Austria through Bulgaria, Romania, and Hungary, allowing supplies from the Caspian region and Iran to flow to Europe. The €4.6-billion project was declared technically and financially feasible in second-quarter 2005 and is currently in development. Construction of the 3,400-km pipeline, with a capacity of 25-30 bcm/year (18.5-22 million tpy) is planned for 2008, with operations beginning in 2011.

Austria lost 35% of the natural gas it typically receives while the Russian-Ukranian dispute was underway, while Hungary lost 40%. Bulgaria has since refused Gazprom’s demand to modify the terms of its natural gas supply contracts, opening the possibility of a new dispute and likely further heightening interest in Nabucco.

• Italy. Requirements that shippers book strategic storage have lessened Italy’s dependence on Russian gas. The Russian-Ukranian crisis should not have a significant effect on Italy’s import infrastructure, as projects are already plentiful and mainly designed to allow new entrants access to the market. Projects to increase capacity in the existing Trans-Austria Gas or Trans-Mediterranean Natural Gas pipelines, however, could be slowed by the crisis, as they would increase the dependence on Russian and Algerian gas, respectively.

The Interconnector Greece-Italy, promoted by Italian utility Edison SpA and Greek state Public Gas Corp. (DEPA) SA, would allow Caspian natural gas deliveries to Italy through Turkey and Greece. It received official political approval in November 2005. Construction of the 8 bcm/year (6 million tpy) pipeline is planned for 2007-10.

A dozen new LNG receiving terminals are also projected for construction in Italy, but to date only three have received national approval. Construction has begun on the Rovigo terminal in the Adriatic Sea, but the Brindisi project in Puglia still faces strong local opposition.

In February 2006, a 2.8-million-tpy project off Livorno, Tuscany, received final approval from the Italian ministries of industry and environment. The project, owned 51% by Spanish Endesa SA and Italian Gruppo Amga SpA, would cost €400 million and is to start operations in 2007. The remaining 49% is owned by private investors. The terminal still needs approval from the environment ministry.

• UK. The UK still produces the majority of the natural gas it consumes and does not import any Russian gas under contract. It will, however, become a net importer.

The Langeled pipeline from Norway and two new LNG terminals at Milford Haven will help alleviate this shortfall in the near-term. And, looking farther out, either the NEGP or the 15 bcm/year (11 million tpy) Dutch Interconnector project could supply the UK with Russian gas to cover future shortfalls.

The Russian-Ukraine crisis is likely to give a general boost to other European LNG terminal projects to the degree they provide access to alternative supplies. Poland and Germany in particular are likely to push for the construction of LNG terminals to reduce their dependence on Russian natural gas, despite the higher costs involved.

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Table 1 provides a sampling of new LNG terminals proposed in Europe outside of Italy.

Asia, Europe relations

A delay in Norway’s Snøhvit liquefaction facilities will increase the tightness of the already tight LNG market in 2006-07. The Atlantic Basin will not be able to meet regional demand for additional cargos in case of supply disruptions. LNG buyers in Spain, France, Turkey, and Belgium will probably want to improve their relations with Middle East and Asian suppliers to secure easier and quicker access to spot cargos, especially in the event of future supply disruptions.

Asian supply security

In contrast to Europe, where LNG represents only a small part of natural gas imports, several Asia-Pacific importers rely exclusively on LNG. It allows for enough diversification of supply sources to outweigh potential delays due to weather or maritime transportation disruptions, or disruption of a long-term contract.

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Of three long-time regional buyers, for instance, only Taiwan still relies heavily on Indonesian LNG (Table 2). This will change in 2008 when a 3.2-million-tpy contract between Chinese Petroleum Corp. and Ras Laffan Liquified Natural Gas Co. II (Rasgas II) comes into effect.

Other Asian countries depend entirely on pipeline supplies. Thailand relies exclusively on imports from Myanmar for the 30% of natural gas demand it meets through imports, and Singapore imports all its consumption by pipeline from Malaysia and Indonesia. These two countries are therefore more at risk in case of supply disruptions.

Singapore plans to diversify its methods of supply by building an LNG terminal. The country, however, also needs to diversify the sources of its natural gas to guarantee security of supply, looking away from Malaysia and Indonesia even if it means incurring a price increase.

Political risk

India is currently studying three major international pipeline projects, each carrying a significant level of political risk. Their effect on India’s supply security, however, should be limited.

• The volumes supplied by the Myanmar-to-India pipeline will be limited to around 300 bcfd.

• The Iran-Pakistan-India and Turkmenistan-Afghanistan-Pakistan-India pipeline projects carry more political risk. Under our base-case scenario of supply and demand in India, however, these pipelines would supply only 5% of India’s demand in 2015 and 18% in 2020. Similarly, and adding LNG supplies from Iran, India’s dependence on Iranian natural gas would be limited to around 10% of demand until 2017, increasing to roughly 20% in 2020.

In our base-case scenario of Chinese supply and demand, pipeline imports (mainly from Russia) will meet 13% of natural gas demand in 2015.

China’s policy for security of supply relies on three main points:

• Reducing the country’s dependence on foreign supplies by supporting domestic exploration and production. The recent increase in natural gas retail prices in China sought in part to improve incentives to invest in domestic exploration and development projects.

• Diversifying new supply projects (LNG receiving terminals and international pipelines) and suppliers.

• Systematically securing shares in foreign natural gas fields and investing in exploration and development projects abroad.

The author

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Cecile Jovene is a senior consultant at FACTS Inc. Before joining FACTS, she was a senior executive with Gaz de France, where she was responsible for procuring the company’s southern supplies. This included negotiating bilateral short-term contracts with gas producers, developing Gaz de France’s LNG trading activities in the Mediterranean basin, and optimizing the company’s Spanish assets by OTC gas and LNG contracts. She holds degrees in management, finance, and business from Bordeaux Ecole de Management.