Special Report: Demand for Russian Gas will require massive investment
Tim Lambert
Wood Mackenzie
Edinburgh
Wood Mackenzie expects the call for Russian and Central Asian gas will increase from slightly less than 680 bcm today to 945 bcm in 2020.
Russia’s economy is highly energy intensive, and gas supplies a significant proportion of energy demand. Although future growth in gas demand is subject to some significant uncertainties - the extent to which gains arising from economic growth will offset reductions arising from price increases and from increasing energy efficiency - we here at Wood Mackenzie expect that Russian domestic gas demand will continue to grow at an average 1.1 percent annually, from some 420 bcm in 2003 to just over 500 bcm by 2020.
The western part of the former Soviet Union (Estonia, Latvia, Lithuania, Belarus, Ukraine, Moldova, and the Caucasus states) will continue to be heavily dependent on gas transported from or via Russia. By 2020, we forecast that imports into the western FSU will increase to 136 bcm from 100 bcm in 2004.
While Europe’s dependence on gas imports from or via Russia is already high (Russian gas accounts for more than a quarter of the western European market), European demand for gas will continue to grow while indigenous production from areas such as the North Sea will decline.
The shortfall produced by these developments can be partly met by liquefied natural gas (LNG) and from sources such as Norway, Algeria, and the Middle East. But these supplies are not unlimited, and Wood Mackenzie forecasts that an increasing contribution will need to come from Russia. In fact, we believe that Russia will account for nearly 40 percent of the market by 2020, compared to around 25 percent today. In volume terms, this equates to an increase from around 140 bcm currently to 330 bcm by 2020.
European gas supply by source 2000-2020
Gas from Central Asia (with the exception of Azeri volumes) is included within the Russia piped category based on the assumption that these volumes will flow via, and essentially be controlled by, Russia.
As a result, the total Russian, western FSU, and European demand for gas from or via Russia will increase by almost 40 percent by 2020, from just less than 680 bcm today to 945 bcm in 2020. This does not include domestic demand in the East Siberia and Far East regions, LNG exports, or pipeline exports to Asian markets. The 945 bcm requirement will need to be met either by gas produced in Russia or Central Asian gas transported westward via Russia.
Massive investment needed
Russia’s supply potential is not in doubt. The country has commercial and technical reserves that could sustain production at current levels for about 85 years. There is also a significant exploration upside. Russian gas production, which totaled 639 bcm in 2003, has the potential to meet the call of 945 bcm by 2020.
However, a key feature of Russia’s future production profile is the decline of Gazprom’s three producing fields (Urengoiskoye, Yamburgskoye, and Medvezhye) - giant, shallow gas fields that have produced huge volumes of cheap gas for many years. As these fields decline, they will be replaced by others that are more remote, technically challenging, and costly. Significant investment will be required to make this transition, and the average cost of gas supply from Russia will rise considerably, from approximately $26/mcm in 2005 to $43/mcm by 2020.
In the future, Gazprom will continue to dominate the supply picture with production of 635 bcm by 2020. However, the contribution from other Russian producers will become more significant in the longer term. We estimate that by 2020 large volumes (up to 245 bcm) of non-Gazprom gas will be required to meet demand in addition to 80 bcm of Central Asian volumes.
Considerable infrastructure investment also will be needed in the transportation system to enable exports to meet required levels. Given that a significant proportion of the Russian pipeline system is old, repair and replacement of existing infrastructure will be required. In addition, construction of new schemes will be necessary to accommodate the forecasted level of increased exports to Europe.
The total capital expenditure requirement for upstream developments, the transportation system within Russia, and new pipelines to the European border amount to around $240 billion (in 2004 US dollars) over the 2004-2020 period. This represents average annual investment levels of $14 billion.
The estimated $122 billion investment in the Russian pipeline system would account for around 50 percent of total requirements. Investment levels will be much higher in the latter part of the forecast period, particularly from 2011-2015.
Investment requirements to meet the western call on Russian gas
Lower demand for Russian gas from Europe would have a significant impact on investment requirements. If European demand growth were half the level assumed in the analysis above, the need for major new field and infrastructure developments would be substantially reduced and capital investment levels almost $50 billion less.
Can Gazprom finance the investment?
This huge investment program rests largely with one company - Gazprom, which dominates the entire gas chain in Russia. It produces two thirds of the country’s gas output, it is the monopoly transporter and gas exporter, and it supplies 58 percent of the domestic customer base through its distribution business.
Given this position, much of the investment burden will fall to Gazprom and a natural question is: will the company be able to finance the investment required?
On the positive side, Gazprom’s revenues are set to rise steeply, driven by two key developments. First, significant increases in domestic prices are expected in the near term. In 2004, the Russian government agreed to a track of average price rises of 23 percent, 11 percent, and 8 percent, respectively, from 2005 through 2007.
Early this year, Gazprom argued that current levels of domestic prices are insufficient to cover costs and pressed for bigger price increases in 2006 and 2007. It seems likely that the Russian government will accede to this (as it has in the past), although the extent to which this can continue to happen in the future will be limited by the government’s aim to control inflation.
Second, export revenues will rise dramatically. Prices in European markets are linked to oil prices and are much more attractive than domestic markets. Revenues will increase dramatically as volumes increase. The combination of these two effects will nearly triple Gazprom’s revenues to around $80 billion by 2020.
Costs are a major concern, however. Gazprom’s recent record on controlling costs - capital and operating costs - has not been impressive, and its ability to finance its activities could be severely impaired if it fails to get a grip on costs.
Wood Mackenzie believes that, if oil prices remain in excess of $25/bbl, Gazprom will likely be able to finance the necessary investments required from its own resources through 2010. Post 2010, however we believe that Gazprom could be financially stretched, particularly at low oil prices, and might have to secure significant levels of debt finance. Additionally, a lower demand for gas would also benefit the company financially due to the lower requirements for capital investment that would apply.
Alternatively, Gazprom would need to seek a higher European gas price than would be given by linkage to oil at prizes of around $20/bbl - a potential upwards pressure to de-link European gas prizes from oil.
What are Gazprom’s plans?
Gazprom’s aspirations extend far beyond satisfying the demands of European markets, and it has ambitious plans for the future:
• LNG: Gazprom is intent on developing a position in global LNG. The company has agreed to exchange pipeline gas in Europe for LNG delivered into the US, which indicates that a rapid entry into the LNG business is planned.
• Power: Gazprom is also engaged in development of a position in the power sector - it is already a significant shareholder in UES, Mosenergo, and other regional energos.
• Oil: While the proposed merger with Rosneft has been aborted, it is possible Gazprom will still seek to achieve a significant position in the Russian oil sector.
• Sakhalin: Gazprom looks set to achieve long-held ambitions to secure a stake in the Sakhalin projects, Sakhalin-2 having the additional attraction of involvement in LNG.
• Overseas expansion: Gazprom can be expected to continue its program of acquiring gas companies in eastern Europe, establishing strategic partnerships with key players, and building market share in western European markets such as the UK.
In addition, as a key instrument of Russian government policy, Gazprom will be required to undertake other strategic initiatives, including the development of East Siberia, extension of the gas supply system throughout Russia, and the development of new foreign markets such as Asia and the US.
Taken as a whole, the full range of activities that Gazprom might undertake represents a massive challenge. Where does supplying gas to Europe stand in Gazprom and the Russian government’s priorities?
A key determinant of the company’s plans is the Russian government’s energy strategy. In this context, it is clear that the call on Russia from Europe considered in the analysis above (~330 bcm by 2020) significantly exceeds levels envisioned in Russia’s stated energy strategy (~180 bcm).
Although there are signs that Gazprom may be planning to deliver in excess of 200 bcm, there remains a large gap between what Europe might need by 2020 and what Gazprom might be gearing up to deliver.
What this means to Europe
If the required volumes of gas were not available from Russia, or there was a perception that this could be the case, then European customers, governments, and policy makers would need to address a number of issues:
• What are the options for alternative sources of gas?
• What could be done to diversify transportation routes to the European market?
• Should reliance on gas be limited via government policies such as strengthened emphasis on energy efficiency measures or moratoria on new gas-fired generation?
• What are the implications for the future of nuclear power?
European customers can expect upward price pressure post 2010 in a $20.50/bbl oil price environment, given that Russia will need to recover increased costs of supply, and its market share will provide the leverage to do so.
This upwards pressure could be greater in more westerly markets (such as the UK and France) if and when gas prices increasingly reflect transportation cost differentials between hubs, as opposed to the current netback pricing mechanism.
The relationship between Europe and Russia will remain finely balanced as one of mutual partners in the gas industry. However, given Europe’s growing dependence on Russia to meet its gas requirements, the real influence of the European Union on Russian policy - such as introducing TPA and competition into the Russian gas sector - may be limited.
While Gazprom has already bowed to pressure from the European Union to remove certain restrictive elements from long-term contracts, its need to underpin investment in the future development of reserves and infrastructure will mean that long-term contracts will remain a firm feature of the European gas industry.
Therefore, European buyers will need to accept that they will have to continue to manage long-term import contracts within the increasingly competitive environment of the European downstream gas market. OGFJ
The author
Tim Lambert, ([email protected]) vice president - energy consulting for Wood Mackenzie, has more than 15 years of energy consulting experience with a focus on strategy and market analysis, restructuring, policy analysis, and mergers and acquisitions. His clients have included such major international oil and gas companies as ExxonMobil, Shell, PDVSA, ChevronTexaco, and Gazprom. He has also worked with national oil companies and several US and European utilities. Prior to consulting, Lambert served with a major UK energy company and for Shell. He directed and was a primary author of Wood Mackenzie’s multi-client studies on Russian gas (2004) and Russian oil (2003).
Russian gas study released
Wood Mackenzie's study Time to Step on the Gas: Will Russia Realize its Potential? provides a comprehensive assessment of Russia's gas sector. The study examines the Russian gas market and the outlook for reform; the "western" call on Russian and Central Asian gas and its implications. It also analyzes the strategy of the key player, Gazprom, and its ability to finance the investment needed in the future, and considers the implications of the study for a range of stakeholders in the Russian gas sector.