Local Gas Pricing Hurts Sakhalin Gas-Export Project Economics

July 19, 1999
Planned gas-pipeline projects on Sakhalin Island will suffer from the current gas-pricing scheme employed in the country. And lasting effects of the Russian financial crisis in August 1998 will only exacerbate the poor economics of the projects.

Planned gas-pipeline projects on Sakhalin Island will suffer from the current gas-pricing scheme employed in the country. And lasting effects of the Russian financial crisis in August 1998 will only exacerbate the poor economics of the projects.

Mandatory gas sales will be at less than $10/1,000 cu m ($0.28/Mcf).

Worsening economics

Domestic sales of natural gas in Russia have been a money-losing business since the breakup of the Former Soviet Union.

Before the financial crisis of August 1998, the state-regulated price of gas averaged $39.10/1,000 cu m (approximately $1.16/Mcf), which was higher than the average delivery cost of gas in Russia. The market, however, could pay only 65% of gas bills with the rest being completely lost. On each 1,000 cu m sold in Russia, therefore, former state gas-transmission company Gazprom was losing at least $10.50/1,000 cu m (nearly $0.30/Mcf).

Since the crisis, the Russian currency has lost three-quarters of its value, but the gas price-fixed in rubles-has remained the same. This has driven the average domestic price down to $10.56/1,000 cu m. The drop in delivery cost was less drastic because the cost has a number of dollar components (debt service, for instance), which have not changed.

Click here to enlarge image

As a result, Gazprom is now losing an estimated $13.16/1,000 cu m (Table 1). Apparently, from the government`s standpoint, Gazprom makes enough profit on export sales to Europe and can afford the domestic loss. This was true before last year`s crisis.

The collapse of the ruble caused Gazprom to lose $1.8 billion in 1998. The Russian market, however, is unable to pay a higher price for gas, and the government has in effect left it to Gazprom to subsidize that part of the Russian economy.

The state will likely regulate the gas price at levels below the delivery cost for another decade, so that the domestic market will continue to function as an additional cost of exports.

A similar situation is likely to develop in the Russian Far East after launch of the Sakhalin gas-export program. It is useful, therefore, to evaluate the possible gas off-takes by local customers and associated economic losses.

Pipeline system

Click here to enlarge image

The pipeline system for the Sakhalin gas stretches into the two provinces of Sakhalin and Khabarovsk (Fig. 1).

The Sakhalin portion consists of 355 km of 20-in. pipeline and 175 km of extensions, loops, and feeding pipelines of smaller diameters in the northern part of the island. Natural gas feeds one power plant, supplies residential markets, and supports oil production.

Click here to enlarge image

In the late 1980s, a 440-km, 20-in. pipeline from Sakhalin Island to Komsomolsk on the mainland was built to feed the Amurstal steel mill, two power plants, and the residential sector of Komsomolsk-on-Amur, Khabarovsk province.

The steel mill, once the largest one in the Russian Far East, is now bankrupt and operates at only 25% of capacity.

The Sakhalin system expansion envisions a new 700-km, 40-in. pipeline from about the Katangli area to Yuzhno-Sakhalinsk in the southern part of the island.

In the Khabarovsk province, the existing pipeline will be extended 68 km to Amursk to feed the local power plant and residential sector. Construction started earlier this year.

The Russian government`s Russian Far East gas program anticipates construction of a new 1,400-km, 40-in. pipeline from Sakhalin to Komsomolsk-on-Amur, Khabarovsk, and Vladivistok (Primorye province). This $2.2 billion project, however, is unlikely to get under way before 2015 because of the lack of financing.

The officially reported recoverable gas reserves of 672 billion cu m of Sakhalin are a bit too low to feed two 40-in. pipelines as well.

Domestic market

Table 2 breaks down historic gas consumption and the current price of gas in the two provinces.

Unlike oil or coal prices, the price of natural gas produced by Sakhalinmorneftegaz is regulated by the state. Moreover, Russian law makes it very difficult for a producer to reduce or halt supplies even to nonpaying clients.

This makes natural gas extremely attractive for the heating and power-generating companies of the two provinces because they are the natural beneficiaries of gas expansion projects in the area.

The heating and power sector is the least expensive to switch to natural gas. Large volumes of the fuel would provide the biggest benefits from this switch.

Click here to enlarge image

Table 3 presents the current state of the heating and power-generating sector of the two provinces along with estimated maximums for 2015.

Future gas consumption is based on the current load factor (number of firing-hours per year) of each plant and assumptions on the gas use per kw-hr of electricity. It is assumed that the 2,740-mw of installed capacity of the Primorye province will continue working on coal through 2015.


East European Gas Analysis Inc. has developed low and high scenarios for gas use in the two provinces.

The low scenario has the following assumptions:

  • Slow recovery from the economic crisis
  • Large number of nonpaying customers and shortage of capital
  • Low price of gas.

The high case assumes a faster economic recovery, making more capital available for conversion from coal to gas and permitting a higher state-fixed price of gas.

Click here to enlarge image

The high scenario (Table 4) also assumes half of the Vakhrushev plant capacity and all of the Yuzhno-Sakhalinsk plant to switch to gas by 2015. The Amursk power plant is expected to switch from coal to gas completely.

The low scenario assumes a slower introduction of gas in the power sector.

The municipal and residential sector takes more time and money to convert to natural gas. The low scenario here assumes the per-capita consumption of this sector would reach the average Russian level. The high scenario expects the consumption to reach the average for the climatic zone of the two provinces.

In general, by 2015, the area comprising the two provinces will take a moderate 2.7-3.5 billion cu m/year from the total production flow of natural gas. These sales will cause losses, especially through 2005, which in turn would hurt the net present value of the cash flow of the entire export project.

The Author

Click here to enlarge image
Mikhail Korchemkin is founder and president of East European Gas Analysis Inc., Malvern, Pa., a consulting firm specializing in cost-benefit and financial analyses of oil and gas projects and fuel-market forecasting in the Former Soviet Union. His previous experience includes teaching at the University of Pennsylvania and visiting scholarships at Harvard University and Erasmus University (The Netherlands).

In the 1970s and 1980s Korchemkin was a researcher and project leader for several feasibility studies performed for the Soviet Gas Ministry, now Gazprom.

Korchemkin holds an MS from the Tallinn Technical University, Estonia, and PhD in economics from the Estonian Academy of Sciences.