Valdai Club

A reduction in the transit via Ukraine has become an issue of strategic importance for the Russian leadership.

Ten years ago Russia began reconsidering its energy pricing and transportation policy. An important policy shift -- known as the “strategy of transit avoidance” -- was implemented in order to directly link Russian energy resources and Moscow’s major clients in Europe, bypassing potentially unstable transit countries in the CIS. In this context, a reduction in the transit via Ukraine has become an issue of strategic importance for the Russian leadership, which considers Ukraine’s gas transmission system the weakest link of Gazprom’s gas supply chain. Naftogaz’s recent decision to breach its’ transit contract with Gazprom and to impose a 50 percent increase in transit fees for exporting Russian gas across its territory to Europe seems to confirm Gazprom’s worse suspicions and further increase Moscow’s determination to build Nord Stream – 2 gas pipeline in order to circumvent Ukraine. Furthermore, the decision to put the Turkish Stream gas pipeline on hold announced in early December 2015 further increased the strategic importance of the Nord Stream – 2 as the only new natural gas route circumventing Ukraine.

Apart from saving on excessively high Ukrainian transit fees, there is also an additional economic rationale justifying investment in this otherwise quite expensive transportation project. Most of domestic gas supplies in the EU originate from the rapidly depleting fields situated in the United Kingdom and the Netherlands. The gas production in the UK has declined from 96.4 billion cubic metres (bcm) in 2004 to 36.6 bcm in 2014. During the same period, Netherland’s gas output has fallen from 68.5 bcm to 55.8 bcm. Overall indigenous production in Europe (EU plus Norway) has decreased from 345.6 bcm in 2004 to estimated 258.8 bcm in 2015. Not only Nord Stream – 2 could supply EU countries currently dependent on the transit via Ukraine, there is also a new market niche for the Russian gas in the Northwest Europe.

Let’s also not forget, currency devaluation also had a positive impact on Gazprom’s lifting costs (including mineral extraction tax) which went down from $38.8 per 1000 cubic metres (cm) in 2014 to $24.7 per 1000 cm in 2015. These numbers allow Gazprom to easily outcompete future US Liquefied Natural Gas (LNG) supplies even at the current pricing conditions (U.S. domestic gas price (NYMEX) at around $70 – 75/1000 cm and transportation costs at $35/1000 cm)

However, it must be noted that all is not so rosy for this trans-Baltic undersea project.

One the one hand, economic crisis and low energy prices affect Gazprom and other consortium members – BASF/Wintershall, ENGIE, E.ON, OMV and Shell. Furthermore, economic sanctions imposed by the EU and the US -- although not directly aimed at the Nord Stream – 2 – affect the Nord Stream’s ability to raise long-term financing through debt capital markets, while funds are also becoming scarce in Russia.

On the other hand, the project might face a number of bureaucratic hurdles linked with the project’s compatibility with the EU 3rd Energy Package, while a number of new EU Member States have called upon Brussels to take action to ban the pipeline altogether. The situation is further complicated by claims that the EU Energy Law might be also applied to the Baltic’s seabed. Should this option become the reality, the Nord Stream – 2 will be forced to keep 50 % of its capacity reserved for the non-Gazprom suppliers both in submarine offshore and onshore pipelines. Gazprom already faces similar problems with the full unrestricted access to the OPAL gas pipeline in Germany and the company is likely to face similar difficulties with both onshore and offshore segments of the Nord Stream – 2.

An elegant solution to this problem is one that requires less time and work than simply trying to get an exemption from the existing EU energy rules. Russia has already liberalized its’ LNG exports and no one prevents Moscow from booking 50 % of the Nord Stream-2 pipeline for non-Gazprom supplies. This decision will be beneficial to all parties concerned: the project will be fully compatible with the EU Law; Gazprom will have its’ guaranteed share of gas supplies (minimum 27.5 bcm) and could also share the pipeline construction bill with Russian independent gas suppliers; the participation of non-Gazprom suppliers will allow to export more Russian gas to Europe and consequently increase the Government’s revenues. Last but not least: the exports liberalization will also allow foreign buyers to purchase Russian gas on the St. Petersburg International Mercantile Exchange (SPIMEX), thus raising profile of this platform as the key place offering a fair price-setting mechanism for natural gas in Europe.