The growth of shale gas market segment is an indirect threat to Russia, which has already materialized. Also European power plants are increasingly switching from gas to coal on the back of increased imports of cheap American coal.
In early July, Moscow hosted the second summit of the Gas Exporting Countries Forum (GECF), bringing together market majors in the Kremlin to outline development strategies for this industry.
The Gas Exporting Countries Forum did not bring about any breakthroughs. No game-changing agreements were reached. Unlike Saudi Arabia in OPEC, which is by far the biggest oil producer and leads the pack in a number of other indices, GEFC members lack an outspoken leader capable of promoting its agenda. Technically, Russia produces the most natural gas, but our exports are limited to the European market, and Russia’s share on the liquefied natural gas (LNG) market is insignificant.
The GECF is unlikely to become the OPEC of the gas industry. In fact, the two organizations have little in common, besides the fact that the GEFC also brings together major exporters, in this case of gas. OPEC coordinates production, but this is relatively informal process. Although free from binding obligations, OPEC members believe that a shared position benefits all. What OPEC actually does is issue recommendations with regard to oil production, which would be extremely hard to do in the gas industry. First, changing gas production volumes is technically challenging. For instance, Saudi Arabia acts as a global coordinator within OPEC. With the country’s oil output concentrated in several major fields and controlled by 100% state-owned Saudi Aramco, it has broad latitude to adjust production volumes. Second, all gas companies of GECF member states operate under long-term contracts and are obligated to honor them. Such contracts set forth specific volumes that the company must supply. This means that calls from an organization to scale down gas production would run counter to commitments under long-term contracts.
Being unable to influence output volumes, the organization focuses on reaching common ground among major gas exporters with respect to price formation in the gas market. There is a kind of understanding among importers and major consumers that gas is an independent energy resource, which means gas needs pricing mechanisms that are independent from other fuels. The system in which gas prices are pegged to oil prices emerged in 1970s. A lot has changed since then: gas no longer competes against crude oil and petroleum products. Consequently, it is the market that should determine a fair price for 1,000 cubic meters of gas. That said, a number of countries, including Russia, believe that the development of the global gas industry has been driven by the fact that the price of gas was tied to that of crude product, and that abandoning such pricing mechanisms is not a smart option.
The European market has changed dramatically over the last five years. The UK used to have the only gas trading hub in Europe, which was regarded as relatively liberalized. Now there are other European trading points, although they are still far behind the US or the UK’s National Balancing Point (NBP) in terms of liquidity. Market pricing also impacts the price of gas as an independent commodity, which should also be taken into account. As we all know, Gazprom lost a lawsuit to Germany’s RWE in late June, when the court ruled that the Russian gas giant must change its pricing formula by introducing spot pricing, which sets a precedent for amending long-terms contracts. In my opinion, such moves are not aimed against Russia. The European Union and the European Commission are at liberty to take such actions, since they are entitled to set the rules for their internal market. Although Gazprom used to vehemently oppose any changes to long-term contracts, Russia now seems to have moved on to a more balanced approach, which I consider to be a step in the right direction. For instance, while Russia has been selling gas at high prices, Norway was willing to offer discounts and saw its European-bound deliveries climb in the year 2012, while Russia’s exports declined. What this actually means is that Norway has taken a bite out of Russia’s market share. Russia is losing profits due to unfavorable court rulings, while its market share is shrinking. I believe that these developments call for a more flexible approach.
Qatar is currently one of the major players on the LNG market. The country is seeking to consolidate its leadership in the segment, and it has already become the largest producer. Qatar benefits from a favorable geographic location between Europe and Asia, and is also a maritime country. As a major producer, the country can balance its exports by supplying both the European and the Asian markets, depending on which one offers the best price. For example, last year LNG prices were high in Asia and low in crisis-hit Europe, which prompted Qatar to shift much of its exports to the Asian market. Qatar’s annual export capacity currently stands at about 100 million metric tons, which is slightly below one third of global LNG supplies. Russia is a small player, behind even such countries as Indonesia and Malaysia in terms of LNG deliveries. However, Qatar’s production capacity is no longer growing, since it needs to expand its resource base and develop new fields, while the country has recently introduced a moratorium on the development of new gas fields.
A number of new players are about to join the LNG market, including Australia, which is expected to surpass Qatar within five years, while the US is granting its producers permits for exporting LNG to non-FTA countries. Russia has to take swift action, as competition on the LNG market is heating up. For instance, high prices on the Asian market have made it an attractive destination for LNG exports. Russia has a number of advantages here. The Japanese market is attractive for Russia, since a tanker needs just a few days to travel from Sakhalin, which lowers transportation costs. Projects under development, such as Vladivostok-LNG, are strategically smart, since they provide Russia the opportunity to consolidate its foothold in the lucrative Asian market. It should also be taken into account that demand for LNG is traditionally low in Europe – Spain being the only exception – while demand for gas has remained unchanged over the last ten years. It has not gone up. The Asian market is different. It continues to expand. Many exporters view Asian markets as a strategic priority, and Russia should also step up efforts in this direction. President Vladimir Putin promised at the St. Petersburg International Economic Forum to liberalize LNG exports. The relevant decisions are expected to be taken by the end of the year, giving the green light to independent producers, such as Novatek’s Yamal-LNG and possibly Rosneft, which could roll out a Sakhalin-based LNG project.
Another important factor is shale gas. The growth of this market segment presents an indirect threat to Russia, which, in fact, has already materialized. At a first glance, the logic behind these developments is not always clear. Why is demand for Russian gas decreasing in Europe? As a matter of fact, European power plants are increasingly switching from gas to coal on the back of increased imports of cheap American coal. In fact, low gas prices have led to a decline in coal-based power generation in the US. This has made coal redundant, which resulted in cheap Europe-bound exports to the detriment of Russian gas. The reduction in Russia’s share on the European market is attributable to competition between different fossil fuels, not to European consumers turning to other gas suppliers. The US does not currently have export-ready LNG, but the situation is expected to change within the next five years, which will directly threaten Russia’s standing. There is a lot talk in Russia about how production costs of shale gas are several times higher than that of conventional gas. However, it should be noted that not only production costs but also the final price matter. A number of experts from across the spectrum agree that shale gas production costs vary from $80 to $150 per 1,000 cubic meters depending on the extraction field. Gazprom’s production costs are actually lower at $40 (including the Mineral Extraction Tax), but the offering price of Russian gas on the European market stands at $370 per 1,000 cubic meters. Consequently, apart from the difference in production costs, the relevance of the offering price should also be taken into account. Russia must come to the terms with the fact that shale gas is here to stay. Shale gas accounts for about a third of US gas production, which is about 200 billion cubic meters or one third of Russia’s gas production. These are major figures, so it would be hard to ignore them and pretend that they do not exist. This situation is sure to impact Russia’s standing as a major energy exporter. Russian companies should bear in mind that the US is actively using this new energy resource.