Gas trade between Russia and Europe has had its ups and downs for over half a century but has brought tremendous benefits to both sides. Europe’s energy policy ambition of a fast shift to a carbon-neutral economy for which natural gas is undesirable and merely a near-term, stop-gap solution is a threat to Russia-Europe gas trade. In these circumstances, Russia is likely to intensify its efforts to diversify away from its dependence on the European gas market both in terms of methods of gas delivery and target markets, writes Vitaly Yermakov, expert with the Centre for Comprehensive European and International Studies, National Research University Higher School of Economics.
How short memories are! There was an extreme glut of gas in Europe in the 2018-2020 seasons. Gas prices during summer of 2020 dropped to less than $65 per million cubic metre on the European gas hubs. Gazprom played the role of involuntary swing producer, adjusting its pipeline exports to accommodate the sharp decline in demand for its gas, plus the oversupply of LNG that had existed for several years. Making significant losses on its gas exports to Europe, especially on the route running via Ukraine, where transit tariffs are two times higher than on alternative routes, Gazprom refrained from launching a price war, and instead “waited out” the glut as a price taker, thus bearing both the volume risk and the price risk.
In 2021, however, the market pendulum has swung back. A “series of unfortunate events” — cold weather, a rebound of economic activity, and limited wind power generation due to quiet weather — have put pressure on the European gas balance. With declining gas production in Europe and a limited availability of LNG owing to the strong pull from premium markets in Asia, the European gas market started to tighten quickly during the summer. The market tightness in Europe stems from a combination of demand-side factors such as weather and the economic recovery, alongside supply-side factors including declining European gas production and reduced supply from other importers of gas to Europe (save for Algeria), including LNG.
The levels of gas in European storage have been running significantly lower than in previous years. Since September 2021 gas prices at the European gas hubs started to set new records on almost a daily basis. In the beginning of October, the gas price reached the previously unthinkable level of $1300/mcm. As the world’s largest pipeline gas exporter and a significant emerging LNG exporter, Russia is appearing a clear winner of the market tightening. At the same time, gas buyers have been struggling to secure supplies, even at premium prices, and have been concerned about the availability of gas and possible energy insecurity during the coming winter.
Europe now demands greater flexibility from suppliers—in both price and the ability to swing gas deliveries.
Dutch gas used to relieve most of the seasonal flexibility in Europe. With declining production from the Groningen field, this flexibility is now lost. Many European analysts and market watchers expected that Russia, as the largest swing producer and exporter, would value an opportunity to expand its market share, at least in the short term, and quickly respond to higher demand for gas in Europe in 2021.
The litmus test of Gazprom’s capacity as a swing supplier was its ability to drop production dramatically in 2020 and then to bring it back up again quickly (and then some) in 2021. Gazprom has not been able to bring any more spare production capacity online—it does not have more left. Gazprom has been “firing on all cylinders”, pushing its gas output to maximum levels at all of its key fields for most of 2021 so far. There was no sharp cyclical decline in output over the summer months, as Gazprom’s near-term productive capacity reached its peak limit and remained close to these levels.
By the beginning of the summer of 2021, Gazprom proved to be unable to cover the call for increased gas production or to fully refill gas storage—both in Russia and in Europe. The explanation for that is due to the fact that the circumstances in 2021 have been quite unusual: very low gas prices in 2020 prompted extremely high withdrawals of gas from storage to minimise transportation costs and reduce losses. And then, during 2021, the combined effects of a robust rebound of gas demand, extreme cold and then extreme hot weather and limited availability of LNG for Europe have resulted in extreme market tightness and record high gas prices. Amid these circumstances, Gazprom has increased its deliveries to Europe and managed to meet its contractual obligations but could not single-handedly address Europe’s energy insecurity.
Russia is not running out of gas and its prolific gas reserves allow Russia to meet much higher overall demand, but this requires time, money, and contractual assurances of offtake. Bringing additional production online cannot be done at the push of a button. Russia can produce much more gas in the medium and long-term but wants to secure this output by signing new supply contracts with offtakers; it is not going to maintain spare productive capacity “just in case”, to be able to meet the spikes of the European gas demand for a few weeks during the year.
The geography of Russian natural gas reserves, production, and transportation has been shifting: a lot of new reserves are available and ready for development on the Yamal peninsula, whereas legacy production in the NPT is declining. This tectonic shift in Russia’s production base has been accompanied by a change in the configuration of the gas transportation system and gas flows within Russia and abroad.
Particularly significant is the downgrading of the Central corridor of Russia’s GTS. The physical links between the Central corridor (connecting Russia’s old and declining gas fields in Nadym-Pur-Taz with consumers in Central Russia and leading towards Ukraine), and the Northern corridor (connecting Russia’s growing new production in Yamal with northwest Russia and leading onto Nord Streams) are few, and Gazprom cannot swing the flows between the Northern and Central corridors, especially during the winter. On top of that, the location of the new GPP plant at Ust-Luga (to be finished in 2023) means that the incremental production of wet gas from NPT’s Achimov developments will be diverted from the Central corridor towards the Northern corridor, further limiting pipeline capacities leading towards Ukraine.
Under the current agreement with Ukraine, Ukraine enjoys pre-paid ship-or-pay contacts with Gazprom. Gazprom has booked all the capacity under these arrangements from the Ukrainian company GTSOU (about 40 Bcm per annum) but has not been booking additional interruptible capacity offered by Ukraine. Gas flows via Ukraine and Belarus/Poland are unlikely to increase. Moreover, these flows may exhibit significant volatility, which is already the case for Yamal-Europe and is likely to become the new reality for Ukraine after the expiration of the transit ship-or-pay deal with Gazprom in 2024.
Gazprom prioritises the routes (i.e., Nord Stream 1 and Turk Stream) that connect to Gazprom subsidiaries that run these pipelines, thus saving on transit fees. The transportation costs become part of Gazprom’s internal accounting. Also, the transportation distances are shorter. Given the regulatory uncertainty around utilisation rates on Nord Stream 2, Gazprom seems to be reluctant to add new productive capacity on the Yamal Peninsula proactively for fear of idling the investments.
In the future, Russia will likely not be able to meet sudden spikes in European demand. With lots of available transportation capacity leading towards Europe, Gazprom could ramp up exports to Europe substantially but would only do so if the offtake is guaranteed by new contracts. There is no point in spending capex on maintaining spare productive capacity that would be used only during short-term spikes in demand. The supply flexibility has a lot of value, and Gazprom will be looking at ways to monetise it.
Gas trade between Russia and Europe has had its ups and downs for over half a century but has brought tremendous benefits to both sides. Europe’s energy policy ambition of a fast shift to a carbon-neutral economy for which natural gas is undesirable and merely a near-term, stop-gap solution is a threat to Russia-Europe gas trade. In these circumstances, Russia is likely to intensify its efforts to diversify away from its dependence on the European gas market both in terms of methods of gas delivery and target markets. This means the end of the era of new upstream investments targeting Europe and new gas pipelines from Russia to Europe. Instead, Russia intends to allocate new investment to developing new LNG capabilities and accelerating its Pivot East. Russian gas output in Eastern Siberia has been rising to meet the schedule of the contracted deliveries to China via Power of Siberia. Gazprom is negotiating new contracts with China, which may become game changers in the overall orientation of Russian gas export flows.