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Clock ticking on China-Russia gas supply deal talks

Russia still hopes to strike a gas supply deal with China – vital if the country’s strategic shift from Europe to Asia is to succeed. But, as Justin Jacobs argues, Russia needs to act quickly or miss out on the opportunity

After more than a decade of fraught negotiations, time may finally be running out for China and Russia to agree a major gas supply deal that could reshape the region’s energy relations, UK-based think tank Chatham House warned in a new report. “The next few months will be crucial for decisions on the entry of Russian pipeline gas to China. Missing the opportunity will deprive both countries of a win-win solution to their energy and development problems,” Keun-Wook Paik, an Asia energy expert at Chatham House, wrote in the report, Through the Dragon Gate? A Window of Opportunity for Northeast Asian Gas Security.

On the face of it, the logic of the long-discussed deal is straightforward. Russia’s vast, untapped gas reserves in East Siberia need a market. Just across the border, meanwhile, China expects its gas demand to quadruple to as much as 550 billion cubic metres a year (cm/y) over the next 20 years and is investing billions of dollars around the world to secure supplies to meet that demand.

But a deal has proved maddeningly elusive for the countries. A series of talks at the highest levels of government, which most recently saw Russian president Vladimir Putin visit Beijing in June 2012, have failed to produce a deal.

Price has been the major stumbling block. Russia has insisted that China pay more than $300 per thousand cubic metres (/’000 cm), or $8.50 per thousand cubic feet (/’000 cf), according to reports. That would keep prices roughly in line with Russian gas monopoly Gazprom’s revenue from European gas sales.

Russia says the price is necessary to make development of the gasfields and associated infrastructure economic. Moreover, Gazprom is loathe to offer a lower price to China at a time in which it is renegotiating terms with many of its major European buyers, who could turn around and demand similar terms.

China, meanwhile, has pushed for a price around $200/’000 cm, or $5.66/’000 cf, in line with the cost of pipeline supplies from Central Asia. China’s major state-run energy companies have encouraged the government to hold firm on its price position. The companies stand to lose billions of dollars if they are forced to import gas at European prices, only to have to sell it into the domestic market where government-set prices average around $5/’000 cf.

Although price has been the major impediment to a deal, the countries have also been unable to bring their broader energy and political interests into alignment.

For Russia, the gas supply deal with China marks a strategic shift. It is hoping to further diversify its sales away from Europe, where demand for Russian gas is expected fall in the coming years, to Asia. And although China is the lynchpin in Russia’s shift to the east, it is only part of the strategy. As Paik says, Russia also sees major supply deals with South Korea and Japan as integral to the strategy. “China is an essential part of the picture, but the Russian government is keen to avoid being locked into a relationship with it as the single dominant customer,” Paik said.

Pipeline plans

Russia has proposed building both an extensive gas pipeline network as well as liquefied natural gas (LNG) export infrastructure to link the East Siberian fields with the Chinese, South Korean and Japanese markets. But there are hurdles at every stage of the plan.

First, Russia has prioritised exports into western China, via the so-called Altai Route. That route would pipe gas from West Siberian fields into China’s Xinjiang province. From there, Gazprom hopes the gas can be integrated into China’s domestic pipeline network.

The route holds some major advantages for Gazprom. Because it would rely on existing producing fields and infrastructure, it would be cheaper to develop. Perhaps more importantly, by sending gas to both Europe and China from the same supply source, it could pit the two against each other, making the supplies a more potent political tool for the Russian government, particularly in its dispute with Ukraine.

China, though, has little interest in the Altai Route and has rebuffed Gazprom’s efforts to gain access to the West-East Pipeline corridor, which pipes gas from Central Asia to southeast China. Instead, Chinese officials prefer the East Siberian proposal, which would bring gas into China’s more populous northeast provinces, where there is a greater need.

China had offered to buy 20bn cm/y through the route. Russia, though, says it needs commitments for more than 30bn cm/y to make development of its East Siberia gasfields economic.

As a result, Russia is seeking a deal to supply a further 10bn cm/y from the fields to South Korea. Russia’s preferred development plan is the construction of a pipeline from Russia through North Korea into South Korea.

That route would achieve an important political goal for Russia, making it an indispensable player on the Korean peninsula, giving it a stronger voice in international talks over North Korea’s nuclear programme and a central role in the region’s development.

However, there are a number of seemingly insuperable obstacles. Not least of which is that North Korea and South Korea are, technically, still at war with each other. Relations between the countries are prone to repeated cycles of brinksmanship. It seems unlikely that South Korea would risk its security of supply, given the likelihood of future disputes with Pyongyang. Both countries have seen leadership changes recently, with Kim Jong-Eun taking power in North Korea, and Park Geun-Hye in the south. Park and Kim could choose to take up the proposal again, but it is far from certain. It is also unlikely that the pipeline could be built without a broader rapprochement between the countries.

China, for its part, does not seem to believe the pipeline will be built any time soon. Last year it put forward an alternative proposal for a subsea gas link running from Weihai on China’s Yellow Sea coast to Incheon in South Korea. To sweeten the offer, China offered to buy a further 10bn cm/y of Russian gas, bringing its total commitment to 30bn cm. Assuming South Korea sticks with its pledge to purchase 10bn cm/y, that would push the total supply opportunity for Russia to 40bn cm/y, making the development of Gazprom’s East Siberian reserves economic.

Russia has, in the past, rejected the subsea pipeline proposal, even though a detailed feasibility study indicated the project is both technically and economically possible, in favour of the North Korea route. But after years of failed negotiations it may be forced to revisit the proposal.

In the meantime, South Korea has been aggressively expanding its investment overseas to secure gas supplies, potentially undercutting the need for any Russian gas at all.

Russia also sees Japan, the world’s largest LNG buyer, as an important part of its northeast Asia strategy, particularly after the Fukushima nuclear disaster, which has led to a rapid rise in gas demand. Russia has proposed building an LNG export terminal in Vladivostok, on its Pacific coast, to supply Japan with up to 10m tonnes a year of LNG. The countries have signed a memorandum of understanding on the project, but it has not yet sanctioned.

However, without the East Siberian gasfields, the Vladivostok project has no feedstock. And developing those fields for just the Vladivostok terminal is unlikely to make economic sense. Progress on the Vladivostok terminal, then, is linked to progress on supply deals with China and South Korea.

Russia has found itself in a bind. It needs a series of highly complex gas supply deals to move forward in unison, otherwise it might lose all of them. “There should be a fantastic opportunity for Russia, which sits in both Europe and Asia, to benefit in the shift to Asia. But Russia is not, at this stage, in any way able to capitalise on that opportunity,” said John Lough, a Russia expert at Chatham House with experience in Russia’s energy industry.

In energy relations with China, Russia has been outmanoeuvered by Central Asian producers. “The Russians are very concerned by the speed of Chinese penetration into Central Asia, particularly their ability to work out an export deal very quickly. That has been a wake-up call for the Russians, but I wouldn’t say an awful lot of action has been taken,” Lough added.

Out of time

Time may be running out for Russia, Paik warned. Changes in the global gas market are only going to make a deal more difficult. Three developments in particular are working against Russia: the development of China’s domestic shale gas reserves; the likely emergence of East Africa as a major LNG supplier to Asia; and the transformation taking place in North America that could see the US and Canada export LNG to Asia. “I’m not that optimistic about a shale-gas revolution in China before 2020,” Paik said. “The real threat is the major gas finds in East Africa.”

Both Japanese and Korean companies have stakes in those discoveries and are eyeing future supply deals. China’s state-run companies, which have invested in gas projects across the world, may not be far behind. Eni and Anadarko have agreed to jointly develop what could be one of the world’s largest LNG export facilities on the coast of Mozambique, well situated to supply the Asian market.

Although there are a number of forces working against the Russia-China gas deal, Paik warned against writing off the chances of a deal. Crucially, Russian piped gas still holds a cost advantage over more expensive LNG supplies. China paid an average of $459.01 per tonne, or $8.80/’000 cf, for its LNG imports in October of 2012, the last month for which data is available. And that is only expected to rise as new export projects seek higher prices.

The key to any deal, he said, will be expanding its scope. Rather than a straightforward gas-supply agreement, countries should seek a deal that includes upstream and downstream cooperation, giving China’s state-run companies exploration and production opportunities in Russia and Gazprom downstream opportunities in China. “I am expecting there may be a breakthrough in the first half of this year, if there can be a breakthrough on downstream cooperation,” Paik added.

Meanwhile, the clock is ticking and the vast gasfields that Russia sees as key to its economic and political reorientation to the east may turn out to be little more than a missed opportunity.

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