Russia: more investment needed
While the world has been fretting about oil prices near $100 a barrel, what it should really be worried about is gas. Europe today and the US in the future are moving towards a staggering dependence on imported natural gas. By Nadejda Victor, Program on Energy and Sustainable Development, Stanford University
AS OIL prices rise, the price of gas for European consumers will also rise, as it is linked to the prices of diesel and heating oil. However, the primary concern about gas is not price, but security of supply. Europe imports 60% of its gas, mostly from Russia and Algeria, and that dependence (especially from Russia) is set to grow.
Russia is an energy superpower: it holds the world's largest gas reserves, the second-largest coal reserves and the seventh-largest oil reserves. Russia alone produces 21% of the world's gas and it will remain a crucial pillar of the world's energy security for years to come. Russia has been a reliable gas supplier for decades, although spats with Ukraine in 2006 served to focus the world on the security of Russian supply.
At the same time, nationalisation in the oil and gas sectors has raised concerns about whether continued investment in new supply will be timely, especially given the need to develop more difficult fields in eastern Siberia and northern Russia. The concerns about fiscal, legal and regulatory reforms (including environmental and safety regulations) remain unchanged.
While oil is traded in a global market, there is not yet a truly global gas market – there exist three main regional markets:
- Europe – importing mainly from Norway, Russia and Algeria by pipelines and in the form of LNG;
- North America – importing mainly from Canada by pipeline, but also some LNG; and
- The Pacific – primarily Japan and South Korea, importing LNG from Indonesia, Australia, Malaysia and the Middle East.
Each regional gas market is characterised by specific supply costs and conditions, gas-demand patterns and types of competition. Traditionally gas prices have been tied to oil prices and trade dominated by long-term contracts. The rise of LNG, which comprises 26% of total gas trade, will happen gradually, as the capital required to build liquefaction capacity is much greater than for pipelines.
At the end of 2006, the world's proved gas reserves were 181.5 trillion cubic metres (cm) according to BP, with Russia's 48 trillion cm by far the largest – accounting for 27% of the total. Thus, the world's potential gas supply is concentrated in fewer hands than its oil: Russia, Iran and Qatar hold 56% of gas reserves.
Although OECD countries hold less than 7% of reserves, they are among the biggest gas producers: the US, Canada, Norway, the UK and the Netherlands produce 38% of supply – more than Russia, Iran, Qatar, Venezuela and Algeria combined. However, the combination of falling output and rising demand (notably for power generation) in the developed economies will change the dynamics of the global gas
Fundmentals of the World Gas Industry 2008. Buy it now.
The fall in OECD production must be compensated by all exporting regions, but disproportionately by the Middle East, Russia and Africa. The share of gas traded between regions will increase rapidly (see Figure 1). According to the IEA, OECD countries will depend on more gas imports, over longer distances, and about two-thirds of incremental supply by 2015 will be in the form of LNG.
Gas is the fastest growing energy source in Europe, with consumption of 0.54 trillion cm in 2006 up by 60% since 1990. Germany, Italy, and France are the largest users. Germany depends on Russia for 42% of its supply, and Italy and France import 30% and 21%, respectively, of their needs from Russia. The EU receives 25%-40% of its gas from Russia, with 17% coming from Norway and 10% from Algeria. The biggest increase in imports is projected to occur in Europe: where imports are forecast by the IEA to equal about 70% of consumption, almost 490bn cm, by 2030.
North America, which is self sufficient in gas at present, will be a significant importer by 2030. According to the Energy Information Administration (EIA) Reference Case scenario, imports in the form of LNG will meet about 20% of total US gas needs in 2010. In the more distant future the US will import LNG in even more significant quantities – more than 80bn cm in 2015 and more than 100bn cm in 2020.
Although North America has traditionally sourced gas through regional pipelines under long-term contracts, and the Pacific region LNG, neither can afford to ignore the global picture. Gas demand growth in developing Asia will also affect the market: demand is projected to grow most rapidly in China, from 50bn cm in 2005 to 240bn cm in 2030, and in India from 35bn cm in 2005 to 112bn cm in 2030 according to the IEA.
Increasingly, gas is becoming a global commodity and previously separate regional developments can no longer be considered in isolation. Resource nationalism in the Middle East, South America and Russia, combined with increased demand, are shifting the balance of power in markets. Perhaps more importantly, investments upstream and in liquefaction capacity in the Middle East, South America and Russia do not appear to be proceeding at the necessary pace. Gas investments everywhere are suffering higher costs and construction delays, although proposed LNG projects seem especially affected.
Insufficient investment in the Russian gas sector is a serious issue – upstream investments are considerably below the amount required. The growing importance of gas imports to modern economies forces new thinking about energy security and the role of Russia.
History and uncertainty
Natural gas development on an industrial scale started in Russia at the end of the 19th century. It was used primarily for lighting and was mainly produced and used locally. Russia did not lay long-distance gas pipelines until well after World War II, several decades after the appearance of the first long-distance pipelines in the US. By the early 1930s, the Soviet economy consumed 10m-15m cm/y, but within a decade, this figure had grown to 3.4bn cm/y.
By 1955, the Soviet Union was still producing only 9bn cm of gas from fields across European Russia and Ukraine. As the small and dispersed gasfields west of the Urals and close to demand centres depleted, production shifted east. The Soviet invasion of Afghanistan in 1979 led to US sanctions to limit access to hard currency that the Soviets could earn through gas exports. The bite of sanctions slowed numerous projects and led the Soviet Union to develop its own technology.
The dissolution of the USSR in 1991 had a significant effect on the contractual environment for gas exports to the West. In particular, the political changes created transit countries. All pipelines west from the European part of Russia passed through Belarus and the Ukraine – at the time of the Soviet Union's dissolution, about 90% of Russian gas exports passed through Ukraine.
The collapse of the Soviet Union caused economic shock waves that dramatically lowered domestic gas demand, as well as demand in eastern Europe. With a shrinking economy, consumption in Russia declined by over 16% in the 1990s – from 420bn cm in 1990 to 350bn cm in 1997. Exports to CIS countries also declined, by 31%, from 110bn cm in 1990 to 75.6bn cm in 1998. And they were forced to pay semi-hard export prices, which were higher than the internal Soviet price, but lower than the price charged for exports to the west.
About 80% of Russian reserves are in western Siberia, where there are many large and a few super-large fields. Gas discoveries peaked in the early 1970s, although more will probably be made offshore in the Arctic. However, this extremely hostile environment makes exploration unattractive, at least in the near future, and with nearly 60% of known gas reserves not being produced there is little incentive.
The main uncertainties in Russian gas production are the steady decline of the country's three main gasfields and a lack of strategy for the development of new fields. The output from western Siberia's Urengoy, Yamburg and Medvyezhe fields is declining at a fairly rapid rate and huge investments will be needed to continue production or replace their output from new fields. Aside from Yuzhno-Russkoye and the Zapolyarnoye, state-owned Gazprom has not brought any new fields on stream since 1991. While the projected annual output of Yuzhno-Russkoye and Zapolyarnoye are considerable, these fields alone cannot stem the stagnation of Gazprom's production.
Gazprom's investment in developing gasfields has been minimal in recent years, leading to output stagnation. Instead of investing upstream, it has been expanding its interests in other sectors, such as oil, power generation, overseas downstream operations and media. Yet its monopoly over transportation infrastructure has constrained the development of independent gas producers. OECD criticism of Russian gas strategy comes at a time of growing concern about the country's ability to sustain and increase production.
Russia's future production level is uncertain. Most forecasts point to output of 0.6-0.8 trillion cm/y by 2020 (see Figure 2). A December 2006 government forecast predicts Gazprom will produce 0.56 trillion cm in 2010 and 0.62 trillion cm in 2015. Independent producers (oil companies particularly) could fill the gap, but the prospects of independent producers contributing more gas – allowing Russia to increase exports – will depend heavily on reforms of Gazprom, liberalisation of internal gas pricing and whether the pipeline network is effectively opened to the private sector.
Another significant uncertainty in the Russian gas balance is domestic usage. Russia is the second-largest gas consumer after the US, using 432bn cm in 2006 – a rise of nearly 7% over 2005. This suggests a hearty and growing appetite for gas, an appetite that is rising faster than predicted. One reason for such a high level of gas consumption, and a point of concern, is the inefficiency of gas usage, the result of both embedded inefficiencies – over 90% of residential and industrial consumers do not have meters, while the country's gas-fired generators operate at only 33% efficiency on average. Another problem is subsidised prices – over the last decade gas was cheaper than coal. Future demand is highly dependent on much-needed efficiency improvements and domestic price increases.
At the end of 2007, domestic prices were around $52/'000 cm – 13% higher than in 2006. From 2008 and beyond, prices could rise by up to 25% a year. Although this remains low by EU standards, where the price is around $250/'000 cm now, these moves could be politically and economically difficult.
The price elasticity for gas demand tends to be larger (in absolute value) than the price elasticity for oil: gas demand could be expected to decline by at least 1% for every 10% permanent increase in price, but it is unclear if this would happen in Russia. The government hoped higher domestic prices would encourage independent producers to increase output and supply about 50% of domestic industrial clients' needs by 2010, up from 29% now.
However, an internal gas-price increase would not guarantee the security Russian supply, which is related more to the development of fields in the far north and eastern Siberia, as well as the shelf deposits of northern and far eastern seas. But Arctic-shelf projects are capital-intensive because of lack of existing infrastructure; they also require advanced technologies that Russia does not yet have, necessitating the involvement of foreign investors.
In recent years, Russia has filled the gap in gas supplies by squeezing Turkmenistan to sell most of its exports to Russia at a deep discount. However, Turkmenistani exports, if not poised to decline, could at the very least flow a different way. The proposed Nabucco pipeline project, from Azerbaijan through Turkey to western Europe, could carry gas from the east of the Caspian, while other proposals include a pipeline to China.
The tight supply situation in Russia is not the result of limited reserves, but rather Gazprom's Kremlin-driven investment strategy. The need for fiscal, legal and regulatory reforms (including streamlined environmental and safety regulations) remains pressing. Such measures are critical to ensuring an attractive environment for gas investments that will buoy Russian economic growth and global energy market stability.
Russia is and will remain an energy superpower. Its energy self-sufficiency puts the country in a strong position for future economic development and the energy sector will remain attractive to foreign investors. At the same time, Russia remains gas-dependent and energy inefficient. But instead of concentrating on market and structural reforms and energy-efficiency improvement, the government focused on tightening the state's grip on what it deems a strategic sector.
However, most Middle Eastern countries are closed to foreign investment, or at least to ownership of reserves; Latin America is an increasingly challenging place to do business with the rise of resource nationalism in Venezuela and Bolivia; and west Africa's chronic political instability causes repeated problems. For all its shortcomings, Russia still offers an attractive combination of rich deposits and a workable business climate, with reason to hope that future investments can be both secure and profitable.