Gazprom's next gas battle
The Russian giant is ready to defend its market share in Europe and face off the threat of American LNG
The past twelve months have been something of a curate's egg for Gazprom—good in parts. The company has managed to halt its recent production decline with a small rebound in output to just under 420bn cubic metres, but has struggled in several business segments. Sales to former Soviet Union countries fell sharply as Ukraine made a determined effort to reduce imports from Russia to zero; domestic market share fell again; two liquefied natural gas projects (Baltic LNG and Sakhalin 2 expansion) were delayed again, this time until 2023-24; and negotiations with China over a second export pipeline have dragged, while the start of supplies under the first contract (via Power of Siberia) seem to be heading for the back end of the 2019-21 timescale.
One market stood out as a beacon of success for Gazprom—Europe. Exports in 2016 reached an all-time high of 179bn cm, almost 20bn cm higher than the previous year. Although around 10bn cm of this increase was really gas sold back to Ukraine, the overall result is impressive. The combination of exports to Europe and the FSU increased year-on-year by almost 14bn cm: strong growth even without the Ukraine effect.
A significant recovery in European demand, thanks to colder weather and more gas used in power generation, helped. But the rise also showed the increasing competitiveness of Russian gas. Weaker oil prices also helped, as oil remains one driver of Gazprom's export price, but the company also tried to ensure that its export price reflected market conditions. Contract renegotiations have introduced a significant amount of spot-linked pricing, rebates have ensured that customers will not be out of the money if oil prices rise and Gazprom has demonstrated flexibility, willing to trade and auction gas on a short-term basis.
200bn cm - amount of cheap surplus gas supply available for export by Gazprom
Indeed, the recent announcement that Gazprom and the European Commission (EC) have come to an agreement over the investigation into Gazprom's business practices in eight Central and Eastern European countries seems to confirm the company's new more market-oriented attitude. Gazprom has agreed to remove all destination clauses from its contracts, which were inhibiting the free trade of its gas in certain European countries, and committed not to use its dominant market position in some countries to control pipeline infrastructure. Most importantly, Gazprom has undertaken to price its gas relative to competitive benchmarks, such as the liquid gas hubs, and allow customers to renegotiate contracts if prices diverge significantly from a competitive level. In effect, this confirms the strategy that Gazprom had initiated in a number of western European countries. The company is now prepared to compete on price across the continent.
This might look like a concession to the EC—but it's arguably a necessary condition for Gazprom to achieve its main goal in Europe, which is to maintain market share. Gazprom executives have been clear in public lately that they will not cede customers and will compete on price with the most obvious new competitor, US LNG. The results from 2016 suggest the strategy is working so far: Gazprom's share of European supply increased to 34%. But the big challenge is yet to come.
Last year was something of a false dawn for LNG in Europe. Despite the hype around the launch of Sabine Pass' first cargoes, only a handful of cargoes actually came to Europe. Most were sold in South America and the rest headed to Asia, especially when cold weather and nuclear problems in South Korea boosted demand and prices. As a result, LNG imports to Europe were down by 1bn cm in 2016: Gazprom faced no new competitor.
Over the next few years this situation should change, as new developments come online in the US and projects in Australia ramp up to peak capacity. Much will depend upon levels of demand in Asia, as well as the possibility of delays in new LNG start-ups. Still, the much-discussed wave of new supply should arrive at some point before 2019. That's when Gazprom's commitment to market share and willingness to compete on price will be tested, as any spare LNG cargoes are likely to end up in Europe.
Gazprom certainly has the firepower. Chief executive Alexei Miller points to a 200bn cm surplus of cheap gas, especially while the weak rouble keeps domestic costs down. That gas could be delivered to the German border at $4 per million British thermal units. The combination of this competitive breakeven cost and Gazprom's new commitment to pricing its gas relative to market benchmarks, confirmed by its agreement with the EC, suggests that the company is preparing to meet its new challenge. Indeed, Gazprom may finally embrace the opportunity that liberalised markets in Europe can offer it as the region's low cost producer.
James Henderson is the Director of the Natural Gas Programme at the Oxford Institute for Energy Studies