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Russia's turf wars

Even as the country's gas sector thrives, its major companies face political battles at home and abroad

The future of Russian gas in 2018, and in particular the prospects for exports to Europe, will be influenced by a number of contrasting factors that suggest a complex outlook for gas giant Gazprom. The foundation on which the company will be building is solid, as its production rebounded sharply in 2017 to reach about 470bn cubic metres (from 420bn in 2016) and exports stood at a record 185bn-190bn cm (up from the previous record of 179bn in 2016). This commercial success has been based on two factors: Gazprom's willingness to adapt its pricing strategy away from oil-linked contracts; and the surprising lack of competition from liquefied natural gas, as the expected surge in supply hasn't yet affected the European market.

However, it's political risk at home and abroad that offers the biggest challenges for 2018—in Europe, opposition to new export pipeline projects continues amid a desire by some EU states to diversify away from Russian gas, while at home, the state oil company Rosneft is threatening Gazprom's export monopoly. As a result, although the overall prospects for Russian gas in 2018 look good, with an additional boost coming from the start of Novatek's Yamal LNG project, underlying political problems remain a key issue.

Interestingly, the strength of Gazprom's competitive position in Europe, where its gas is one of the lowest-cost supply options, may be at the root of its political problems, allied of course with a more general concern over Russia and its intervention in Ukraine. The European Commission appears keen to prevent the seemingly inevitable expansion of Russian influence in the gas market, and so is seeking ways to obstruct infrastructure projects that could bring new supplies to the market. The Nord Stream pipeline has been a particular focus, and in 2018 the debate over the future of the Nord Stream 2 project will continue, with discussions over its legal status and potential route. Equally important, though, will be the impact of the second round of US sanctions, imposed in November 2017, which specifically target Russian gas export infrastructure and explicitly mention both Nord Stream 2 and a desire to support US LNG exports to Europe.

As a result, 2018 will be a year when the divide between companies and countries that support Russian gas exports to Europe and those that oppose it come into increasing conflict. Gazprom may need to find a suitable compromise to accommodate all parties. It will have opportunities to do this, as it finalises its agreement with the European Commission's Directorate-General for Competition over its business practices in Central and Eastern Europe and also reacts to the Stockholm arbitration case over its historical gas-sales price and transit business in Ukraine.

The European Commission is seeking to obstruct infrastructure projects that could bring new Russian supplies to the market

In addition, negotiations over the possible future use of the Ukraine gas-transit system will likely be initiated ahead of the 2019 termination of the current contract. If a suitable balance of outcomes can be found across all these ostensibly commercial, but in fact very political, issues, then an important milestone for the future of Russian gas exports to Europe can be achieved. The outcome is very much in the balance, however, meaning that 2018 will be a critical year for Gazprom and the EU.

Should Gazprom falter, and Russia's position appears to be under threat, then it's possible that Rosneft, Russia's largest oil company, may accelerate its attempts to enter the gas-export business. Rosneft's leader, Igor Sechin, has been arguing for some time that a diversity of exporting companies could be a better option than Gazprom's current monopoly; but the imminence of presidential elections in March 2018 and the importance of Gazprom as a state vehicle and large tax-payer have deferred any real debate. However, if, as expected, President Putin is returned to the Kremlin early in 2018, then Sechin, a close ally of the president, may feel emboldened to push the debate.

Gazprom's position is already being undermined by the success of Novatek and its Yamal LNG project, which will develop its second train in 2018. The state gas company, meanwhile, continues to procrastinate over its own LNG plans. Furthermore, it's also possible that Novatek could take a final investment decision on a second LNG project in Russia's Far North, Arctic LNG. This would underline that the company is set to become Russia's largest LNG player by 2020, and emphasise that "independent" producers can play an active role in expanding Russia's position in the global gas market.

In the face of the potential growth in domestic competition, Gazprom will go on developing alternative projects in 2018. Turkish Stream, a pipeline across the Black Sea to Turkey and beyond, will continue to be laid, with planned start-up in 2019, providing an alternative to Nord Stream 2, should that be delayed or cancelled. However, challenges remain: Gazprom plans to lay two lines in order to export 31bn cm a year of gas through Turkish Stream, but it's still unclear where half the supply will ultimately be sold, as demand from Turkey can be met from one line alone. Markets in Europe will need to be found, leading to further negotiations with EU authorities.

Perhaps even more important, the Power of Siberia pipeline to China should be approaching completion by the end of the year, ahead of another 2019 start-up. The line will be an important strategic and geopolitical boost to Russia's overall "pivot to Asia". Furthermore, negotiations over two more pipelines to Asia, Altai in the west and Sakhalin in the far east, will also provide opportunities for Gazprom to prove its credentials as Russia's key gas-export player. Success could see exports in the east expand to almost 100bn cm/y over the next decade, but once again Rosneft is pressuring Gazprom's position with requests to have access to the pipelines itself.

In this debate, Rosneft has one important bargaining chip: its gas reserves at the Sakhalin 1 project, which Gazprom would like to use to expand its Sakhalin 2 venture with a third train. The negotiations over the use of Sakhalin 1 gas have been going on for more than a decade, with Rosneft threatening to develop its own LNG project (Far East LNG) to challenge Gazprom, rather than sell its gas at a low domestic price. The dispute could finally be resolved in 2018, as the Russian government has already indicated that it wants an optimal resolution that can benefit the country as a whole.

One outcome could see Rosneft selling its Sakhalin gas in return for access to one or more of the export pipelines to China, marking a potentially significant shift in the Russian gas sector. It will therefore be important to monitor the Sakhalin debate, as despite its remote location it could have very broad implications.

Although Gazprom is riding high with growing levels of production and exports, the challenges for 2018 will largely come in the political sphere. Negotiations with the European Commission and with China could provide a platform for further expansion; but if unsuccessful they could also provide an opening for influential competitors at home to exploit weakness and attempt to break the current export monopoly. Kremlin support for the status quo can be expected ahead of the elections in March, but once a new term for Putin has been secured the potential for change increases.

As always, Gazprom's position as a vital cog of economic and foreign policy provides it with some protection, but the LNG market has shown what third parties like Novatek can achieve. So 2018 may be the year when a real challenge to Gazprom's pipeline-export monopoly could begin in earnest if Rosneft and its powerful leader decide that diversification into the gas sector really is a core strategic imperative.

James Henderson is Director, Natural Gas Programme at Oxford Institute for Energy Studies

This article is part of Outlook 2018, our annual book looking at energy market trends for the year ahead. To purchase a copy, click here

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