Opening Russia’s gas market after liberalisation of LNG exports
Domestic liberalisation is a boon to the country’s large independent suppliers and is busting open Gazprom’s monopoly on exports
Last December Russian President Vladimir Putin signed a decree partially liberalising liquefied natural gas (LNG) exports. The legislation allowed Russia’s two largest independents – Novatek and Rosneft – to ship LNG abroad. It is part of a transition under way in Russia’s energy sector, which is adapting to more difficult conditions brought by the post-2008 economic malaise, both in domestic and international markets, as well as by the tectonic shifts in North America’s energy market.
Russia’s internal market is oversupplied with natural gas, with the glut amounting to about 20 billion to 30bn cubic metres (cm) of supply. Several factors have contributed to this. Slower industrial growth, particularly in Russia’s energy-intensive industries, sent annual gas consumption sharply lower. In 2011, demand was 496.3bn cm. A year later, it had fallen to 459.5bn cm. Last year, it reached just 456.3bn cm.
At the same time, there has been slow progress in finding alternative uses for gas, for example in transportation. Russia has just over 100,000 natural gas vehicles – but is far behind countries such as Iran, Pakistan or the US, where rapid gasification of the transport fleet is under way.
Anti-gas flaring legislation has also put more supply into the system, by significantly reducing flaring of associated gas. These measures come amid a sharp rise in associated gas output, which has grown from 37.4bn cm in 2003 to 51.7bn cm last year.
This glut of supply has unleashed new gas-on-gas competition, between independent gas producers not restricted by Russia’s Federal Tariff Service (FTS) regulations and state-controlled Gazprom. Often, these independent suppliers have risen at the expense of Gazprom. Novatek and Rosneft, the two largest independent gas producers, have sought to consolidate their new position both within Russia and abroad, aggressively pursuing mergers and acquisitions focused on the extension of their reserves and client base.
Rosneft’s arrival as an independent gas player came with its takeover of TNK-BP and Itera in 2013. It also last year agreed a deal to buy the gas assets of Alrosa (Geotransgaz and Urengoy Gas Company, with estimated production of 6bn cm of dry gas and 1.2m tonnes of condensate). The acquisitions helped push Rosneft’s output to 38.17bn cm in 2013. Rosneft continued this strategy last month, in a deal to take control of the Pechora LNG project.
Novatek has been similarly expansive. In 2010, it beat competition from Rosneft to buy 25.5% of SeverEnergia (now called Arktikgaz), including reserves of 1.3 trillion cm of dry gas and 155m tonnes of condensate. In 2011 Novatek also received four upstream licences on the Yamal Peninsula. Arktikgaz’s shares are now split evenly between Gazprom Neft and Novatek, which in 2012 also bought 49% of NorthGaz (with reserves of 1.7bn barrels of oil equivalent). This buying has lifted Novatek’s overall gas output, too: it increased in 2013 by 8.5% to 62.2bn cm.
All this activity has increased the independents’ share of Russia’s total gas output from 9.6%, or 55.5bn cm, in 2010 to 27%, or 180.6bn, in 2013. By contrast, Gazprom’s output has been almost flat: production was 487.4bn cm in 2013, only a slight increase from 487bn in 2012 and 5% beneath the 513.2bn produced in 2011. Almost all of Russia’s gas output growth last year – a 2% increase, from 655bn cm in 2012 to 668bn cm in 2013 – came from the independent sector.
While Gazprom’s exports to Europe rose last year to a record of 162.7bn cm, it continued to shed domestic market share, which fell by about 6% during the course of 2012. The company’s chief executive, Alexei Miller, even indirectly admitted the existence of underused spare capacity of 130bn cm when he said the company’s output capacity had reached 617bn cm a year (cm/y).
The rise of Russia’s independent gas producers is explained by their ability to secure new supply contracts and to control lifting costs. Political connections have also played an important role, enabling them to lobby for tax breaks, state aid and favourable legislation.
Yamal LNG, the Novatek-led project in Russia’s north, would have been unthinkable without important tax incentives, and a generous tax regime was a key factor in Total’s decision to join the project, too. Crucially, in January 2012, the Russian government granted Yamal LNG and other new Yamal projects exemptions from both export tax and the mineral extraction tax. Tax breaks cover production of 250bn cm of natural gas and 20m tonnes of condensate within the first 12 years. The government will also provide support for the maritime infrastructure at Sabetta port.
New export rules introduced at the end of last year also opened opportunities for Novatek and Rosneft. Modification on 1 December 2013 of article 3 of the Law on the Export of Gas and articles 12 and 24 of the Law on the External Trade granted export rights to Gazprom and other firms provided they met certain conditions. One condition was that the exporter held an LNG terminal construction license issued before 1 January 2013. Only Novatek’s Yamal LNG could benefit from this decree. The other condition allowed for exports by companies under more than 50% state control that held exploration licenses for Russia’s continental shelf. This applied to Rosneft and Gazprom, though the law can be further modified to accommodate new projects proposed by Novatek (for example, a second Yamal liquefaction plant) or for any LNG development by Rosneft based on Kara Sea gas reserves.
Pechora LNG, a $4bn private LNG project based on the Barents Sea coast, with proposed capacity of 2.4m tonnes a year, was not included in this because its developer, Alltech Group, didn’t receive its LNG licence in time. That may not be a problem now, though. Late last month, Rosneft and Alltech agreed to create a joint venture (with Rosneft taking 51% and Alltech the rest) to develop Pechora LNG. Alltech will bring the Kumzhinskoe (119.3bn cm of dry gas and 4.5m tonnes of condensate) and Korovinskoe (41.1bn cm and 1m tonnes) gasfields into the venture, while Rosneft will fund the project and build a liquefaction terminal in Indiga. Rosneft also intends to bid this year for the Layavozhskoe (137.9bn cm of gas and 8.6 millions tonnes of oil) and Vaneivisskoe (85bn cm and 5.7m tonnes) gas fields listed in an undistributed federal fund. Inclusion of those fields would significantly raise the project’s output. The cost of project is unknown – though it could cost as much as $6.6bn, with a new capacity of 5m t/y.
Other factors have also supported the rise of the independents. Gas trade in Russia is regulated by the FTS. While Gazprom, as the operator of the country’s gas distribution network, has to respect prices stipulated in the FTS (within about a 3% margin), independents can sell below the minimum price, allowing them to gain market share. In turn, this has attracted the independents to gas distribution infrastructure itself – principally to get access to premium markets. To that end, in 2011 Novatek bought Mezhregiongas Chelyabinsk, in the Urals region, after buying a majority stake in Gazprom’s Mezhregiongas Kostroma (Central Russia) in 2010.
Independent gas producers have been able to gain premium market share: about 40% of sales to industrial consumers and power plants are now done by non-Gazprom producers. Furthermore, 75% of their customers are located close to independent producers’ key production areas. At the same time, though, Gazprom has kept a monopoly on lower-profitability market segments. The residential sector, for example, accounts for 19% of Russia’s gas demand – but more than a third of Gazprom’s sales. Independent suppliers, by contrast, have only few residential clients, while Gazprom supplies up to 90% of that market.
A case study of Tula oblast, a proxy for a typical region, shows the difference between the low-profitability residential sector and premium industrial consumers. In 2013, FTS tariffs (all minus VAT) for residential consumers averaged 3,058 rubles ($88.60) per 1,000 cm, while industrial consumers had to pay 4,062 rubles/’000 cm. Industrial consumers subject to the principles of state regulation (for example, power stations) were billed 4,468 rubles/’000 cm.
Gazprom’s monopoly on storage and transportation is also under threat. Anatoly Golomolzin, deputy head of the Russian Federal Antimonopoly Service, has proposed unbundling transport and storage infrastructure from Gazprom’s remit, which would allow indiscriminate access to the company’s pipeline system and underground gas storage facilities.
What can Gazprom do about all this?
The company needs to recover the premium market segments lost to independent suppliers. In an oversupplied gas market, however, the reintroduction of spot trading, expected this autumn, could support even further expansion by the independents at Gazprom’s expense – especially if the state-controlled firm doesn’t pursue a flexible pricing policy.
On the other hand, relaxation of some rules might help Gazprom – if, for example, it receives the right to sell 20% less than the limits set by FTS for deliveries to premium industrial consumers whose demand exceeds 100m cm/y. If this measure is implemented, gas-on-gas competition will start benefiting Gazprom and the independents’ expansion will come to an end. To mitigate this, the independents will lobby for access to pipeline exports (initially to China). Indeed, Rosneft and East Siberian independent Irkutsk Oil Company could load at least 20bn cm/y into the Power of Siberia pipeline to speed up development of that export project.
All this leaves the sector in some flux. The Kremlin’s rationale for opening up competition is, however, strategic. Its draft energy strategy to 2035 foresees LNG exports reaching 30m tonnes a year (t/y) by 2020 and 100m t/y by 2035. Gazprom alone would not be able to reach these goals and will need help from independent producers.
Boosting the role of the independents also gives Russia the luxury of having alternative, non-Gazprom exporters able to supply foreign markets. For political reasons, Gazprom’s gas is increasingly unwelcome in Europe and the EU is in general unfriendly towards vertically integrated energy companies – especially those controlled by the Kremlin. The crisis in the Ukraine has exacerbated this. Independent exporters may help Russian gas retain its share of Europe’s market. There are also economic reasons. More competition in Russia’s domestic energy market should create efficiencies, supporting industrial growth as an internal source of expansion for the country’s economy.
There are several likely outcomes of this new competition between Gazprom and the independents producers. It will delay netback parity scenarios for Russian gas, by keeping domestic prices beneath export prices. Gazprom will receive the right to sell gas at a price lower than regulated, while independent gas producers will participate in domestic gasification. The market will still be dominated by large players: Gazprom, Novatek and Rosneft. Further gradual liberalisation of the Single Export Channel (a 2006 law) will be extended to new LNG projects and potentially (and with some restrictions) to the pipeline infrastructure. Tailor-made legislation will persist as a general trend. All of this will also mean that the energy regulator will play a bigger role, especially as operational unbundling for Gazprom becomes a reality.