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Second export deal in the pipeline for China and Russia

A deal is in the works. But it would be a geopolitical coup for the Kremlin and a commercial one for Beijing

A second major gas deal between China and Russia, which would see gas piped from Russia’s huge West Siberia gasfields through China’s western provinces, could be done as soon as 2015 as Russia remains under heavy pressure from Western sanctions and China steps up its search for gas from abroad.

It took more than a decade of tense negotiation for Beijing and Moscow to seal their first major gas pipeline trade deal, which was signed by presidents Vladimir Putin and Xi Jinping in Beijing in May. That deal will eventually see 38 billion cubic metres per year (cm/y) of gas shipped through the Power of Siberia pipeline from Gazprom’s large undeveloped East Siberia gasfields, across the northern border between the countries, to China’s energy-hungry northeast. 

It was a major political victory for Putin, who has touted his burgeoning energy ties with China as a counter to increasingly heavy sanctions from the West. It was a less clear-cut victory for Gazprom, which may struggle to make the project profitable. To get to a deal, Gazprom had to agree to a price that was competitive with China’s Central Asian imports, rather than a higher price comparable to its European exports or more expensive northeast Asia liquefied natural gas (LNG) the company wanted to get in China. 

Alexei Miller, Gazprom’s boss, said when the agreement was signed that it was worth around $400bn, or around $10.50 per million cubic feet (cf). However, that valuation came before the steep decline in the international crude price, which will have brought down the value of the deal. Shipments won’t start until at least 2019, by which time oil prices may be back above $100 per barrel.

Even if Gazprom had to compromise on price, the China deal gave its Asian expansion programme a kick start. It sees this as a necessary strategy to help the company find growth in the face of declining demand from Europe. Gazprom hopes to build on the deal to establish new pipeline and LNG routes to Japan and the Korean peninsula, which could significantly improve the economic prospects of the company’s eastern opening. Japanese and South Korea backing for sanctions on Russia, however, have slowed progress on that front. With the ink barely dry on the Power of Siberia deal, Russia started pushing for a second major gas deal with China this summer.

The agreement now under discussion is actually the original gas deal the two sides started pursuing more than a decade ago, known as the Altai, or Western route. Under the proposal, Gazprom would send gas from its well-developed West Siberia heartland to China’s northwestern Xinjiang province through the Altai Mountains, near where China receives gas from Central Asia. 

After years of faltering discussions for the Altai project in the 2000s, largely over price, China turned its attention from Russia to Central Asia. China swiftly secured a number of gas deals in Central Asia, primarily with Turkmenistan, and started building import infrastructure that diminished the short-term need for Russian gas. China then prioritised the Eastern route in its discussions with Gazprom, and Russia had little choice but to go along if it wanted access to China’s growing gas market. With that deal done, senior Russian officials sought to capitalize on the momentum and said they thought a second deal could be signed in 2014.

That proved optimistic, but Putin touted it as another big victory in his pivot to Asia when he signed a framework deal that would see another 30bn cm/y of gas shipped to China via the Altai route during his November trip to Beijing for the Apec economic conference. The agreement was hyped in some corners of the international press as all but sealed, and further evidence of Putin’s ability to outplay his Western counterparts, even with a weaker hand.

But there are good reasons for skepticism. It took Russia and China years, and many similar framework agreements, to finalise the first deal. Moreover, it appears that key aspects of that deal, such as a proposed $25bn advanced payment from China National Petroleum Corporation (CNPC) to help Gazprom finance the East Siberia development, have not been nailed down. Nor is it clear that Gazprom has the financial firepower to undertake both multi-billion dollar pipeline projects at the same time.

James Henderson, a Russia expert at the Oxford Institute for Energy Studies, a think tank, has argued in a new report that there is strong commercial and political logic for a deal to be signed sooner rather than later, with major consequences for the region and the global liquefied natural gas (LNG) market.  

For Russia, the motivation for securing the Altai route has only become stronger. “Events over the past five years, which have seen demand for Gazprom’s gas go into decline in all its traditional markets, have increased the need to find new outlets for gas that would otherwise be left in the ground, while the geo-politics surrounding the Ukraine crisis have exacerbated the need to create a demonstrable link between gas that could go to Europe or Asia,” writes Henderson. 

As Henderson points out, Russian exports to Europe fell from 160bn cubic metres (cm) in 2008 to 140bn cm in 2012, and few expect a swift rebound in demand. As a result, Gazprom has been forced to cut its production from 560bn cm in 2008 to 463bn cm this year, leaving it with huge amounts of idled production capacity.

The production decline and inability to open new markets has been deeply concerning for Gazprom. The company’s market value has never recovered from its steep fall after the financial crisis and its star has faded domestically. Rosneft, its domestic state-owned rival, has risen in favour at the Kremlin and Gazprom has seen its gas export monopoly threatened with progress Novatek’s Yamal LNG project. Rosneft has also found some in Russia open to the idea of allowing it to export some of its gas via pipeline.

Another major deal further opening the China market, Henderson argues, would help solidify Gazprom’s role as Russia’s pre-eminent gas exporter, especially as Yamal LNG struggles under increasingly difficult Western sanctions.

Opening the Altai route would also allow Putin to position Russia as a swing supplier between Europe and China, forcing the sides to compete for the same West Siberia supply sources. A credible threat to divert supplies away from Europe could give Putin a powerful hand to play in future disputes with the West and could strengthen Gazprom’s hand in negotiations with its European buyers. 

That’s the view from Moscow, anyway. Henderson throws some cold water on this idea, arguing any such threat would be largely toothless given the huge amount of spare production capacity in West Siberia. Russia could easily supply 30bn cm to China without disrupting supplies given the region’s gas oversupply, Henderson says.While Russia clearly wants to open the Altai route, it remains an open question whether or not China wants more Russian gas.

Beijing has watched with envy as the US shale gas industry has swiftly brought the country self-sufficiency. China’s policymakers have entertained hopes that China’s own apparently substantial shale gas deposits could do the same for it. But China’s state-run oil and gas industry has struggled in its early experiments with unconventional gas and it is clear that the country will need to import a substantial amount of gas for years to come. China’s energy policymakers recently cut their forecast for domestic shale production from 100bn cm in 2020 to 30bn cm, and even that looks like it hard to reach.

To this end, Beijing has pursued a complex import strategy, aimed at securing supplies from diverse sources, entering the country at different points, while trying to avoid locking itself into high-cost contracts. China has signed deals that will see piped supplies enter the country from Russia in the northeast, Central Asia in the west and Myanmar to the south, while rapidly expanding its LNG import capacity along the populated eastern seaboard. After several years of extremely high LNG costs in northeast Asia, however, the country seems to have shifted its focus to maximising pipeline imports, which it has been able to secure more cheaply. 

As well as the headline-grabbing Power of Siberia pipeline deal with Russia, China has also signed supply deals over the past year in Central Asia that will see a huge rise in imports from the region over the next decade. Imports from Turkmenistan, which already account for more than half of China’s gas imports, could increase from 23bn cm last year to 65bn cm by 2020. Uzbekistan and Kazakhstan have also agreed to increase shipments into China via the huge East-West gas pipeline system.

By contrast, China’s national oil companies have slowed their search abroad for new LNG supply, and Sinopec is reportedly looking to offload some of its LNG contracts. China’s LNG import facilities are running at around 50% of their capacity because high international prices make LNG imports uncompetitive. Another major deal with Russia would be a blow for international LNG producers from Australia to North America to East Africa, which have been counting to a large degree on significant demand growth from China.

With China seeking supply diversity, Henderson says, it may see the Altai route as a way to introduce competition for Central Asia at the western border, which could make supplies more secure and force the sides to compete on price. At the same time, China will be concerned by its growing reliance on Russian supplies. Henderson says that the combined 68 billion cm/y of supply from the Power of Siberia and Altai pipelines could make up a third of total imports by 2030. However, it would account for less than 15% of total supply when domestic production is taken into account, which could ease security concerns.  

Perhaps the biggest driver for the Chinese side to get a deal done quickly is its superior bargaining position, which will not last forever. “Given the geopolitical pressure on the Russian government and Gazprom to diversify export sales, it is arguable that there may never be a better time for China to discuss a second gas purchase agreement,” Henderson writes. 

Henderson argues that China would want a price of around $9.50/m cf) at the China-Russia Western border, which would make it competitive with Central Asian supply and its lower-cost LNG contracts. Analysts at JP Morgan, an investment bank, have said that China may push for a steep discount on its existing Central Asian supplies, potentially as low as $8.50/m cf at the border. 

If China can use its strong negotiating position to secure supplies in that price range, which is likely to be lower than the LNG supplies it will get, it would likely pursue the deal, even if it raised some concerns of over-reliance on Russian gas. 

Henderson reckons that Gazprom would make an internal rate of return of about 9% at $9.50/m cf and about 8% at $8.50/m cf on the Altai project. Although unspectacular, Gazprom would likely find this acceptable, he thinks. More importantly, Putin might accept that price, too. For Putin, Henderson writes, “the low commercial return on the Altai project would be a small price to pay for the benefit of finally being able to say that Russia and Gazprom could now swing gas from the same core producing fields either to western or eastern markets, providing an arbitrage opportunity and a political bargaining point.”

Moreover, in the same way the Power of Siberia deal was seen as a way to open up new pipeline and export routes across northeast Asia, Russia might see the Altai route as a way to open up markets further south. Russia and India have discussed investing tens of billions of dollars on oil and gas pipelines that would traverse, and need the cooperation of, China. “While it would be foolhardy to go so far as to predict that a deal will be signed in 2015, the arguments in favour appear stronger than many commentators would seem to suggest,” Henderson concludes.

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