Europe’s addiction to Russian gas: How long before withdrawal symptoms set in?

by Leonid Krutakov for Odnako

(translated by: Robin)

In mid-January, EU Energy Commissioner Maroš Šefčovič held talks with Gazprom CEO Alexey Miller and Russian Energy Minister Alexander Novak in Moscow. After the talks, Mr. Šefčovič expressed surprise at three circumstances.

First, Gazprom has no intention of building the South Stream pipeline. Second, in the future natural gas will be delivered to Europe via Turkey. And, third, Russia is not prepared to discuss the terms of its gas deliveries to Ukraine.

To quote Mr. Šefčovič, all three circumstances, were “very surprising,” even though Russia’s decision to cancel South Stream and instead build Turkish Stream was announced in December of last year in Ankara at a joint press conference held by the Presidents of Russia and Turkey.

It’s easy to wax ironic about Mr. Šefčovič’s ignorance of South Stream in Turkey. And most commentators did just that. But his attempt to discuss new conditions for gas supplies to Ukraine with his Russian partners deserves much more attention. And confirmation of that was not long in coming.

Last week, Russian Prime Minister Dmitry Medvedev convened a meeting with Messrs. Miller and Novak. He asked them for the details of their talks with Mr. Šefčovič, Ukraine’s gas debt and the repayment period. The meeting was broadcast live almost in its entirety.

Mr. Miller reiterated to Mr. Medvedev that Europe had only a few years to build its own transmission infrastructure to the Greece-Turkey border, where it will have to connect to the Russo-Turkish pipeline system. If Europe fails to do so, the gas will go to other markets.

And Mr. Novak pointed out that, when last year’s agreement on a $100 discount for gas sold to Ukraine expires on April 1, there will be no new discussions or agreements. The contract is valid and no one has cancelled it.

If we compare these statements, the fact that they were reiterated and broadcast live makes it clear that Russia has given Europe a firm ultimatum, outlined the consequences and set a deadline. So what is the nature of the ultimatum?

It’s a long story. But, like any long story, it offers an advantage. It allows you to assess the Ukrainian events not in terms of the abstract and immediate concepts of a struggle for freedom and democracy, but rather in the concrete terms of profit and loss over the long run.

At first glance, the link between the recent events in the Ukraine (the Maidan protests, the coup and the civil war) and the supply of Russian gas to Europe and the gas contract that Yulia Tymoshenko concluded in 2009 seems improbable. But any event whose workings are hidden from us is bound to seem improbable and inexplicable.

The European Union’s Third Energy Package (TEP) also came into effect in 2009. The gist of this document is that it establishes uniform rules for the gas supply system within the EU. All gas purchases must take place on an “entry-exit” basis at the European border. In other words, it creates a sort of single virtual gas buyer able to dictate terms to the seller.

The document sets other parameters, but they are all generally based on the idea of unbundling gas suppliers from the EU’s internal infrastructure and retail market, where prices are often more than three times the price of the “entry” price.

The stated reason for TEP was the need to enhance competition and reduce costs at the expense of a free flow of gas within Europe. This statement didn’t fool anyone. It was a new instrument that targeted only Gazprom, which is tightly connected to the European system.

In the event that Europe adopted unacceptable conditions, suppliers of liquefied natural gas (LNG) could at any time redirect their deliveries. In fact, that is what happened after TEP was adopted. The main flows of LNG left for the Asian markets. Gazprom, whose gas deposits are far from ports and have to be shipped by pipeline, could not pull off this trick.

As a result of the adoption of TEP, European gas prices did not fall; in fact they went up. From 2009 to 2013, the price of gas in the EU rose by an average of 29% to 30%. At the same time, the average price of Russian gas fell from US$410 per thousand cubic metres in 2008 to US$385 in 2013. And the volume of gas increased.

The paradox of a rising domestic price along with a falling “entry” price is easily explained by the nature of the increase. The increase was due mainly to the higher cost of gas transmission within the EU, which rose about 16%, and internal taxes, which were up 13%.

In fact, the energy component of the final gas price increased by no more than 2%, and even that was due to LNG. At the same time, the significant increase in the price of LNG was offset by the discounts that the EU obtained from Gazprom, taking advantage of Gazprom’s lack of wiggle room. And this occurred despite long-term contracts linked to the price of oil, which increased four-fold from 2008 to 2011.

In fact, TEP ultimately ended Gazprom’s access to the internal European market and, moreover, obliged it to sell 50% of its gas while still in the pipeline, even before it entered the EU. Under TEP, gas carried by the pipeline system has to come from at least two suppliers.

As for the timing, Gazprom’s long-term contracts with its European customers were renegotiated in 2004, and the following year saw the beginning of the TEP discussions. The peak of the discussions took place in 2008-2009, and precisely at that time the second Ukrainian-Russian gas war broke out.

Kiev, which was behind in its payments for Russian gas deliveries, began to siphon off transit volumes illegally, and in response Russia cut off the flow of gas. The EU had to take urgent action, brokering a gas contract signed by Yulia Tymoshenko almost entirely on Russia’s terms. Six months later, when peace prevailed, TEP was adopted, and so began the systematic effort to squeeze out Gazprom across the board.

South Stream was blocked on the grounds of non-compliance with TEP, even though the contract for its construction was agreed to before TEP was adopted on the government level. In point of fact, TEP was created to prevent individual countries from taking such “initiatives” in the future.

It should be noted that South Stream was blocked immediately after the start of the events in the Ukraine. The structure developed in such a way that the Ukraine retained its status as a major transit country for Russian gas and became a sort of gas reservoir for Europe. With the advent of TEP, under any new contract Gazprom had to halve its gas supplies to the EU or sell half of the volume to the Ukraine on the Russian border.

Simply put, Russia ultimately was expected to pay from its own pocket the cost of the Ukrainian coup and the formation of a Russophobic government in Kiev. That is why the United States initially tried to bail out Naftogaz of Ukraine. The son of U.S. Vice-President Joe Biden even became a member of the Ukrainian gas monopoly’s board.

Vladimir Putin’s visit to Ankara and his agreement with Recep Tayyip Erdoğan on the construction of Turkish Stream has put paid to all that. The role of European transit country has now shifted to Turkey; moreover, in accordance with TEP rules, to fulfill a contract all Gazprom has to do is deliver the gas to the EU border. Moving it any farther is not Gazprom’s responsibility.

It was a calculated, well-aimed blow. Turkey is the only communication corridor offering an alternative route for Russia’s gas. For example, the proposed Nabucco pipeline to supply gas from Central Asia and the Middle East to the EU, bypassing Russia in the process, is based exclusively on Turkey as a transit country. But now there’s no getting around Russia.

The only question without a public response is the deadline attached to Russia’s ultimatum to Europe. Mr. Miller did not specify any period, saying only that Europe has little time left, in fact only a few years. This is understandable because contract terms and conditions are confidential.

But, not being bound by any confidential agreements, we are free to speculate about the deadline. Most of Gazprom’s European contracts, as already stated, were concluded in 2004. Earlier on, in the 1980s, such contracts had a term of 30 years. The term of the last contract was reduced to 15 years. It follows that D-Day – the time for renegotiation of contracts under the terms of TEP – will arrive in 2019, in other words, in only four years.

Four years is a political framework that limits Europe’s decision-making time. The choice is very difficult. In fact, there is no choice. Rejecting Russian gas supplies to Europe is tantamount to suicide. Switching to LNG, which is from one and a half to two times more expensive, would instantly make all European industries uncompetitive.

Europe needs Russian gas. All it can choose is the routes and the means for its delivery. It can negotiate with Russia on clear and transparent conditions, or it can break Russia’s resistance in order to gain access to the gas on its own terms. And the conductor standing behind the EU finds only the second scenario acceptable.

In fact, Europe has even less time (just making a decision is not enough) because it has to build a pipeline to the Turkish border. Otherwise it will have to “surrender” Ukraine. We do not want to play the role of Cassandra, but in four years anything can happen – even attempted assassinations of top politicians, in both Russia and Turkey.

By the way, one curious detail is that the Russian-Ukrainian contract signed in 2009 by Yulia Tymoshenko and Vladimir Putin has a non-standard term of 10 years. And, like most of Gazprom’s European contracts, it ends in 2019. Would that be by coincidence or by design?

The Importance Of The Cancellation Of South Stream

by Alexander Mercouris

The reaction to the cancellation of the Sound Stream project has been a wonder to behold and needs to be explained very carefully.

In order to understand what has happened it is first necessary to go back to the way Russian-European relations were developing in the 1990s.

Briefly, at that period, the assumption was that Russia would become the great supplier of energy and raw materials to Europe. This was the period of Europe's great “rush for gas” as the Europeans looked forward to unlimited and unending Russian supplies. It was the increase in the role of Russian gas in the European energy mix which made it possible for Europe to run down its coal industry and cut its carbon emissions and bully and lecture everyone else to do the same.

However the Europeans did not envisage that Russia would just supply them with energy. Rather they always supposed this energy would be extracted for them in Russia by Western energy companies. This after all is the pattern in most of the developing world. The EU calls this “energy security” - a euphemism for the extraction of energy in other countries by its own companies under its own control.

It never happened that way. Though the Russian oil industry was privatised it mostly remained in Russian hands. After Putin came to power in 2000 the trend towards privatisation in the oil industry was reversed. One of the major reasons for western anger at the arrest of Khodorkovsky and the closure of Yukos and the transfer of its assets to the state oil company Rosneft was precisely because is reversed this trend of privatisation in the oil industry.

In the gas industry the process of privatisation never really got started. Gas export continued to be controlled by Gazprom, maintaining its position as a state owned monopoly gas exporter. Since Putin came to power Gazprom’s position as a state owned Russian monopoly has been made fully secure.

Much of the anger that exists in the west towards Putin can be explained by European and western resentment at his refusal and that of the Russian government to the break up of Russia's energy monopolies and to the “opening up” (as it is euphemistically called) of the Russian energy industry to the advantage of western companies. Many of the allegations of corruption that are routinely made against Putin personally are intended to insinuate that he opposes the “opening up” of the Russian energy industry and the break up and privatisation of Gazprom and Rosneft because he has a personal stake in them (in the case of Gazprom, that he is actually its owner). If one examines in detail the specific allegations of corruption made against Putin (as I have done) this quickly becomes obvious.

His agenda of forcing Russia to privatise and break up its energy monopolies has never gone away. This is why Gazprom, despite the vital and reliable service it provides to its European customers, comes in for so much criticism. When Europeans complain about Europe's energy dependence upon Russia, they express their resentment at having to buy gas from a single Russian state owned company (Gazprom) as opposed to their own western companies operating in Russia.

This resentment exists simultaneously with a belief, very entrenched in Europe, that Russia is somehow dependent upon Europe as a customer for its gas and as a supplier of finance and technology.

This combination of resentment and overconfidence is what lies behind the repeated European attempts to legislate in Europe on energy questions in a way that is intended to force Russia to “open up” its the energy industry there.

The first attempt was the so-called Energy Charter, which Russia signed but ultimately refused to ratify. The latest attempt is the EU's so-called Third Energy Package.

This is presented as a development of EU anti-competition and anti-monopoly law. In reality, as everyone knows, it is targeted at Gazprom, which is a monopoly, though obviously not a European one.

This is the background to the conflict over South Stream. The EU authorities have insisted that South Stream must comply with the Third Energy Package even though the Third Energy Package came into existence only after the outline agreements for South Stream had been already reached.

Compliance with the Third Energy Package would have meant that though Gazprom supplied the gas it could not own or control the pipeline through which gas was supplied.

Were Gazprom to agree to this, it would acknowledge the EU’s authority over its operations. It would in that case undoubtedly face down the line more demands for more changes to its operating methods. Ultimately this would lead to demands for changes in the structure of the energy industry in Russia itself.

What has just happened is that the Russians have said no. Rather than proceed with the project by submitting to European demands, which is what the Europeans expected, the Russians have to everyone’s astonishment instead pulled out of the whole project.

This decision was completely unexpected. As I write this, the air is of full of angry complaints from south-eastern Europe that they were not consulted or informed of this decision in advance. Several politicians in south-eastern Europe (Bulgaria especially) are desperately clinging to the idea that the Russian announcement is a bluff (it isn’t) and that the project can still be saved. Since the Europeans cling to the belief that the Russians have no alternative to them as a customer, they were unable to anticipate and cannot now explain this decision.

Here it is important to explain why South Stream is important to the countries of south-eastern Europe and to the European economy as a whole.

All the south eastern European economies are in bad shape. For these countries South Stream was a vital investment and infrastructure project, securing their energy future. Moreover the transit fees that it promised would have been a major foreign currency earner.

For the EU, the essential point is that it depends on Russian gas. There has been a vast amount of talk in Europe about seeking alternative supplies. Progress in that direction had been to put it mildly small. Quite simply alternative supplies do not exist in anything like the quantity needed to replace the gas Europe gets from Russia.

There has been some brave talk of supplies of US liquefied natural gas replacing gas supplied by pipeline from Russia. Not only is such US gas inherently more expensive than Russian pipeline gas, hitting European consumers hard and hurting European competitiveness. It is unlikely to be available in anything like the necessary quantity. Quite apart from the probable dampening effects of the recent oil price fall on the US shale industry, on past record the US as a voracious consumer of energy will consume most or all of the energy from shales it produces. It is unlikely to be in a position to export much to Europe. The facilities to do this anyway do not exist, and are unlikely to exist for some time if ever.

Other possible sources of gas are problematic to say the least. Production of North Sea gas is falling. Imports of gas from north Africa and the Arabian Gulf are unlikely to be available in anything like the necessary quantity. Gas from Iran is not available for political reasons. Whilst that might eventually change, the probability is when it does that the Iranians (like the Russians) will decide to direct their energy flow eastwards, towards India and China, rather than to Europe.

For obvious reasons of geography Russia is the logical and most economic source of Europe’s gas. All alternatives come with economic and political costs that make them in the end unattractive.

The EU's difficulties in finding alternative sources of gas were cruelly exposed by the debacle of the so-called another Nabucco pipeline project to bring Europe gas from the Caucasus and Central Asia. Though talked about for years in the end it never got off the ground because it never made economic sense.

Meanwhile, whilst Europe talks about diversifying its supplies, it is Russia which is actually cutting the deals.

Russia has sealed a key deal with Iran to swap Iranian oil for Russian industrial goods. Russia has also agreed to invest heavily in the Iranian nuclear industry. If and when sanctions on Iran are lifted the Europeans will find the Russians already there. Russia has just agreed a massive deal to supply gas to Turkey (about which more below). Overshadowing these deals are the two huge deals Russia has made this year to supply gas to China.

Russia's energy resources are enormous but they are not infinite. The second deal done with China and the deal just done with Turkey redirect to these two countries gas that had previously been earmarked for Europe. The gas volumes involved in the Turkish deal almost exactly match those previously intended for South Stream. The Turkish deal replaces South Stream.

These deals show that Russia had made a strategic decision this year to redirect its energy flow away from Europe. Though it will take time for the full effect to become clear, the consequences of that for Europe are grim. Europe is looking at a serious energy shortfall, which it will only be able to make up by buying energy at a much higher price.

These Russian deals with China and Turkey have been criticised or even ridiculed for providing Russia with a lower price for its gas than that paid by Europe.

The actual difference in price is not as great as some allege. Such criticism anyway overlooks the fact that price is only one part in a business relationship.

By redirecting gas to China, Russia cements economic links with the country that it now considers its key strategic ally and which has (or which soon will have) the world’s biggest and fastest growing economy. By redirecting gas to Turkey, Russia consolidates a burgeoning relationship with Turkey of which it is now the biggest trading partner.

Turkey is a key potential ally for Russia, consolidating Russia's position in the Caucasus and the Black Sea. It is also a country of 76 million people with a $1.5 trillion rapidly growing economy, which over the last two decades has become increasingly alienated and distanced from the EU and the West.

By redirecting gas away from Europe, Russia by contrast leaves behind a market for its gas which is economically stagnant and which (as the events of this year have shown) is irremediably hostile. No one should be surprised that Russia has given up on a relationship from which it gets from its erstwhile partner an endless stream of threats and abuse, combined with moralising lectures, political meddling and now sanctions. No relationship, business or otherwise, can work that way and the one between Russia and Europe is no exception.

I have said nothing about the Ukraine since in my opinion this has little bearing on this issue.

South Stream was first conceived because of the Ukraine's continuous abuse of its position as a transit state - something which is likely to continue. It is important to say that this fact was acknowledged in Europe as much as in Russia. It was because the Ukraine perennially abuses its position as a transit state that the South Stream project had the grudging formal endorsement of the EU. Basically, the EU needs to circumvent the Ukraine to secure its energy supplies every bit as much as Russia wanted a route around the Ukraine to avoid it.

The Ukraine’s friends in Washington and Brussels have never been happy about this, and have constantly lobbied against South Stream.

The point is it was Russia which pulled the plug on South Stream when it had the option of going ahead with it by accepting the Europeans’ conditions. In other words the Russians consider the problems posed by the Ukraine as a transit state to be a lesser evil than the conditions the EU was attaching to South Stream .

South Stream would take years to build and its cancellation therefore has no bearing on the current Ukrainian crisis. The Russians decided they could afford to cancel it is because they have decided Russia’s future is in selling its energy to China and Turkey and other states in Asia (more gas deals are pending with Korea and Japan and possibly also with Pakistan and India) than to Europe. Given that this is so, for Russia South Stream has lost its point. That is why in their characteristically direct way, rather than accept the Europeans’ conditions, the Russians pulled the plug on it. 

In doing so the Russians have called the Europeans’ bluff. So far from Russia being dependent on Europe as its energy customer, it is Europe which has antagonised, probably irreparably, its key economic partner and energy supplier.

Before finishing I would however first say something about those who have come out worst of all from this affair. These are the corrupt and incompetent political pygmies who pretend to be the government of Bulgaria. Had these people had a modicum of dignity and self respect they would have told the EU Commission when it brought up the Third Energy Package to take a running jump. If Bulgaria had made clear its intention to press ahead with the South Stream project, there is no doubt it would have been built. There would of course have been an almighty row within the EU as Bulgaria openly flouted the Third Energy Package, but Bulgaria would have been acting in its national interests and would have had within the EU no shortage of friends. In the end it would have won through.

Instead, under pressure from individuals like Senator John McCain, the Bulgarian leadership behaved like the provincial politicians they are, and tried to run at the same time with both the EU hare and the Russian hounds. The result of this imbecile policy is to offend Russia, Bulgaria's historic ally, whilst ensuring that the Russian gas which might have flown to Bulgaria and transformed the country, will instead flow to Turkey, Bulgaria's historic enemy.

The Bulgarians are not the only ones to have acted in this craven fashion. All the EU countries, even those with historic ties to Russia, have supported the EU's various sanctions packages against Russia notwithstanding the doubts they have expressed about the policy. Last year Greece, another country with strong ties to Russia, pulled out of a deal to sell its natural gas company to Gazprom because the EU disapproved of it, even though it was Gazprom that offered the best price.

This points to a larger moral. Whenever the Russians act in the way they have just done, the Europeans respond bafflement and anger, of which there is plenty around at the moment. The EU politicians who make the decisions that provoke these Russian actions seem to have this strange assumption that whilst it is fine for the EU to sanction Russia as much as it wishes, Russia will never do the same to the EU. When Russia does, there is astonishment, accompanied always by a flood of mendacious commentary about how Russia is behaving “aggressively” or “contrary to its interests” or has “suffered a defeat”. None of this is true as the rage and recriminations currently sweeping through the EU’s corridors (of which I am well informed) bear witness.

In July the EU sought to cripple Russia’s oil industry by sanctioning the export of oil drilling technology to Russia. That attempt will certainly fail as Russia and the countries it trades with (including China and South Korea) are certainly capable of producing this technology themselves.

By contrast through the deals it has made this year with China, Turkey and Iran, Russia has dealt a devastating blow to the energy future of the EU. A few years down the line Europeans will start to discover that moralising and bluff comes with a price. Regardless, by cancelling South Stream, Russia has imposed upon Europe the most effective of the sanctions we have seen this year. .

The quote by Putin which says it all...

My Bulgarian colleagues have always told me that whatever happens, they would certainly implement South Stream, because this corresponds to their national interests. But here, unfortunately, this did not come to pass. If Bulgaria is deprived of the opportunity to act as a sovereign nation, then they should at least demand money from the European Commission to compensate for their lost profits, because direct revenues to Bulgaria’s budget alone would have been no less than 400 million Euros a year. But ultimately, this is also the choice of our Bulgarian partners; it seems they have certain obligations. Still, that’s not our business – it’s our partners’ business.

Vladimir Putin