In Background, Russia

Cancellation of South Stream makes economic sense

By Hedvika Kodousková and Martin Jirušek, published on, Dec. 12, 2014

On December 1, 2014, Vladimir Putin announced that Russia would abandon construction of an ambitious $40 billion project – the South Stream gas pipeline.

The project, together with Nord Stream pipeline, would have bypassed traditional transit countries of Russian gas (especially Ukraine) and, according to many commentators, carried clear geopolitical overtones. One of its biggest assets would have been its route, which was planned to go through the countries with friendlier relations to Moscow and thus reduce the risk of repeating the “Ukrainian scenario”.

South Stream gas pipeline

South Stream gas pipeline

Although in many cases Russia is willing to prioritize its strategic goals over economic costs, the commercial viability of the South Stream pipeline was uncertain from the very beginning. The economics of the project would be problematic, especially if the principles of EU’s internal energy market would have been introduced, particularly the third party access principle. From the technical point of view, huge amounts of money would have been spent to build an additional supply route to Europe, which is not necessarily needed. Generally speaking, the demand curve of traditional consumers is not favorable for the project’s construction. It rather seems that Gazprom is being forced to confront a new reality and revise its current strategies, focusing on prospective markets.

Europe versus Asia

The focus on the growing Asian market is increasingly apparent in the company’s activities. This May, after ten years of tough negotiations, Gazprom and China’s CNPC finally concluded a gas deal. Under the 30-year contract, Russia will supply China with gas supplies gradually increasing up to 38 billion cubic metres a year (bcm/y) via the eastern route pipeline. The first part of the project, the so-called ‘Power of Siberia’ pipeline running from eastern Siberia to Vladivostok on the Pacific coast, is to bring gas from the Kovykta gas field in the Irkutsk region and Chayanda gas field in Yakutia, to the Chinese-Russian border, where the spur pipeline to Chinese territory is to be built from. The first gas deliveries are to reach China in 2018. While previously Gazprom appeared to be a tough negotiator, insisting on the construction of a Western route instead (the so called Altai project – an extension to the Russian-Chinese border of the existing transmission corridor from Western Siberia to Novosibirsk) and on higher gas prices paid for the supplies, the pressure from political leadership and changing conditions in international markets forced Gazprom to abandon its previous demands and proceed to the practical implementation of the project.

Power of Siberia pipelineWhile gas demand in the European Union (EU) weakens, the demand of Asian economies, especially Chinese, is rising to unprecedented heights. In 2000, China consumed approximately 28 bcm/y of gas. In 2013, it demanded nearly 162 bcm/y of natural gas, while its domestic production stands at 117 bcm. That year, more natural gas was only consumed in the U.S., Russia and Iran. In 2009, China overtook Japan to become the largest consumer of natural gas in the. worldIt is expected that Asia-Pacific will become the centre of gravity of internationally traded gas in coming years. In Asia, the biggest increase will be in LNG trade.

It is thus not surprising that assumptions suggesting the share of eastern markets will rise at the expense of European markets can be found even in official Russian policy documents. According to the Energy Strategy of Russia for the period up to 2030, the volume of gas supply to the European market will be retained at the necessary level, while the eastern direction of export will be “multiplied”. Similarly, an amendment to the Strategy for the period up to 2035 states that demand of the traditional consumers will stagnate while it is expected that in the countries and regions where the Russian presence has been limited so far the demand will rise. This conclusion is also confirmed by the International Energy Agency (IEA), according to which the rate of Russian gas export up to 2020 will grow only moderately. Considerable expansion is expected only after 2020, thanks to the construction of the gas pipeline to China.

Another factor influencing Gazprom’s strategies is the legislation of the European Union (EU). Gazprom is forced to obey the rules of the EU’s internal energy market which in fact is in contradiction with the traditional Gazprom’s strategy of individualized contracts and partitioned market. Growing interconnectivity, consumer pressure to renegotiate long-term contracts and banning the so called destination clause profoundly change the environment. Gazprom is thus no longer the creator of the market, but rather its subject subordinated to the rules that are weakening its position.

Gas pipelines Russia-China, image by Trish McAlaster, Globe and Mail, May 2014

Gas pipelines Russia-China, image by Trish McAlaster, Globe and Mail, May 2014

Another factor that needs to be taken into account along with the demand changes in Asia and Europe is the rather moderate rise of the demand on Russian domestic market. Moreover, competition among the suppliers on the Russian market is predicted to increase as well as competition on the LNG market is expected to intensify with new LNG exporters (U.S., Canada, Australia, East Africa, etc.) stepping on stage in the near future. The related remark of Putin illustrates this assumption: “The U.S. and Canada are already carrying out active shale gas production… Another new trend has also long been underway – that of rising trade in LNG”. Gazprom is therefore definitely intending to focus on the eastern markets where the greatest growth in LNG demand is expected.

Increasing domestic competition

However, concerns that tankers of new LNG exporters will reach Asian customers before Russia manages to develop its enormous yet untapped gas resources in the Eastern Siberia are not the only ones to impact the revised Gazprom strategies. Gazprom has been facing increasing domestic competition from its rivals as well–Novatek’s Yamal LNG and Rosneft’s Sakhlin I. projects. Last year, the Russian government discontinued Gazprom’s monopoly over LNG exports in a clear effort to boost Russian share of the global LNG market to around 10 % by 2020. An enacted amendment package to the “Gas Export Law” opened up a possibility of exporting LNG from the particular sources, which clearly favors Gazprom’s rivals and their project partners. On the other hand, Gazprom’s monopoly on pipeline gas export stayed untouched. Still, if Gazprom fails to penetrate the lucrative Asian market in the next few years, it could soon face competitive supplies from the independent producers as well as other Russian state-owned oil companies.

Recent development suggests that Gazprom currently and probably also prospectively gives more attention to LNG exports. The company announced it was considering a possible expansion of the first Russian LNG export project – Sakhalin II. At the beginning of this year, Gazprom and its project partner Royal Dutch Shell signed a roadmap which envisages the preparation of documentation for a third LNG liquefaction unit. Alexei Miller, Gazprom’s CEO, commented as follows: “The global LNG market is booming – primarily in Asian countries. New LNG production capacities are the key to achieving a strong position on this market.” Although such memoranda cannot be regarded decisive, such events can be definitely attributed to the revision of Gazprom’s strategies with regard to the changing situation on the world markets.

Investment and financing

The financial part of Gazprom’s planned projects also appears to be an issue. In order to export liquefied natural gas to the Asian market, Gazprom originally favored its own project in Vladivostok. The terminal should be supplied with gas both from Eastern Siberian gas production regions and the Sakhalin III project. After the October meeting of Gazprom and CNPC, however, Alexei Miller said that Gazprom is rather considering the possibility of pipeline gas exports to China as an alternative to LNG shipments from Vladivostok. Relevant world media ascribed reconsideration of the project to the anti-Russian sanctions which complicate its subsidiaries to gain key technologies and components as well as necessary funds from western banks and investors. The South Stream project probably faced similar problems, despite the fact that it was still considered the priority project in latest Gazprom’s financial strategies (with regard to the “geopolitical situation” in Europe and the US and EU sanctions). Western financial institutions, under the effect of anti-Russian sanctions, were reluctant to provide loans for the construction of expensive offshore section of the pipeline.

Investments in the Siberian infrastructure projects thus remain primarily on the agenda, even though the ‘Power of Siberia’, at an estimated cost of $55 billion, is extraordinarily expensive project, even for Gazprom. China has a crucial role in this regard, as it allegedly promised to invest up to $20 billion into the construction of the Chinese section of the pipeline, gas storage and other supporting facilities. Although details of the contract have not been made public, speculations have surfaced concerning an advantageous loan of $25 billion which the Chinese supposedly promised to Russians in exchange for the future gas supplies (“loan-for-gas” agreement), in order to facilitate the development of the expensive project.

Cancelled South Stream gas pipeline

Cancelled South Stream gas pipeline

Cooperation with China could partially offset Gazprom’s earlier investments on the Yamal peninsula. In fact, the uncertainty of the demand within the traditional markets, and the rise of new players in Russia, led to uncertainty whether Yamal fields would be fully utilized. Moreover, the higher the gas supplies from Yamal at the expense of Gazprom’s older fields, the higher the costs. Recent news about a framework agreement being signed between Gazprom and CNPC on gas imports from Russia via the western route can be perceived as a political gesture to the West – a demonstration of Gazprom’s future ability to connect western and eastern markets and flexibly respond to the regional demand development (but also to current political and economic relations). However, it may also be regarded as a simple reflection of current trends within which Gazprom focuses on growing prospective markets.

To sum up, it is now becoming obvious that the unshakeable faith in the European gas market and its ability to generate sufficient profits is a thing of the past. Considering also the current Russian position on financial markets and uncertain revenues, we may conclude that the cancellation of the South Stream project makes economic sense and probably is, most likely, not motivated politically.

Hedvika Kodousková and Martin Jirušek comment on the wider context of this decision. Kodousková and Jirušek work as analysts and lecturers at the Department of International Relations and European Studies, Faculty of Social Studies, Masaryk University, Czech Republic.



EDITOR’S NOTE: We remind our readers that publication of articles on our site does not mean that we agree with what is written. Our policy is to publish anything which we consider of interest, so as to assist our readers in forming their opinions. Sometimes we even publish articles with which we totally disagree, since we believe it is important for our readers to be informed on as wide a spectrum of views as possible.

Recent Posts
Contact Us

We're not around right now. But you can send us an email and we'll get back to you, asap.

Start typing and press Enter to search

Translate »