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The Political and Commercial Dynamics of

Russia’s Gas Export Strategy

The Political and Commercial Dynamics of

Russia’s Gas Export Strategy

James Henderson

SWEDEN, MARCH 2016

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• Supply and demand for Russian gas is only balanced because of decline

in Gazprom production

• Domestic demand is stagnant and independents are gaining market share

• Demand from CIS countries is declining as they look to diversify away

from Russia (especially Ukraine)

• European demand has been in decline and EU now wants to reduce

reliance on Russia

• Emergence of Asia is currently based on one LNG plant on Sakhalin;

future growth relies on pipelines to China

The Russian Gas Matrix – Gazprom decline reflects

commercial reality

The Russian Gas Matrix – Gazprom decline reflects

commercial reality SUPPLY SOURCES: 2002 2008 2012 2013 2014

Gazprom production 522 550 488 487 444

Non-Gazprom production 73 114 169 181 196

Central Asian imports 34 61 29 33 26

TOTAL 629 725 686 701 666

MARKETS:

Russian gas demand (UGSS) 412 462 465 461 453

Exports to CIS countries 89 89 63 57 36

Exports to Europe (physical Russian gas) 129 159 139 163 147

LNG Exports to Asia 0 0 14 14 14

Change in Storage -1 15 5 6 17

TOTAL 629 725 686 701 666

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300

350

400

450

500

550

600

650

19

88

19

89

19

90

19

91

19

92

19

93

19

94

19

95

19

96

19

97

19

98

19

99

20

00

20

01

20

02

20

03

20

04

20

05

20

06

20

07

20

08

20

09

20

10

20

11

20

12

20

13

20

14

20

15

bcm

Gazprom’s production decline reached a post-

Soviet low in 2015

Gazprom’s production decline reached a post-

Soviet low in 2015

Gazprom production peaked at just over 600bcm in 1992, 2015

production fell to 418.5

Russian production fell to 633.5 Bcm; non-Gazprom production

rises to 215 Bcm

Yamal output is increasing to compensate for decline in core fields

3

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e Gazprom paying the price for investment in

relatively high cost reserves in Yamal region

Gazprom paying the price for investment in

relatively high cost reserves in Yamal region

Gazprom has seen its production profile shift away from its core

West Siberian mega-fields

Gazprom committed to development of Yamal peninsula in

2005/06, just before the economic crisis and impact of shale gas

It is now stuck with this strategy, and is having to rein in

production plans due to lack of demand

However, Yamal is a long-term, ultimately low-cost resource with

capex now largely sunk 4

Delays in Yamal production

0

20

40

60

80

100

120

140

2012 2013 2014 2015E 2016E 2017E

bcm

Production Capacity Initial Estimate

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e Russia has a gas bubble searching for markets Russia has a gas bubble searching for markets

Russia’s total supply capacity to western markets is c.750-800bcm

Demand for Russian gas currently stands at 670bcm (2014)

Supply capacity is set to rise by 2020 as Gazprom and Independents

develop new fields

Demand in core markets is at risk – Russia needs to protect existing

sales and find new customers rapidly

S-K

-V

5

Core Supply Capacity

Gazprom – 550-600bcm

Independents – 200bcm

East Siberia Capacity

Gazprom – 60bcm

Independents – 30bcm? Sakhalin Capacity

Gazprom – 15-22bcm

Independents – 15bcm?

Europe Demand

Gazprom –

165bcm

CIS

Gazprom – 45bcm

Domestic Demand - 460bcm

Gazprom – 270bcm

Independents – 190bcm

Chinese Demand

Gazprom – 0-100bcm?

Independents – 0-???

Asian Demand

Gazprom – 15-???bcm

Independents – 0-???

Existing Pipeline

Planned Pipeline

Existing LNG

LNG under construction

Possible LNG

Central Asia

Imports – 25bcm

250

300

350

400

450

500

550

600

650

Production 2008 Production 2014 GZP capacity 2013 GZP capacity 2014

bcm

Gazprom – 100bcm+ of extra capacity

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0

50

100

150

200

250

300

350

400

450

500

Total Demand Transport Own Use Gazprom Group Prod'n 3rd Party Prod'n

The changing Russian domestic gas market The changing Russian domestic gas market

Rising prices have incentivised alternative supply in the Russian

gas market

Gazprom has been limited in its ability to compete due to regulated

prices, despite requests to allow discounts

Independents have offered discounts and more flexible contract

terms to win significant market share

Independent production now accounts to more than 30% of the

Russian total, but questions now emerging about ability to supply

customers

6

To

tal D

em

an

d

Ind

ep

en

den

t

Sale

s

Lo

sses

Gazp

rom

Gazprom’s market share down to 55% in 2014 Independents produce more than 30% of Russia’s gas

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

35.0%

40.0%

No

n-G

azp

rom

Sh

are

of

Ou

tpu

t

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0

20

40

60

80

100

120

0

500

1000

1500

2000

2500

3000

3500

4000

45001

99

7

19

98

19

99

20

00

20

01

20

02

20

03

20

04

20

05

20

06

20

07

20

08

20

09

20

10

20

11

20

12

20

13

20

14

20

15

20

16

E

US$

/mcm

RU

R/m

cm

RUR/mcm US$/mcm

The Russian domestic gas price

The Russian domestic gas price

Rising trend in regulated price halted mid-2014. June 2015: tariffs

up by 7.5%, transportation tariffs for independents by 2%.

Dollar price has collapsed as a result of devaluation – netback

parity achieved by default

Regulated price continues to be used as a benchmark, although

actual prices are increasingly set around it

October 2015, the antimonopoly service said: expect tariff increase

of less than 5% in 2016, and 35 bcm of gas traded on exchange 7

The Impact of Devaluation

Assumes 5.5% increase in ruble gas price in 2016, and exch rate of RR76=US$1

0.00

2.00

4.00

6.00

8.00

10.00

12.00

2010 2011 2012 2013 2014 2015 2016

US$

/mm

btu

Industrial Price Russia Net Forward to Europe Europe Spot Price

Netback parity has almost been achieved

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e Europe sales rebounded in 2016, but FSU

exports continued to decline

Europe sales rebounded in 2016, but FSU

exports continued to decline

European sales have rebounded in 2015, to reach 158.5bcm

January and February data in 2016 is also up year-on-year

FSU sales fell again as Ukraine continues its strategy of

diversifying away from Russia

Gazprom has stated its intention to maintain at least a 30% market

share in Europe, and has talked of expanding this figure over time

The company continues to be sceptical about the threat from US

LNG, but will clearly face an increasing challenge

8

0.0

50.0

100.0

150.0

200.0

250.0

300.0

2007 2008 2009 2010 2011 2012 2013 2014 2015

bcm

Europe (LTC supply) FSU (sales)

Gazprom sales to Europe and FSU Gazprom market share in Europe

0%

5%

10%

15%

20%

25%

30%

35%

0

100

200

300

400

500

600

700

19

901

991

19

921

993

19

941

995

19

961

997

19

981

999

20

002

001

20

022

003

20

042

005

20

062

007

20

082

009

20

102

011

20

122

013

20

142

015

E

% R

uss

ian

imp

ort

s

bcm

Europe Demand Russian Imports % Russian imports

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• Stagnant gas demand and continuing rise of renewables in European

power sector – Cheap coal price displacing gas as back fuel for renewables

• Climate change talks and future of carbon pricing

• Global oversupply of LNG and consequent price competition – Imminent start of US LNG exports

• Impact of EU legislation and regulation, including DG COMP investigation

• Hostile attitude towards Russian gas within EU

• Ukraine transit and impact of Russia’s by-pass strategies

• Possibility of increase in oil price

• Changing governance structure of European utility sector

Issues for Russian gas exports to Europe Issues for Russian gas exports to Europe

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e Challenges in the West have prompted a “Pivot to Asia” Challenges in the West have prompted a “Pivot to Asia”

Gazprom and the Kremlin understand that Europe is looking for a

way to reduce its dependence on Russian gas

Politically and commercially Russia can benefit from diversifying

its export markets

The “pivot to Asia” is the obvious choice given China’s increasing

demand and NE Asia’s use of LNG

Pipeline exports to China can offset the worst case scenario in

Europe, and provide a potential bargaining chip

10

The new geography of Gazprom’s export strategy

0

20

40

60

80

100

120

140

160

180

200

bcm

Europe 70% ToP Power of Siberia Altai Far East Pipeline

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e Eastern Gas Programme had multiple objectives Eastern Gas Programme had multiple objectives

11

Gas exports to China via two, or perhaps three, pipelines

LNG exports from Sakhalin and Vladivostok

Development of domestic economy to encourage industrial

growth and re-population

Gazprom given the lead role, but now being challenged

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Price at entry

to China

Transport

to

Shanghai

Price in

Shanghai at

City Gate

Transport

back to

Xinjiang

Net back

price at Altai

pipeline

entry point

US$/mmbtu US$/mmbtu US$/mmbtu US$/mmbtu US$/mmbtu

Turkmen price in West China 4.00 4.48 8.49 4.48 4.00

Russia East Siberia Gas 4.13 2.50 6.63 4.48 2.15

Asia Spot LNG (Jan 2016) 6.45 0.00 6.45 4.48 1.97

Average LNG imports (Dec 2015) 7.64 0.00 7.64 4.48 3.16

Qatar LNG (Dec 2015) 8.83 0.00 8.83 4.48 4.35

US LNG (HH $2/mmbtu) 9.30 0.00 9.30 4.48 4.82

Myanmar imports 4.68 1.85 6.53 4.48 2.04

Benchmark Import Price 3.21

China domestic price (Shanghai) (Nov 2015) 10.72 0.00 10.72 4.48 6.24

Average Overall Benchmark Price 3.59

• Low gas prices are raising questions about economics of exports

• Uncertainty about future of Chinese gas demand also undermining Russian

export plans

• Chinese politics also not helping deals to be concluded, especially impact

of anti-corruption drive

• Questions must surely be asked about viability and timing of Power of

Siberia pipeline

• Altai will struggle to compete at current prices, especially as it presumably

needs to offer a price lower than Power of Siberia

Competitive position of Russian pipeline gas to China Competitive position of Russian pipeline gas to China Economics of Russian pipelines look challenging

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e Russia’s LNG prospects undermined by economic

reality

Russia’s LNG prospects undermined by economic

reality

Breakeven prices for Russian LNG projects suggest they are all

too expensive at current gas price

Assuming a rebound in the oil price before 2020, Yamal LNG can

cover its cash costs and Sakhalin 2 will continue to produce

Expansion of Russia’s LNG plans will depend upon cost control

and partnership

Sakhalin 2 expansion and Baltic LNG the most likely to progress,

but not before 2021 at the earliest

Breakeven economics of Russian LNG

projects compared to gas prices

13

0

10

20

30

40

50

60

70

80

90

2015 2020 2025 2030

mtp

a

Sakhalin 2 Yamal LNG Baltic LNG

Sakhalin 2 Expansion Vladivostok LNG Far East LNG

Arctic LNG Pechora LNG Shtokman

0.00

2.00

4.00

6.00

8.00

10.00

12.00

14.00

US$

/mm

btu

US LNG SRMC

Asia price

Europe price

Outlook for Russian LNG projects

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• Energy strategy to 2035 sees rapid growth in hydrocarbon exports to Asia

• Power of Siberia pipeline appears to be firm – construction has started on

both sides of border – Flexibility remains in 2019-2021 start date

– Potential for renegotiation remains

• Russia would prefer Altai pipeline, but discussions appear to have stalled

given Chinese uncertainties

• LNG plans are going backwards – Vladivostok LNG postponed indefinitely,

no Sakhalin 2 expansion before 2021, Far East LNG no longer a priority

• A level of desperation appears to have emerged on the Russian side, with

the proposal of a third pipeline from the Far East a clear example

• Realistically only one Russian pipeline is needed before 2025 unless

Chinese gas demand growth accelerates rapidly

Current status of Russia’s Asian plans Current status of Russia’s Asian plans

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• Russia has adopted a rather opportunistic export pipeline strategy over

the past 12-18 months

• South Stream (63bcm) cancelled– Turkish Stream (63bcm) announced –

Nord Stream expansion (55bcm) as alternative – Turkish Stream (1 line,

15bcm) the current plan – Greek pipeline under discussion – potential

Tesla and Eastring connections to Europe

• Position on Ukraine transit has also changed – now looking to negotiate

for access post 2019, as by-pass strategy will not be available by then

Confused evolution of Gazprom’s export strategy to

Europe exemplified by pipeline uncertainty

Confused evolution of Gazprom’s export strategy to

Europe exemplified by pipeline uncertainty South Stream and Turkish Stream Nord Stream, Lines 1-4

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0

2

4

6

8

10

12

US$

/mm

btu

Gas cost Liquefaction Transport Regasification Price Estimate

• US LNG can offer a proxy for the likely increase in availability of LNG to

Europe over the next five years

• Gazprom has stated that it will be prepared to compete with this new source

of supply, perhaps for political as well as commercial reasons

• A key issue for Gazprom (and any other major suppliers) is how to

disincentivise new projects

• Gazprom has rejected the idea of a price war, but has said that it will

compete for market share, and will match US LNG on cost

Uncertainty exacerbated by imminent challenge

from LNG in Europe

Uncertainty exacerbated by imminent challenge

from LNG in Europe

LRMC

SRMC

The potential impact of US LNG in Europe

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30 35 40 45 50 55 60 65 70 75 80 85 90 95 100

0.00

1.00

2.00

3.00

4.00

5.00

6.00

7.00

8.00

9.00

10.00

Coal Price (US$/tonne)

Ga

s P

rice

(U

S$/m

mb

tu

Equiv Gas Price Current Carbon Equiv Gas Price (Euro 20 Carbon)

Equiv Gas Price (Euro 40 Carbon)

• Currently low oil prices are making Gazprom’s gas more competitive (average

import price in December 2015 was $5.73/mmbtu)

• However, this is not low enough to compete with coal in Europe or with US

LNG at SRMC

• In addition, renewables costs are also coming down fast

• Gazprom can be competitive on cost of supply with all these sources of

energy, but will it choose to do so (especially if oil prices rebound)

• Preference would clearly be NO, but necessity may lead to change in strategy

Gazprom could be motivated to start a price war? Gazprom could be motivated to start a price war?

Cost of Russian gas supply versus competition Gas must be priced at $3-4/mmbtu to

compete with coal in Europe

0

2

4

6

8

10

12

US$

/mm

btu

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Gazprom can benefit from a Saudi-style price war Gazprom can benefit from a Saudi-style price war

0

2

4

6

8

10

12

Russian gasexportprice at$100+

US LNG(SRMC)

Russian gasexport

price (Jan2016)

US LNG(SRMC)

US LNG(Full Cost)

US$

/mm

btu

20

22

24

26

28

30

32

34

36

38

2016 2017 2018 2019 2020

Gro

ss R

even

ues

(U

S$b

n)

ACQ at US SRMC Current volumes at 2015 price

70% ToP at 2015 price 70% ToP at NBP forward

Current volumes at NBP forward Current volumes at US SRMC

• Gazprom is one of the lowest cost suppliers to Europe

• In the past a price war strategy made no sense in a relatively tight market

• However, prices have now fallen so far that the benefits of a further price

cut could outweigh the risks

• Gazprom may not proactively choose an aggressive price competition, but

it may be forced to fight for market share

Cost comparison of Russian and US gas to Europe A higher volume/lower price strategy can

now work for Gazprom

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e Gazprom already showing signs of competing,

and gas price will inevitably go lower by autumn

Gazprom already showing signs of competing,

and gas price will inevitably go lower by autumn

Gazprom has shown an inclination to make its gas price more

competitive

Inevitably its oil-linked price will go lower, given 6-9 month lag

effect

At least some market observers in Russia are suggesting that

Gazprom is in a position to adopt a Saudi strategy

The key question is what will happen as and when the oil price

recovers

19

-30%

-20%

-10%

0%

10%

20%

30%

40%

50%

60%

70%

0

50

100

150

200

250

300

350

400

450

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Q12015

Q22015

Q32015

Gaz

pro

m P

rem

ium

/Dis

cou

nt

US$

/mcm

Gazprom Price to Non-FSU NBP Spot Gazprom Premium/Discount

0

20

40

60

80

100

120

140

0.00

2.00

4.00

6.00

8.00

10.00

12.00

14.00

16.00

Jan-

11

Apr

-11

Jul-

11

Oct

-11

Jan-

12

Apr

-12

Jul-

12

Oct

-12

Jan-

13

Apr

-13

Jul-

13

Oct

-13

Jan-

14

Apr

-14

Jul-

14

Oct

-14

Jan-

15

Apr

-15

Jul-

15

Oct

-15

Jan-

16

Apr

-16

Jul-

16

Oct

-16

Oi P

rice

(US$

/bbl

)

Gas

Pri

ce (U

S$/m

mbt

u

Oil Price (RHS) Oil-linked contracts (11% slope with 6-9mth lag)

Russia Gas Price to Europe UK Spot Price

Gazprom price to Europe versus NBP Outlook for oil-linked gas price

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Conclusions Conclusions

Gazprom has a supply bubble of up to 100bcm of gas that can be

sold at SRMC into Europe

This gas can compete with US LNG, depending on the level of

Henry Hub gas price

Gazprom has tried to diversify to Asia, but LNG plans have been

pushed back and pipeline plans are moving slower than hoped

Europe will remain the company’s core market for at least the next

decade, and it may have to fight to retain market share

Gazprom has already shown its readiness to adjust prices to

competitive levels

It is showing signs of actively implementing a volume over price

strategy – its oil-linked price will be going lower in any case

The main question is what happens when oil prices start to rise

again – DG COMP outcome may be key to providing answer

Pipeline strategy reflects export uncertainty

20