As The Cold War Returns, Russia Turns East

by | published May 20th, 2014

Tonight I am a guest again on Chinese national TV. I’ll be appearing live via satellite from Ft. Lauderdale, Florida, and we’ll be discussing the crisis in Ukraine.

This time, however, we’ll be talking directly about energy.

With a new Cold War mentality returning to Europe, China is now about to take center stage in Moscow’s export strategy. The Kremlin has turned its attention to the East.

As Russian President Vladimir Putin digs in his heels for a long-term showdown with the West, natural gas has become his primary tool. Today, Europe is the single largest regional buyer of Russian gas, and about 25% of it travels across Ukraine.

But heading into the Conference on Interaction and Confidence Building Measures in Asia (CICA) that kicked off today in Shanghai, the situation is about to change.

And what happens over the next few weeks could dramatically change investment expectations worldwide.

Let me explain…

A History of Frosty Relations

The ongoing conflict in Ukraine is once again causing concerns over gas deliveries to Europe and the continuing position in the market of Gazprom, Russia’s natural gas behemoth.

But at least this time around, it is happening during a better time of year for end users.

The last dispute happened in January, 2009 during one of the coldest winter snaps in years. A pricing disagreement erupted between Russian and Ukraine which resulted in Gazprom cutting its deliveries. Unfortunately, that meant the pass-through volume across Ukraine to Europe ended as well.

In the intervening years, the European Union has since somewhat diversified the continent’s sourcing for its gas needs. Today, there is more liquefied natural gas (LNG) arriving at terminals in the Netherlands, Spain, and Italy from places like North Africa and Qatar.

And with the two legs of Nord Stream up and operating, even the supply from Russia has changed direction. This gas pipeline directly connects Russia with northern Germany across the Baltic Sea floor. It had been considered a politically secure transit route, since a former German Chancellor heads up the corporation running it.

Of course, that was before the annexation of Crimea, unrest in Eastern Ukraine, and the paralysis in Kiev changed the entire picture.

Putin’s Favorite New Customer

Now, Moscow is considering trade with China as a geopolitical response to its rising acrimony with the West. By moving his exports east, Putin is looking to secure two objectives.

The first is moving Gazprom revenues, essential to Russia’s central budget, from a politically insecure European direction to a more amenable Chinese one.

The second is to outflank the U.S. intentions to use LNG exports as a weapon in lessening Moscow’s influence over both the European and Asian markets.

To be sure, a Chinese initiative is hardly new. Discussions between Moscow and Beijing on gas trade have been ongoing for more than a decade. The impediment throughout has always been the price.

That hasn’t changed. In fact, price is still the problem, since a possible opportunity for an historical accord came and went yesterday during the meetings in Shanghai without a breakthrough. But the expectations these days are higher than at any point since the negotiations began ten years ago.

However, the dynamics of the situations have changed dramatically. The Chinese domestic market is demanding additional gas, both to support a rising internal need and to begin the essential process of weaning its economy from reliance on poor-quality coal.

This is how the all-important pricing issue is shaping up. China at the moment pays about $10 per 1,000 cubic feet for gas imported from Turkmenistan on an existing export pipeline system from Central Asia.

The exact price of such deals is always a matter of national interest and never divulged in this part of the world. But we do know that Russian exports to Europe are averaging about $8.80 per 1,000 cubic feet. The standard of measurement in most other places is via cubic meters. The price to Europe is running some $308.50 per 1,000 cubic meters; 1 cubic meter is a little over 35 cubic feet.

Nobody ever makes these things easy!

Anyway, the price is calculated and revised based on the price of a basket of crude oil and oil product prices. As the price of oil increases (as it is doing now), the price of gas increases right along with it.

There are also other considerations in a Gazprom contract. One is that the accord must be longterm (usually 20 years), while the other is what is called a take-or-pay provision. This requires that an end user accept a certain minimum percentage of a monthly contract volume (usually 75-80%) or pay as if it had.

Inside a Potential $40o Billion Gas Deal

As I have noted before, LNG traffic has been a primary competitor to this approach. That’s because regular LNG deliveries allow for the development of a local spot market where the LNG is received.

Unlike pipeline contracts, spot markets are quick transfers (usually completed within 72 hours) and are ad hoc rather than recurring purchases. The prices realized in spot markets are almost always lower than pipeline prices. Great for the user. Not so hot for companies like Gazprom.

The exception to this rule, at least for now, may be Asia. There, initial LNG from the U.S. would come in at closer to $15 per 1,000 cubic feet, while allotments from the Chevron Corp. (NYSE:CVX) Gorgon project in northwestern Australia or from the Exxon Mobil Corp. (NYSE:XOM) operations on Papua New Guinea may undercut that a bit.

The point is this. LNG as a weapon in Washington’s arsenal to curb Russian expansionary interests plays out much better in Europe than it does in Asia. Such a policy imbalance means the movement of gas east for Moscow is becoming a primary alternative.

According to sources, the agreement on the table in Shanghai is gargantuan – believed to be $400 billion over 30 years, delivering some 38 billion cubic meters (1.34 trillion cubic feet) of gas annually over a proposed $22 billion pipeline. That would translate into around $9.50 per 1,000 cubic feet. Of course, Beijing knows full well what Moscow’s policy situation is and is looking to cut that cost.

Either way, a deal could be announced any time.

When it’s announced, it is going to alter the energy landscape… and the geopolitical picture right along with it.


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