Gazprom: Selective reliability as a power instrument

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The supply shortfall shows once again that the EU is in urgent need of a diversification of gas suppliers, as the premise of stable supplies from Russia is crumbling fast.

The shortfall in gas supply during the recent cold period in February 2012 was in essence directly caused by Russia’s both long-term investment decisions and more immediate decisions at the gas tap. When Gazprom reduced deliveries one could hear the argument that they could “simply not meet demand” due to the extreme temperatures in Russia, as if this was simply an issue of bad luck. But most things in life do not happen by chance and, indeed, Gazprom has withstood similar winters in the past. So what were the problems this year?

As a significant part of consumption takes place in the household sector for heating, the demand for gas is not evenly distributed throughout the year. Gas demand during summertime is often only a third of the demand in winter. As a consequence, gas supply has to deal with high seasonal volatilities. The greater the share of household consumers in total gas demand, the larger the volatility. There are basically two ways to deal with it: the first is to reduce gas production in summer and increase it in winter. This requires a relatively short distance to market, the necessary transportation capacities, and clever management of gas production. The second solution is to construct storage facilities which would allow for storage of gas in the summer and withdrawal at peak demand during the winter.

Storage capacity

Gazprom’s problems mainly stem from the fact that it did not invest into Russian gas storage while peak demand in Russia rose. As Gazprom has the political task of “gasifying” more Russian regions, and as a growing middle class tends to own bigger flats and houses, peak demand is on the rise. So, the share of communal services and households grew at an annual average rate of above 7 per cent from 2006 to 2010. At the same time, Gazprom’s Russian storage capacities were not sufficiently expanded. Russian storage capacity is only double that of Ukraine – while Russia’s domestic gas market is more than four times larger than Ukraine’s.

The lack of investment into storage and production sites was by no means due to a lack of money, but due to political priorities. At the same time as Gazprom has stopped investments into storage facilities, it has forcefully pushed ahead in constructing additional export pipelines such as Nord and South Stream. Currently, export capacity is not a bottleneck – on the contrary, there are significant export pipeline overcapacities. But the pipelines are Putin’s priority, and they are also used as a tool to cement Gazprom’s market position in the EU. Gazprom’s misinvestment into pipelines thus reveals that supply shortfalls did not happen by accident but were due to wrong investment priorities.

Even as Gazprom skipped the storage investments, it could have made additional supplies available from Turkmenistan, as it did previously. Gazprom sits in the middle of the Eurasian pipeline supply system, giving it a privileged position in sourcing supplies from Central Asia. But for some reason Gazprom refrained from contracting additional volumes. Relations with Turkmenistan have soured in general since Gazprom violated its purchasing contract with Turkmenistan in April 2009. And in a move that the gas industry has termed “the Russian way of take-or-pay”, Gazprom simply closed the tap, leading to a pipeline explosion on the Turkmen-Uzbek border.

In addition, Gazprom discriminated between export markets, highlighting the intentional character of the supply shortfalls. Gazprom increased gas deliveries to Turkey above contractual levels at the same time as contractual requests within the EU were not met. This shows that Gazprom is willing to discriminate not only between internal and export markets, but also between different export partners. It is very likely that increased deliveries to Turkey were a reward for its recent permission to lay the South Stream pipeline in Turkish waters, whereas Gazprom wanted to show the EU that it has not been sufficiently cooperative in the past.

The fact that Russia wanted to use the supply shortfalls to further its agenda is revealed by its subsequent moves. Instead of apologizing, Gazprom blamed the EU and used the irregularities to push through its message: gas market liberalisation was supposedly the wrong track. If the EU wanted stable supplies, it would have to scrap its gas market liberalisation plans, or grant exemptions to Russia. This was clouded in a twofold message: market liberalisation supposedly did not work, as spot markets were not liquid enough to deal with the shortfalls. Secondly, the shortfall would confirm that Gazprom’s South Stream pipeline was urgently needed, Gazprom and Putin agreed.

Unreliable behaviour

As during the gas cutoffs of 2006 and 2009, these remarks show that Russia is again trying to capitalise on its unreliable behaviour by exposing the EU’s vulnerabilities. But the Russian propositions turn reality upside down. If the EU conceded, it would induce Russia to behave in similar ways in the future. So it is of paramount importance to get the strategic implications of the situation right.

Firstly, the spot market works – where there is one. Surely, where there is no spot market, it does not work either. The latter was true in Italy, and also in Middle and Central Eastern Europe, where supplies had to be cut temporarily to certain customers. In Northern Europe, which is an area with liquid markets, prices spiked, but supplies were kept stable – despite the unexpected event of Russian gas supply reductions. So, what the supply shortfall rather points to is that long-term contracts with Russia are of a questionable value. Their objective is to secure stable supplies at a price pegged to oil products. The minimal and maximal daily volumes a consumer can take and a producer has to deliver are pre-specified to reduce the risks of delivery shortfall. If a producer can suddenly decide to reduce the amount delivered (and deliver parts of it to another export market instead) the whole rationale of a long-term contract is questionable.

Rather than putting a question mark behind spot markets, the supply shortfalls thus challenge rationale behind existing long-term contracts with Gazprom. This argument is reinforced by the fact that long-term contracts traditionally designated a specific gas field as a supply source which would be used as a basis for fulfilling the contract. The Soviet Union successfully renegotiated these provisions, arguing that its vast supply base rendered such provisions superfluous. Today, this may have turned out to be a grave error committed by the European gas industry.

Secondly, additional export pipelines like South Stream are neither a remedy to the supply shortfalls, nor are they needed to meet supposedly increasing EU gas import demand. Russia does not even produce enough gas to fill the export pipelines that are currently existing or under construction. The second prominent argument advanced to support new pipelines from Russia has been rather geopolitical: Increasing demand from Asia would render those pipelines valuable, as they would show a high Russian commitment to the European market.

This argument hinges on two shaky foundations. First, it presupposes that Gazprom would find similarly attractive markets in Asia, particularly in China. But Gazprom has been failing to reach a price accord with China for years. China has ample natural gas resources on its own and has entered into supply relationships with Central Asia and Australia. Also, Gazprom’s involvement in the Chinese market will be guarded by the Chinese national oil companies, limiting Gazprom’s role to that of an external supplier. Rather, if Gazprom found attractive markets in the East, it would not pursue an aggressive market-seeking policy in Europe. Second, the sunk costs of the pipelines are more limited for Gazprom than the argument suggests. At least in the case of Nord Stream, Gazprom finances only 40 per cent of the whole project. If Gazprom would default on its obligation to use those pipelines, German and Italian taxpayers, EU utilities, and EU banks would have to pay the bill.

Thus, rather than bringing added value in terms of security of supply and prices, the objective of new pipelines is to hinder the development of a liquid gas market in the EU. This is done by lining up EU companies to join the pipeline consortium, by distributing costs across a wide range of constituencies in Europe, and by ensuring control over the connecting pipelines on EU territory. In this context, Gazprom demands exemptions from EU legislation mandating third-party access to pipeline infrastructure. As the pipelines are detrimental for EU gas market development, these demands have to be rejected. Instead, it is important to ensure that Gazprom uses its funds to invest into Russian storage facilities.

Clear lessons

The lessons for the EU should be clear: Russia is not the Soviet Union, the bipolar context is gone, and Gazprom is not the “reliable supplier” that the Soviets may once have been (in the eyes of Western Europe). Gazprom’s market share in the EU turns out to be already too high for the sort of power play Moscow wants to pull off with the EU. By exploiting irregularities and crises to display and test the EU’s vulnerabilities, Russia strives to derail the EU’s market liberalisation agenda, putting its “pipeline-isation” agenda ahead of the EU’s marketisation.

Meanwhile, many EU member states and institutions have so far rather rewarded Russia’s unreliable behaviour: The 2006 and 2009 gas supply cuts contributed greatly to the acceptance of the Nord Stream pipeline as a bypass. The 2009 crisis was also instrumental in the German decision to grant Nord Stream’s connecting pipeline, the OPAL, exemptions from third-party access. Following Nord Stream, South Stream is set to be Russia’s next Trojan horse for the EU agenda. So instead of rewarding Russia, the EU and its gas industry have to focus on diversifying suppliers which is an essential element of completing an internal gas market. Otherwise, the outlook for gas as the “fuel of choice” for the transition to a renewable power generation looks rather bleak.

Jonas Grätz is a researcher with the Center for Security Studies at ETH Zurich. He specialises on the internationalisation of Russian oil and gas companies, EU energy policy, and energy geopolitics.