Diminishing returns: the relative decline of Russia’s pipeline power

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Ship entering the Klaipeda LNG terminal, in Lithuania

When considering EU energy security, big pipelines get most of the ink. NordStream II, TurkStream, and the Southern Gas Corridor (SGC) are the focal points for arguments about EU efforts to diversify natural gas supplies. As much as 70% of any increase in EU imports is due to declining domestic production, not demand growth, and Russia will be the primary player to fill that need no matter what. Russian pipeline projects pose a diminishing threat to energy security due to structural changes on the market and smaller, less-heralded interconnector projects. Much depends on the EU’s commitment to building the Energy Union and using its considerable legal and political mechanisms to pressure Gazprom.

Gazprom – as Russia’s major state owned company – has responded to EU anti-trust actions by offering to allow triggers for reviews of long-term contracts that diverge from hub-based pricing. In other words, Central and Eastern European consumers will be able to review prices in their current contracts based on prices in more diversified markets in Western Europe. Destination clauses will be struck so that gas can be shifted around networks based on demand. That will help separate gas contracts from oil prices and force Gazprom to price its gas by supply and demand over time.

The eight markets affected by the anti-trust case – Poland, Hungary, Bulgaria, Estonia, Latvia, Lithuania, Slovakia and the Czech Republic – accounted for about 20% of Gazprom’s exports to Europe last year. Exports only increased 2% to these eight countries in the last year as opposed to 20% for Western Europe where Gazprom is more subject to competition due to better-developed legal and physical infrastructure. It is telling that the European Commission is trying to extract more concessions out of Gazprom after already reaching a tentative agreement on contracts since most have pegged gas prices to oil prices with a six to nine month delay. Central and Eastern Europe need negotiating leverage, in part by reducing links to oil markets so that supply and demand play a larger role setting prices.

That is where new interconnector, pipeline and liquefied natural gas (LNG) projects come into play. The EU has to achieve just enough diversity of supply to allow the physical integration of different markets and legal structures to restrict Gazprom’s pricing power and hedge against supply interruptions. Progress is uneven and prospects mixed but Russia’s pipeline projects are structurally losing their geopolitical value.

Lithuania’s Klaipeda LNG terminal is the most famous recent example of bringing in external supply to pressure Gazprom’s dominance on a small market. The construction of LNG gasification capacity and floating storage and regasification units (FSRU) lower the ceiling on prices, even for a market completely dependent on Gazprom, by creating the threat of competition. Lithuania achieved a 23% price reduction after launching its LNG project. Allowing even a small amount of supply from another source drives down prices considerably.

Poland has begun signing longer-term LNG supply contracts with the US, a pressure point because Gazprom’s contracts with Poland expire in 2022. Though completion has been delayed until 2021, the Gas Interconnector Poland-Lithuania (GIPL) will help hedge against Gazprom by creating more alternative sources for imports. When the Baltic connector – a gas pipeline linking Estonia and Finland – comes on stream in 2020, the Baltic market will move towards better price integration. Alongside greater use of renewables due to Gazprom’s high prices, the Baltics have significantly improved their bargaining position despite being very dependent.

Construction started earlier this year on the Hermanowice-Strachocina gas pipeline linking Poland and Ukraine’s gas distribution networks. The interconnector will be part of the broader North-South Gas Corridor meant to extend to the Czech Republic, Hungary, Slovakia, and then an LNG terminal on the Adriatic in Croatia. Poland projects that the corridor will be completed by 2022 when it plans to not extend its supply contracts with Gazprom. Despite some delays, Poland and the Czech Republic have signaled their commitment to speed up work.

The story is, in broad strokes, similar elsewhere. Moldova’s plans to privatize Vestmoldtransgaz, its natural gas distributor, are likely a means of passing the company into the hands of the Romanian firm Transgaz. By doing so, projects linking with Romania’s market would go ahead quickly, giving Moldova a competing supplier to force Gazprom to cut prices. Romania is also seeking investment into its domestic reserves for other export opportunities.

Hungarian regulators have narrowed capacity for Romanian export, but the Bulgaria-Hungary-Romania-Austria (BRUA) pipeline project has begun to receive funding through the European Investment Bank. Hungary blocked the expansion of the project into Austria, the most important cog for the project given its role as a gas hub, but all four countries signed a new Memorandum of Understanding at the end of September relaunching it in full. This is where larger pipelines begin to have a larger impact.

The SGC carries knock-on effects through the larger distribution system SOCAR’s investments are building in southeastern Europe. Bulgaria and Greece are finally set to begin construction of an interconnector next year that will allow the importation of small volumes from Azerbaijan, forcing Gazprom to compete. Greece and Macedonia have agreed in principle to build a north-south pipeline integrating their markets. Infrastructure will also be built in Albania and potentially up the Adriatic coast. These pipeline projects are meant to extend to Italy as well.

All of these developments suggest that European markets, by and large, are moving towards pricing based on competition, supply and demand, and more transparent markets. There are plenty of barriers to consider, such as differing national legislation on things like gas storage. But the trend lines show the diminution of the relative power Russia’s pipelines have to set market conditions, though not necessarily because of competing piped volumes from Azerbaijan. Azerbaijan’s export outlook is not strong, as low oil prices have significantly hurt the economic logic of investments into the country’s Caspian fields. Nor would 10 bcm from SOCAR be competitive anywhere in Europe aside from southeastern markets with small import needs. But weakening Gazprom’s grip on supply to Balkan markets will strengthen EU energy security as markets integrate and legal norms strengthen.

NordStream II may not even happen. The European Commission has just put forward proposals stating that all pipelines from third countries entering EU territory would have to comply with EU energy regulations. These would affect offshore pipelines as well. Doing so would potentially render the project unprofitable. Were Gazprom to allow third-party access to its pipelines, its effective piped gas export monopoly in Russia would be begin to fall apart. It is unlikely that will happen in the near-term. But it gives Europe means of pitting different firms in Russia against each other. LNG prices may also begin to integrate by region in the medium term. A pipeline project is not the power play it used to be as Gazprom is finding out.