NOVEMBER 2016: Issue 107 forum

A QUARTERLY JOURNAL FOR DEBATING ENERGY ISSUES AND POLICIES

It is well known that Russia is heavily not be practically possible, meaning CONTENTS dependent on its energy sector, from that oil and gas companies could face both an economic and a political a stealth increase in their overall tax Russian energy issues in a volatile perspective. As a result, the fall in the burden. environment oil price over the past two years and the Tatiana Mitrova then discusses one Russia’s macroeconomic problems and dramatic changes taking place in the of the key factors underpinning the the risks to the oil and gas sector global gas market are having signifi cant survival of Russia’s hydrocarbon Christopher Granville 4 consequences for both the Kremlin and industry in 2016, namely the devaluation Russia’s domestic energy companies. Cost dynamics in the Russian energy sector of the ruble and its impact on cost Tatiana Mitrova 7 However, instead of reviewing the competitiveness. The Russian increased risks for Russia from the The Rosneftization of the Russian oil sector government’s decision not to protect change in global energy markets, this Nina Poussenkova 9 the domestic currency as the oil price edition of the Oxford Energy Forum collapsed has signifi cantly enhanced Securing the future: the implications of discusses how Russia has started the position of exporting industries, India’s expanding role in the Russian oil to adapt its policies and commercial reducing their costs in US$ terms, sector strategies in a number of different areas. Vitaly Yermakov 12 but Mitrova argues that this benefi t Some of the new strategies appear very has limited further upside and could positive, while others carry inherent Ukraine’s dramatic gas import diversifi cation risks, but all show how the world’s indeed be reversed if the oil price Simon Pirani 15 largest producer of hydrocarbons is recovers. What is needed for long-term being forced to respond politically and competitiveness to be maintained is The revived Turkish Stream: what, where, commercially to the shock of lower systemic improvements in business and when? commodity prices. practices across the industry. Katja Yafi mava 17 In the fi rst article Christopher Granville From an oil industry perspective, From Nord Stream 1 to Power of Siberia 1: assesses the potential risks to the Nina Poussenkova then considers the a change in mind-set from Soviet planning oil and gas sector from the Russian growing role of Rosneft in the sector, to capitalist unknowns! government’s need to balance the which is particularly relevant following Thierry Bros 20 budget in a low oil price environment. its recent acquisition of fellow state Novatek leads the advance of Russian LNG Increased taxes from oil and gas company Bashneft in the controversial James Henderson 22 production and exports are clearly privatization. This latest purchase Russian power sector approaching the one possible source of extra revenue, seems to have been driven by Rosneft’s next investment ‘wave’ but power but Granville argues that the Kremlin concerns over its production outlook, companies are still mulling the key and Poussenkova questions whether understands the risks this could create decisions for the industry and will focus instead the dominance of the state oil company Fedor Veselov, Andrey Solyanik, on trying to reduce spending across the will be positive for future Russian oil and Irina Erokhina 24 economy. However, in reality this may output. She also asks whether Rosneft’s

OXFORD ENERGY FORUM

provide a review James Henderson also have interesting implications for interesting implications also have on its need for ects it refl the EU as despite its Russian gas in the future, political concerns. exibility has been Development of fl Russia’s LNG the main driver behind but as strategy, the corporate discusses in his article, now more focus in this area is The on Novatek than Gazprom. competition emergence of domestic for Gazprom started in 2013 when LNG exports were liberalized, and it would now seem that Novatek is set to become Russia’s largest LNG LNG project comes as its Yamal player, to fruition while Gazprom’s plans dent is lag behind. Indeed, so confi Novatek about its future that it already has a second project at the planning stage, raising the possibility that it could become the dominant Russian player in this arena. on a more domestic note Finally, et al Fedor Veselov focusing in of the electricity sector, particular on the implementation of the continuing reform process. They argue that the use of a complex capacity payment system has led to overcapacity in the generation cient market, with older more ineffi plants remaining online beyond their theoretically useful life. On a more positive note they also suggest that this problem is gradually being remedied and that the operational ciency of the sector should therefore effi increase, as decommissioning accelerates and a wave of investment in new plant is encouraged. addresses Katja Yafi mava KatjaYafi then looks at Gazprom’s looming negotiation over gas transit, over gas looming negotiation of deadline for the end as the 2019 with Gazprom the current contract approaches. this negotiation is The other element in diversify its transit Russia’s own plan to options, and on the progress this issue in her article Sea with the being made in the Black Stream pipeline. She reviews Turkish the project, which the volatile history of ected Russian relations with has refl and assesses both the EU and Turkey, the most likely development plan and the future capacity of the pipe. She also considers the potential for the South Stream project to re-emerge in a smaller form (South Stream ‘lite’) and looks at the potential impact of all these options on possible gas transit volumes through Ukraine after 2020, concluding that countries in south-east Europe will remain dependent on this route for some time. Thierry Bros overall pipeline strategy and discusses whether the company is becoming more commercially realistic with its spending plans. He asserts that Gazprom’s traditional ‘gold-plated’ strategy of building capacity to meet all possible demand scenarios was possible in a world of continually growing gas demand, but suggests that the company is developing more cautious plans for a new less optimistic era. He uses the development of the of Siberia pipeline in the Far Power East as an example of how Gazprom is adapting to market needs and is expansion exibility in its creating more fl programme. He argues that this could Simon Vitaly picks up this theme in a picks up this theme OXFORD ENERGY FORUM picks up in the gas sector, but on picks up in the gas sector, 2 discussion of Russia’s, and Rosneft’s, discussion of Russia’s, growing relationship with India and its key oil and gas companies. He highlights two important trends, the rst being a need to bring in partners fi nancing of who can help with the fi new projects, and the second being nd alternatives to Russia’s desire to fi Chinese investment in Russia, as the need to avoid dependence on Russia’s southern neighbour in the East is increasingly being seen as politically and commercially vital. He also highlights the continuation of a Russian ‘upstream–downstream’ strategy which has seen Rosneft take an interest in an ning business to balance the Indian refi upstream deals done in Russia. cation is a theme that Diversifi diversifi cation into the gas sector and the gas sector and cation into diversifi more non-core, activities into other, from its main will distract the company production objective. and Rosneft’s funding constraints eld new fi its need to continue to a growing development have led with foreign trend towards partnership those from companies, especially as allies. countries perceived Yermakov Pirani this occasion it is the more traditional story of a desire to buy less Russian gas. He considers how one key export market for Gazprom, Ukraine, has reduced its import requirement through a combination of falling demand, gas from ow purchases of reverse fl Europe, and a drive to increase domestic output. This has put Ukraine in a stronger position in its commercial relations with Russia ahead of the RUSSIAN ENERGY ISSUES IN A VOLATILE ENVIRONMENT RUSSIAN ISSUES ENERGY A VOLATILE IN

INTRODUCTION TO THIS ISSUE NOVEMBER 2016: ISSUE 107 INTRODUCTION TO THIS ISSUE CONTRIBUTORS TO THIS ISSUE

Thierry Bros is a Senior Research Simon Pirani is a Senior Research Katja Yafi mava is a Senior Research Fellow, OIES Fellow, OIES Fellow, OIES

Irina Erokhina is at the Energy Nina Poussenkova is Senior Research Vitaly Yermakov is Head of the Center Research Institute of the Russian Fellow, Institute of World Economy for Energy Policy Research at Russia’s Academy of Sciences (ERI RAS) and International Relations (IMEMO), National Research University – Higher Russian Academy of Sciences School of Economics Christopher Granville is Managing Director, EMEA and Global Political Andrey Solyanik is at the Energy Research, TS Lombard Research Research Institute of the Russian Academy of Sciences (ERI RAS) James Henderson is Director of the Natural Gas Programme, OIES Fedor Veselov is Head of Department Tatiana Mitrova is Head of Oil and Gas for Development and Reforms in the Electric Power Sector, Energy Department in the Energy Research The views expressed in this issue are solely Institute of the Russian Academy of Research Institute of the Russian those of the authors and do not necessarily Sciences (ERI RAS) and Senior Academy of Sciences (ERI RAS) represent the views of OIES, its members, Visiting Research Fellow, OIES or any other organization or company.

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Russia’s macroeconomic problems and the risks to the oil and gas sector Christopher Granville

As is the case with all petrostates, achievement rely on continued Russia’s macroeconomic stability increases in the tax burden on oil and ‘THE RUSSIAN ECONOMY EXPERIENCED hinges, to a large extent, on the gas companies? ITS SECOND STRAIGHT YEAR OF credibility of government efforts to RECESSION IN 2016 …’ adjust the public fi nances to ‘lower Overall adjustment on track for longer’ oil prices. This is the time On the fi rst theme, the government’s of year when progress on fi scal and 4 per cent thereafter (resulting federal budget proposal for 2017–19 adjustment can most easily be gauged, in the real year-on-year spending cut displays a clear commitment to the as the government’s defi nitive federal being marginally smaller in 2017 than it necessary fi scal adjustment. And it budget for the three years ahead was this year, see ‘Annual changes in seems safe to assume that the huge gets submitted to the State Duma in federal budget spending’ opposite). majority secured by the pro-Kremlin late October and must complete its United Russia party in September’s parliamentary stages in time to be The Russian economy experienced its parliamentary election virtually signed into law by President Putin at second straight year of recession in guarantees that the draft budget will be the end of December. 2016 – albeit milder (with real GDP set enacted without material amendments. to fall by around 0.5 per cent) than last From the perspective of Russia’s oil The two highlights are: year’s sharp contraction of 3.7 per cent. and gas industry, the government’s Although the economy is expected to fi scal policy matters in two main ways. A conservative average oil price return to growth next year, the offi cial assumption of US$40/bbl for the forecast that real GDP will expand by The fi rst – which is equally important entire three-year period. 0.6 per cent is hardly a stellar bounce to the rest of the Russian economy A determination to make the back; the growth forecasts for 2018 and, for that matter, all stakeholders spending side shoulder the main and 2019 – respectively 1.7 and in the country – hinges on whether burden of fi scal consolidation 2.1 per cent – would still leave the the risk to fundamental economic (sticking to a commitment that Putin Russian economy continuing to lose stability from the oil price shock can made in 2014 not to increase taxes share of global output. Against this be contained, with the core of this for the remainder of his presidential background, it may seem strange that challenge lying in the public fi nances term ending in 2018). the Russian government has adopted a and public debt – which must be strategy of fi scal austerity. There might The broad budget framework that placed onto a stable footing on seem to be a good case for postponing emerges from these starting points is conservative oil price forecasts. the necessary fi scal consolidation and summarized in the table below. The second point is more specifi c to using fi scal policy to boost demand, the oil and gas sector (though this Focusing on the spending projections, which would in turn facilitate fi scal also has wider relevance given the the planned reductions in nominal adjustment. The arguments for such a industry’s continued importance to terms amount to substantial real-terms strategy might also include the country’s the Russian economy). To the extent cuts – even if defl ated by no more than ample ‘fi scal headroom’: Russia has that the government manages to the Central Bank’s ambitious infl ation very low public debt (only about 15 per stabilize the public fi nances, will this target of 4.7 per cent average in 2017 cent of GDP in 2016) and substantial remaining resources in government funds – the Reserve Fund (RF) and Federal budget projections 2016–19 National Well-Being Fund (NWF). These 2016 2017F 2018F 2019F funds were accumulated from budget surpluses when the oil price was high Spending (RUR trillion) 16.4 16.2 16.0 16.0 (see ‘Reserve Fund and National Revenue (RUR trillion) 13.4 13.5 14.0 14.8 Well-Being Fund balances’ opposite) Defi cit (% of GDP) 3.7 3.2 2.2 1.2 precisely for the main purpose of Primary balance (% of GDP) –3.1 –2.4 –1.3 –0.3 cushioning painful fi scal adjustment Source: Ministry of Finance of the Russian Federation following any oil price correction.

4 OXFORD ENERGY FORUM NOVEMBER 2016: ISSUE 107

Bank, Finance Ministry offi cials also argue that businesses would be much less likely to invest if they saw growing budget defi cits and feared future tax hikes being imposed to rein in those defi cits.

The next question that must be answered to make sense of the situation – and assess whether Russia is set on a credible path of stabilization and adjustment – is why President Putin is supporting this policy of monetary and fi scal restraint that is Annual changes in federal budget spending crimping the recovery of domestic *Based on the latest Ministry of Finance proposals Source: Ministry of Finance of the Russian Federation demand after a severe recession, in the politically sensitive period leading up to the March 2018 presidential election. The spending squeeze will be further increased by the need to offset the signalled indexation of pensions and some other transfers by deeper cuts in discretionary spending – mainly state investment programmes. Those cuts will have to include the defence budget which, since the start of this decade, has been a sacred cow. Surely Putin would prefer, in a pre-election year, to stimulate growth by expanding state investments and, above all, deliver real- terms increases in social spending.

‘PUTIN’S DECISIONS … DEMONSTRATED HIS STRONG SENSE OF THE DANGER OF Reserve Fund and National Well-Being Fund balances ALLOWING THE PUBLIC FINANCES TO GET Source: Ministry of Finance of the Russian Federation OUT OF CONTROL.’

The main part of the answer to The key policymakers in the demography, growth through factor this question about Putin’s striking government and Central Bank remain accumulation may be safely ruled out). support for his economic team in the resolutely opposed to any such On this view, the fi rst essential condition teeth of criticism from politicians and Keynesian counter-cyclical stimulus. for stimulating private investment is to various industry lobbies probably lies Their strategy hinges on the conviction achieve – for the fi rst time in Russia’s in the depleted state of those same that Russia’s previous growth model – post-Soviet history – a low and government funds that fi nanced his based on high oil prices and expanding stable infl ation rate of 4 per cent. The largesse ahead of the last presidential domestic consumption – is dead and Central Bank’s tight monetary policy election in 2012. Putin’s decisions, must be replaced by a new model in pursuit of this goal (real interest as well as his rhetoric during his 15 based on private investment, believing rates now stand at 5.5 per cent) would years at the helm, have demonstrated that this is the only path to increased be undermined by an expansionary his strong sense of the danger of productivity, without which Russia fi scal stance. Getting infl ation down allowing the public fi nances to get out will have no prospect of sustainable requires a reduction in the budget of control. As well as overall stability, development (given the country’s defi cit. Besides supporting the Central at stake here is the stable hold of his

OXFORD ENERGY FORUM 5 RUSSIAN ENERGY ISSUES IN A VOLATILE ENVIRONMENT

Federal budget defi cit fi nancing in 2016–17 (RUR trillion) The proposed budget projects a 2016 2017 2018 2019 6 per cent increase in oil and gas tax RUR3tn RUR2.8tn RUR2.0tn RUR1.2tn revenue based on these marginal defi cit defi cit defi cit defi cit tax increases and on the expected Net debt issuance 0.58 1.02 0.97 1.02 continued increase in production (if Funds drawdown only by 0.7 per cent after this year’s 2 per cent increase – though this sits From RF 2.14 1.15 0 0 uncomfortably with Russia’s present From NWF 0 0.67 1.16 0.14 public commitment to freeze output Privatization 0.38 0.14 0 0 in support of OPEC’s plan to reduce Balance of RF 1.0 0 0 0 production by up to 1mbd). But the Finance Ministry has gone out of its Liquid balance of NWF 3.0 2.6 1.4 1.3 way to point out that this oil revenue Note: The fi nancing items do not correspond exactly to the forecast defi cits owing to Ministry increase will lag the growth of nominal of Finance accounting practices GDP, refl ecting an important broader Source: Ministry of Finance of the Russian Federation, TS estimates trend of a marked decline in the contribution of the proceeds of oil and gas taxation to total federal budget ruling establishment on power. This Specifi c risks to the oil and gas sector: revenues. This share peaked in mid- imperative now hinges on conserving better than last year 2014 at 52 per cent, but by the third resources in the government funds. The Turning to our second question quarter of this year had fallen back to table below shows the offi cially forecast (how far this fi scal adjustment comes 36 per cent. It is worth noting in this call on the two funds. at the expense of the oil and gas connection the forecasts in the Finance Putin has repeatedly stated that the industry) the short answer is that Ministry’s latest draft long-term budget projections out to 2034 that have also funds should not be fully depleted. although, once again in this year’s just been submitted to the Duma. This would ensure the availability of budget round, oil and gas taxation is These see oil tax revenues falling from emergency funding in the event of the exception to Putin’s tax stability 5.8 per cent of GDP to 3.6 per cent. new shocks. What if, for example, the rule, the programmed tax increases Apart from the expectation of a stably winter of 2017/18 produced a further oil are not that material – and are less low oil price, the main reason for this is price collapse combined with renewed onerous than last year. The headline that production will increasingly come geopolitical tensions interfering with number is an overall increase of from new fi elds that enjoy MET tax Russia’s access to bond markets? RUR170 billion. The Finance Ministry concessions. The table above shows that even then, would maintain that this hike is the government could tap substantial consistent with tax stability since it NWF resources and thereby avoid a merely implements plans introduced in Residual risks from the ‘heavy lifting’ of politically disastrous build-up of wage 2013–14. This goes, in particular, for fi scal adjustment and pension arrears. But this safety net the increase in royalties (mineral So far, we have discussed the depends on sticking to the austerity extraction tax) on the gas sector, implications of the Russian implied by the proposed 2017–19 which has historically been much more government’s fi scal plans as if they budget. In this light, accepting some lightly taxed than oil. This hit to gas were fully realistic. Even on that up-front austerity amounts to a rational producers accounts for over half the assumption, the overall pace of political insurance premium. It means overall increase. In the case of the oil consolidation is leisurely – indeed, foregoing the pre-election pork barrel companies, a RUR322 billion MET hike in fundamental terms, inadequate. that was rolled out in 2011–12. But, is offset by a RUR219 billion reduction This would be all the more true if the as demonstrated by the result of last in export duties on oil products. Here revenue projections in the proposed September’s parliamentary election, again, the government is implementing 2017–19 budget prove over optimistic Putin’s post-Crimea popularity provides a previously announced ‘tax – especially in such areas as improved a viable substitute for the time being manoeuvre’ and, in pleasant contrast tax collection. It would appear that, – and most likely this effect will not to last year when the duty cut was even if the spending discipline holds wear off substantially before the 2018 postponed, the plan now is back on up, the federal defi cit that is supposed presidential election. track. to be reduced to 1 per cent of GDP

6 OXFORD ENERGY FORUM NOVEMBER 2016: ISSUE 107

by 2020 will still be nearer 2.5 per cent camoufl aged by discussions – these in 2019 as a result of the proposed ‘THE TEMPTATION TO EXTRACT HIGHER have already been a feature of this effi ciency gains in tax collection proving STATE RENTS FROM THE OIL AND GAS year’s budget round – on introducing a diffi cult to attain in full. INDUSTRY WILL STRENGTHEN …’ returns-based framework for upstream taxation in place of the present MET This risk may be reduced by the (which is levied on revenues). The apparent political will to take tough Finance Ministry’s stated concern is spending and tax decisions, once accept – but only after 2018. As for that this shift would entail unaffordable the presidential election is out of taxation, the temptation to extract transition costs. In reality, the offi cials the way. On the spending side, a higher state rents from the oil and running fi scal policy would be almost core measure will have to be steady gas industry will strengthen as Russia certain to attempt a stealth increase in increases in the pension age, which enters into the ‘heavy lifting’ phase of the overall tax burden on oil and gas Putin has signalled that he will probably fi scal consolidation. This risk will be companies in Russia.

Cost dynamics in the Russian energy sector Tatiana Mitrova

After a signifi cant increase during the conditions in many regions adding to 6 The political and commercial risks of 2004–8 period, when a combination of the infrastructure burden and the doing business in Russia have also rising global energy demand and diffi culties of producing and led to the industry having a high cost increasing consumption of Russian transporting oil and gas. of capital compared to other hydrocarbons in international and 3 Russia’s relatively limited service countries (about 16 per cent – see domestic markets created infl ationary industry has also been an issue. the website of WACC Expert: pressure, the period 2009–14 saw energy Despite the arrival of international www.waccexpert.com). costs stabilize but at a relatively high companies such as Schlumberger 7 High transaction costs are also level. In addition to the pressure created and Halliburton, and the growth of apparent due to the ineffi cient by booming energy markets, a number of domestic players such as Integra regulatory environment and additional factors also drove up the cost and Eurasia Drilling, the limits of numerous bureaucratic barriers. of producing hydrocarbons in Russia. drilling and oilfi eld service capacity 8 Finally, comparatively high labour have been reached, increasing cost costs have also been a feature in pressure. ‘THE PERIOD 2009–14 SAW ENERGY Russia as, according to Sberbank 4 Transport costs are also COSTS STABILIZE BUT AT A RELATIVELY CIB, top management in Russian fundamentally high, because of the HIGH LEVEL.’ companies has been among the landlocked nature of the majority of most highly paid in the world. Russia’s resources and the long distance between regions such as Given these relatively high costs, it has Cost pressures West Siberia and any signifi cant been assumed that the sharp declines 1 As Soviet-era fi elds continued to markets. in hydrocarbon prices seen since mature, higher levels of capital 5 High levels of corruption have also early 2014 would be a major threat expenditure have been required to added another unseen layer of costs to the competitiveness of Russian slow production declines. In onto the more traditional oil and gas exports and the overall sustainability addition, the development of new industry costs (Russia is ranked 119 of the Russian economy, which had fi elds has moved to increasingly out of 168 countries in terms of got used to being very dependent on remote areas (such as East Siberia) corruption levels, with 1 being least hydrocarbon export revenues. Oil and where the lack of existing corrupt – see ‘Corruption by gas, for example, contributed more infrastructure has pushed up costs. Country/Territory’, Transparency than 50 per cent of federal budget 2 Russia’s geography has also not International’s website: revenues in 2014 and around two-thirds helped, with severe climatic www.transparency.org/country#RUS). of export revenues.

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Policy change allowing currency There are a number of positive aspects fl uctuation to this currency fl uctuation: ‘THE LAST TWO YEARS HAVE SEEN AN UNPRECEDENTED RISE IN RUSSIAN OIL However, in a marked change of Firstly, the decision to allow such a EXPORT VOLUMES BOTH TO EUROPE AND strategy compared to the recession massive currency depreciation has TO ASIA.’ of 2009, the Russian government has ensured that the budget remains not tried to protect the national more or less balanced as its currency during the current economic revenues (expressed in rubles) have critical price per barrel’, 13 January crisis. Since the oil price began to not declined and all its costs have 2016, RBC website, drop in 2014, the Russian Central also remained the same, as they are www.rbc.ru/business/13/01/2016/ Bank has introduced a policy of all in rubles. As a result, although a 5694fb659a79471c576b43f5), and allowing the exchange rate to fl oat 4 per cent budget defi cit is expected OPEX by 40–45 per cent. freely, and as a result the ruble has in 2016, this is much lower (and more The upshot has been that, despite depreciated signifi cantly against the manageable) than might otherwise lower oil prices, economic crises, US dollar and other major international have been the case). and sanctions, in 2015 Russian oil currencies. Having started at around Equally as important, the devaluation companies increased their oil output RUR32 = US$1 in 2014, the Russian has also signifi cantly enhanced the by 1.4 per cent to 10.7 mb/d, and in currency fell to a low of RUR80 = US$1 global competitiveness of Russian 2016 the growth is continuing. in early 2016 as the oil price energy exports, as it cut production According to the Russian Energy plummeted from over $100 per barrel costs in dollar terms. Since all the Ministry, oil output growth will have to below $30 per barrel (see ‘Ruble Russian energy companies incur most reached 2 per cent by the end of the to US dollar exchange rate’). Both costs in rubles and their exports are year, bringing Russian oil production have since recovered (the oil price to priced in US dollars, this has meant to a post-Soviet high of more than around $45 per barrel and the ruble an ability to generate higher profi ts in 11 mb/d, surprising many analysts exchange rate to RUR65 = US$1) and the domestic currency. In particular, and commentators who had been a level of stability now seems to have salary costs nearly halved in US dollar expecting a sharp decline amid the returned to the market. Nevertheless, equivalent terms, and the same current economic and political troubles. it is clear that the new Central Bank reduction has also been seen in the Furthermore, a combination of high strategy has had a very signifi cant prices of metals, Russian equipment, production and modest domestic negative impact on the Russian domestic services and, of course, demand for petroleum products (due population (whose savings are now taxes. The overall result has been that to the impact of the economic much lower in US$ terms) but also a average CAPEX costs in the Russian recession) has inevitably led to very positive impact on the Russian oil and gas upstream have decreased export growth. The last two years budget and on the competitiveness of by approximately 35 per cent (see have seen an unprecedented rise in Russian exports. ‘Russian oil companies have called a Russian oil export volumes both to Europe and to Asia – in 2015 Russian oil companies increased their exports 90 by 9 per cent, and in 2016 the 80 government is expecting another 70 signifi cant increase. 60 Although gas production has been 50 constrained by weak European, CIS, 40 and domestic demand, the outlook 30 for 2016 is optimistic as low oil prices 20 have made the element of Russian 10 gas sold under long-term oil-linked 0 contracts one of the cheapest and most attractive options in the European market. Meanwhile the share of Ruble to US dollar exchange rate Russian exports sold on spot Source: Ministry of Finance of the Russian Federation markets has also had a competitive

8 OXFORD ENERGY FORUM NOVEMBER 2016: ISSUE 107

advantage, due to the ruble devaluation by maximizing short-term output and which has lowered its cost of supply. ‘ALTHOUGH RUBLE DEVALUATION HAS exports. However, all the stakeholders As a result, in January–August 2016 CLEARLY BROUGHT BENEFITS, ITS IMPACT involved realize that, although there Russian gas exports to Europe IS NOW STALLING.’ is a clear benefi t to be gained in the increased by 11 per cent. short term, this does not provide a The benefi ts have not just been felt by longer-term sustainable solution for is now stalling. The government is the oil and gas industries, though, as the Russian energy industry. Unless realizing that the main ruble devaluation coal output and exports have also real reforms and improvements in both has occurred already, and it does not reacted to the currency devaluation, business and institutional practices are expect any further serious decline with both coal production costs and implemented in the short to medium of the national currency. According railroad transportation tariffs (which term, then it seems inevitable that to the recent ‘Long-term Forecast of are nominated in rubles) having systemic ineffi ciencies and high country the social-economic development of decreased signifi cantly in dollar terms. risks will push the costs up once more, the Russian Federation up to 2035’ This has suddenly made Russian coal and that this pressure could even (see Gazeta.ru website: www.gazeta. one of the most attractive options on be exacerbated by any rebound in ru/business/2016/10/19/10259831. the global coal market, and as a result oil prices, which could encourage a shtml#page2), by 2025 the ruble coal production in Russia grew by 6 strengthening of the ruble. to dollar exchange rate is projected per cent during the fi rst nine months to reach a level of RUR77 = US$1 In conclusion, then, the ruble of 2016, while coal exports have (implying an additional 30 per cent devaluation may have deferred a increased by 7.5 per cent during the devaluation during the next nine years). number of key issues for the Russian same period. Therefore the potential for further cost energy industry, but there is little doubt reduction via this route would appear that these will have to be faced in the Limited opportunities for further cost to be much more limited. Companies not too distant future if oil and gas reduction via currency fl uctuation and the government are therefore exports are to remain a competitive and However, although ruble devaluation trying to utilize the current window sustainable source of income for the has clearly brought benefi ts, its impact of opportunity as much as possible Russian budget.

The Rosneftization of the Russian oil sector Nina Poussenkova

The recent acquisition of Bashneft by shrank to 75.2 per cent). As a result, Rosneft’s lobbying potential was Rosneft reignited the debate about the process might actually be called clearly demonstrated during the ‘creeping renationalization’ of the ‘Rosneftization’ of the Russian oil negotiations concerning Bashneft, the Russian oil sector. However, the sector. when government offi cials were process is not so straightforward since debating whether it made sense to it is also expected that 19.5 per cent What is certainly clear is that Rosneft is allow Rosneft to participate in the of Rosneft’s shares will be sold soon getting bigger with each new privatization process. Andrei Belousov, as part of a government privatization acquisition and accounts for an assistant to President Putin, and plan to raise funds for the budget (after increasingly large share of domestic oil Arkadiy Dvorkovich, Vice Premier, were the IPO held in 2006, the share of the production. Furthermore, the company actively opposed. However, to no one’s state in Rosneft’s authorized capital is diversifying into the gas industry and great surprise, Igor Sechin, Rosneft’s shipbuilding, thus expanding its CEO, won. He proposed a scheme infl uence over the Russian economy in whereby the state’s budget revenues ‘ROSNEFT IS GETTING BIGGER WITH general. And with its unrivalled would be maximized: Rosneft would EACH NEW ACQUISITION AND ACCOUNTS ‘administrative resource’, it can also buy 50.08 per cent of the authorized FOR AN INCREASINGLY LARGE SHARE OF determine certain rules of the game capital of Bashneft (60.16 per cent of DOMESTIC OIL PRODUCTION.’ regarding the domestic and foreign its voting shares) for RUR329.7 billion policy of Russia. The extent of (US$5.2 billion). This scheme would

OXFORD ENERGY FORUM 9 RUSSIAN ENERGY ISSUES IN A VOLATILE ENVIRONMENT

provide more funds for the budget depend on Rosneft’s ability to create than other contenders (such as value. ‘ROSNEFT HAS A MAJOR RESPONSIBILITY LUKOIL, Tatneft, NNK, Antipinsky …TO THE STABILITY, AND INDEED Rosneft claims that its history of Refi nery, etc. who had expressed GROWTH IN OIL OUTPUT, BUT ITS growth via acquisition gives it unique interest in Bashneft) had been PERFORMANCE TO DATE HAS BEEN experience of integrating new assets, proposing. The Bashneft acquisition according to its press offi cer Mikhail PATCHY.’ would then raise the capitalization of Leontiev. However, having successfully Rosneft and, therefore, it would be integrated these assets, it has than gas. As the country’s leading possible to sell 19.5 per cent of the consistently faced the problem of then producer, and its national oil company, company for more than $11 billion in ensuring further organic growth in a second privatization auction, Rosneft has a major responsibility to production. As is clear from the graph theoretically increasing revenues for contribute to the stability, and indeed below ‘Russia’s and Rosneft’s Oil and the state. growth in oil output, but its performance Condensate Production 1995–2015’, to date has been patchy. For example, following explosive growth due to in 2015, Samaraneftegas, the former Limited growth? acquisitions, Rosneft’s oil production subsidiary of YUKOS located in the has stabilized and is even declining: in Over the past decade, Rosneft has Volga–Urals region, produced 12.1 mt 2013, it produced 189.2 mt; in 2014, evolved from a small player with some of liquid hydrocarbons from mature 204.9 mt; and in 2015, 202.8 mt; 20 million tonnes/y of crude production fi elds, 5.3 per cent more than in 2014, in 2003 into the number one Russian while in 2016 the company’s main while Verkhnechonskneftegas – oil company by aggressively acquiring hope is to maintain crude extraction responsible for developing the attractive assets: at the 2015 level. It has compensated with rising gas production, which Verkhnechonsk fi eld in the Irkutsk Severnaya Neft in 2003, has grown from 38.2 bcm in 2013 to region (the second-biggest fi eld in Yuganskneftegas in 2004, 62.5 bcm in 2015, and Rosneft intends East Siberia after Vankor) – yielded Udmurtneft in 2006, to increase this level to 100 bcm by 8.6 mt, 5.4 per cent more than in 2014. 2020, when it aims to account for over However, other subsidiaries are doing YUKOS in 2007, 20 per cent of the domestic gas less well. Samotlorneftegas, which TNK–BP and Itera in 2013, market. In general, having produced accounts for 10 per cent of Rosneft’s Bashneft in 2016. 254 mtoe of hydrocarbons in 2015, output, produced 20.9 mt in 2015, It has become the world’s biggest Rosneft plans to achieve output of 4.7 per cent less than in 2014 public oil company with 34.5 billion boe 300 mtoe by 2020. (Samotlorneftegas, a former subsidiary of proved reserves (as of 31 December However, Russia’s key priority at of TNK–BP, has 97 per cent of reserves 2015 under the SEC classifi cation). present is oil production, which concentrated in the legendary Samotlor It would seem, then, that Rosneft’s generates a far greater share of export fi eld that produced 150 mt/y at its peak current strategy is strongly determined revenues and taxes for the budget in the mid-1980s). by its desire to be the ‘largest fi sh in a huge pond’, with its humble past perhaps partially explaining its 600 unquenchable thirst for growth – and Rosneft Russia 500 power. 400 In 2015, Rosneft produced 202.8 mt of oil, accounting for 37 per cent of 300 the total Russian output – with an 200 additional 20 mt of Bashneft’s oil production, it would have accounted 100 for 41 per cent. This lion’s share of 0 domestic extraction entails serious responsibilities, since the situation in the sector and the growth of domestic Russia’s and Rosneft’s oil and condensate production, 1995–2015 (mt/y) crude production actually now largely Source: Neft I Capital

10 OXFORD ENERGY FORUM NOVEMBER 2016: ISSUE 107

Jewel in the crown? This has raised a number of contribute little in the way of technical fundamental questions about the expertise. Of particular concern is the situation in Vankor fi eld concerning the reasons West Siberia (West Siberia accounted A similar problem of experience and for and implications of its decline. In for 62 per cent of Rosneft’s oil expertise faces Rosneft’s exploration particular, it is unclear what the major production in 2015) where programme, which now has a special causes have been: Yuganskneftegas, Rosneft’s biggest focus on the continental shelf. However, upstream subsidiary, accounts for Complex geology? the company has had very little 31 per cent of the company’s output. A shortage of state-of-the-art exposure to offshore activity, and plans This production subsidiary technologies and qualifi ed to partner with international companies demonstrated double-digit growth personnel? have been undermined by sanctions. A good example of this is the Arctic well when it belonged to YUKOS in the early Mistakes in the scheme of drilled with ExxonMobil in September 2000s, but is now struggling. The development of the fi eld? output of its giant mature fi elds 2014 which discovered the Pobeda Insuffi cient fi scal incentives? (such as Priobsk, Mamontovsk, fi eld in the Kara Sea. It has since Malobalyksk, and Prirazlomnoye) The opinions of experts differ, although remained dormant, as ExxonMobil grew by 23.1 per cent to 66.49 million they suspect it is a combination of the is now banned from operating in tonnes (mt) between 2005 and 2009, fi rst three factors. However, all believe the Russian Arctic and Rosneft has but by 2015 this had fallen to 62.4 mt. it is a serious blow to Rosneft and may insuffi cient capability to develop the fi eld on its own. Consequently, Rosneft is now point to further issues for the company. focusing on improving performance at Rosneft’s response has been to Given all of these concerns, the its main brownfi eld sites. Eric Liron, a commission a number of major new acquisition of Bashneft will be an company fi rst vice president, has fi elds in East and West Siberia in order ‘acid test’ of Rosneft’s ability not only stated that average decline in oil to reach its 2020 output target. For to integrate assets but also to derive extraction by Yuganskneftegas had example, in the period 2016–20 the lasting growth from them. Indeed, the been reduced from 4.3 per cent in company expects that the development Bashneft case is particularly interesting, 2014 to 0.9 per cent in 2015, and that of the Suzunskoye (expected to yield because it was a dynamically he hoped production from its fi elds over 4 mt/y of oil at peak), Tagulskoye growing company that accounted for might increase to 68 mt over the next (over 4 mt/y), and Lodochnoye (some 29 per cent of the total increment of three years. 2 mt/y) fi elds will offset declines at Russia’s oil production in 2015 and so Vankor, and in fact all three will add to it will be interesting to see if Rosneft Rosneft’s other major problem is the overall output in the Vankor cluster, fails to continue this trend. one of its more recent fi eld using existing infrastructure in the developments, Vankor, which was Bashneft’s oil extraction grew from region. discovered during the Soviet era. 15.4 mt/y in 2012 to 19.9 mt/y in 2015, This giant fi eld is located in East and it achieved impressive results Siberia and contains 500 mt of ‘ROSNEFT FACES ONE OTHER KEY ISSUE on both extremely mature and new proved oil and condensate reserves … IT IS FINANCIALLY CONSTRAINED fi elds. Its production in Bashkiria, a and 182 bcm of gas reserves. Rosneft FOLLOWING ITS ACQUISITION SPREE.’ very old petroleum province of Russia, launched production in 2009 and increased from 15.1 mt in 2013 to 16.1 mt in 2015, while in Nenetsk output was expected to reach 25 mt/y Unfortunately, Rosneft faces one other Autonomous Region (a new area) it at its peak. However, the fi eld key issue, namely that it is fi nancially rose from 0.3 mt in 2013 to 1.4 mt. disappointed and reached a high of constrained following its acquisition Not surprisingly, experts believed that only 21.4–22 mt/y, staying at this level spree. In response, it has invited a Bashneft’s management team was one for three years and accounting for selection of Indian companies as of the best in the Russian oil sector. 11–12 per cent of Rosneft’s total partners into the Vankor project: output. Production then began to ONGC, Oil India, Indian Oil, and However, Rosneft has fi red all of shrink, and Rosneft stated that it Bharat PetroResources will own Bashneft’s top managers following expects a fall of 1 mt to 21 mt in 2016, 49.9 per cent in Vankorneft. However, its acquisition, with Andrei Shishkin, with fears that the decline might then although they bring money, their vice president of Rosneft for energy, accelerate so that production might experience of operating in harsh Arctic localization, and innovation, becoming drop to 13 mt by 2020. conditions is very limited and they will its new president. Clearly there is a

OXFORD ENERGY FORUM 11 RUSSIAN ENERGY ISSUES IN A VOLATILE ENVIRONMENT

real concern as to whether this radical to establish the fi rst mini plant for replacement of Bashneft’s leadership production of LNG in Russia. This ‘MANY COMMENTATORS HAVE ARGUED will benefi t Rosneft, raising a similar move followed Rosneft’s success, THAT ROSNEFT IS SPREADING ITSELF TOO question to that asked in 2007 after together with Novatek, in amending THINLY …’ Rosneft acquired all the oil assets the law on gas exports, thus eroding of YUKOS. Will the new subsidiary Gazprom’s export monopoly; Rosneft GE, Siemens, and Fincantieri to be completely dissolved in Rosneft is now also expanding into gas develop this new business line. These and lose its identity and outstanding processing. Rosneft and Sinopec plan projects will contribute to an important performance, or will it help to raise the to build a gas processing and gas and diversifi cation for the Russian economy, effi ciency of Rosneft overall to new petrochemical complex in East Siberia as well as help to industrialize Russia’s levels by transplanting some of its best (annual throughput capacity of 5 bcm Far East region and to improve living practices to the parent company? Only of gas), providing another challenge standards there. Nevertheless, it is time will tell, but the answer could be to Gazprom’s position in the Russian perhaps surprising that the national oil market. crucial for the Russian oil industry as a company is taking on this burden at whole. In addition, Rosneft has begun to a time when its core business needs develop a major focus on shipbuilding its full attention. Many commentators have argued that Rosneft is spreading Unlimited ambitions? after it became involved in the Zvezda shipbuilding complex in the Far East itself too thinly, especially at a time It would seem that Rosneft is not of Russia – a project it is implementing of low oil prices, raising the question content with just being the biggest with Gazprombank and Rosneftegas. as to whether core oil production in the oil industry, but it also wants to In September 2016 alone, together growth can be achieved. If not, the conquer other sectors as well. It has with the Far Eastern Center of Ship company may feel compelled to already become the number three gas Building and Ship Repair, Rosneft acquire yet another domestic player to producer in Russia, and now plans signed agreements with Hyundai Heavy underpin its position. In which case the to enter the LNG business, with GE Industries, Daewoo Shipbuilding & Rosneftization of the Russian oil sector and Rosneft subsidiary Itera intending Marine Engineering, Exxon Neftegas, may have further to go.

Securing the future: the implications of India’s expanding role in the Russian oil sector Vitaly Yermakov

There are no quick deals in the There are two important drivers that are dependence on a monopsonistic international oil business, with years motivating the Russian side: buyer (China), and has therefore also of careful preparation and positioning been trying to diversify its eastern Firstly, Rosneft, a key driving force usually preceding the announcement exports and is attempting to build behind the expanding cooperation leverage via advancing joint projects of big ticket projects. The recent deals with India, is trying to address the and asset swaps with alternative that have allowed India’s oil problem of fi nancing the resource-hungry countries such as companies to enter Russia’s oil development of the Vankor cluster, India. sector via the purchase of stakes in which has emerged as an important Vankorneft (VN) and Taas-Yuryakh new oil producing province, a key Part sale of Vankorneft to Indian Neftegasodobycha (TYN) – two key source of crude oil for the ESPO consortium Rosneft brownfi eld onshore pipeline, and a foundation for production subsidiaries located in the Rosneft’s existing long-term oil As a result, two opportunities that had northern part of Krasnoyarsk territory supply contracts with China. originally been offered to Chinese and in Sakha-Yakutia republic in East However, from an alternative companies have now been snapped up Siberia – are no exception to this perspective, Russia has also become by Indian competitors. On 5 October general rule. wary of creating too much 2016 Rosneft announced the closure of

12 OXFORD ENERGY FORUM NOVEMBER 2016: ISSUE 107

Neftegasodobycha LLC; this company ‘privatization’ by a state-owned ‘TWO OPPORTUNITIES THAT HAD has been developing the company, so long as it receives a ORIGINALLY BEEN OFFERED TO CHINESE Srednebotuobinskoye fi eld since high acquisition price that would COMPANIES HAVE NOW BEEN SNAPPED October 2013. Again, the deal had allow it to fi nance this year’s federal UP BY INDIAN COMPETITORS.’ originally been offered to a Chinese budget defi cit and maintain nominal company, but then apparently was control over oil assets that are retracted over a disagreement on price. two transactions agreed earlier in June changing hands. As a result, the As a result, India has acquired another at the Saint Petersburg International Indian companies’ payment for signifi cant oil interest in Russia’s Economic Forum. The fi rst deal was Rosneft upstream assets helps Russia eastern regions, as the fi eld’s a $2.02 billion sale of 23.9 per cent close a near term fi nancial gap and ABC1+C2 reserves stand at of Vankorneft JSC to a consortium effectively allows Rosneft to continue its 166 million tonnes of oil and of Indian companies consisting of expansion in the Russian oil sector – an condensate and 180 bcm of gas, Oil India Limited (the leader of the interesting variation on a similar theme while production in 2015 was 0.9 mt/y consortium), Indian Oil Corporation from 2003/4 when Chinese fi nancing (18.4 kb/d) of oil. According to the Limited, and Bharat PetroResources. allowed Rosneft to gobble development plan, the fi eld will be As of 1 January 2016 the Vankorskoye up a bankrupted YUKOS. fi eld contained 2P commercially producing 5 mt/y (100 kb/d) of oil extractable reserves assessed at 265 when it reaches its plateau in a few million tonnes of oil and condensate years’ time, with the assistance of BP, Russian deals with India send signal to and 88 bcm of gas according to which was also sold a 20 per cent China stake (in 2015). the PRMS classifi cation used by A second important consideration is SPE International. (Rosneft reported These deals have important that in forming closer energy ties with that the deal valued the reserves implications, some of them near term, India, Russia is simultaneously at Vankorskoye at $3.4/boe.) The and some longer term, as Russia sending a signal to China that the ‘pivot Vankorskoye fi eld has been producing attempts to continue its ‘pivot to Asia’ to the east’ may be structured in a way since September 2009 and reached a while also seeking to raise short-term that reduces Russia’s dependence on plateau of about 22 mt/y (440 kb/d) of funds to support the continued growth the largest buyer of its oil in Asia. China oil output in 2013. of its oil industry and the fi nancing of has been waiting patiently to improve the federal budget. Interestingly this is the second sale of its negotiating position before equity in the fi eld to an Indian company, committing to large investments in as earlier in 2015 Rosneft sold The fi nancing of Russia’s federal budget Russia, thinking that low oil and gas 15 per cent to India’s ONGC Videsh prices have been boosting its leverage for $1.27 billion and it is currently This latter concern appears to be one and improving its terms of trade. negotiating the sale of a further driver of the current sale of Russian However, it is now clear that Russia has 11.2 per cent; this will reduce Russian upstream assets to the Indians, as become impatient with this tactic and interest in the fi eld to a simple majority Rosneft needs to raise additional has decided to demonstrate that China of 50.1 per cent. As a result, a foreign cash to pay for the purchase of a ‘is not the only game in town’, even if consortium will own almost half of one 50.08 per cent state interest in of Russia’s largest producing oil fi elds, Bashneft, which the Russian state has these latest deals are relatively and it is a pointed reminder to China recently sold to raise funds to reduce symbolic and do not change the overall that it will be Indian companies, and not its budget defi cit (which has reached balance of economic bargaining power. a Chinese NOC, which will be exporting 3.5–4 per cent of GDP in 2016). The Russia will remain reliant on China as oil via the ESPO, despite the fi nal stake in Bashneft had been valued by far the largest market for its destination of the crude. at $5.3 billion, and Rosneft has been hydrocarbon exports in the East. ordered to pay this price as it has essentially been given exclusive rights Indian purchase of Taas-Yuryakh to purchase the company ahead of Neftegasodobycha stake its private sector rivals. The Russian ‘IN FORMING CLOSER ENERGY TIES WITH The second deal was the $1.12 billion state seems to have closed its eyes INDIA, RUSSIA IS SIMULTANEOUSLY sale (to the same Indian consortium) on the ‘one hand giveth and the other SENDING A SIGNAL TO CHINA …’ of a 29.9 per cent stake in Taas-Yuryakh taketh away’ nature of the Bashneft

OXFORD ENERGY FORUM 13 RUSSIAN ENERGY ISSUES IN A VOLATILE ENVIRONMENT

Upstream–downstream model in 2016. If fi nalized, it would provide a ‘RUSSIA HAS OFTEN VIEWED THESE logical conclusion to another example Thirdly, it is also important to see how PROSPECTIVE LONG-TERM BUSINESS of ‘upstream–downstream’ the deals with the Indian companies PARTNERSHIPS AS PILLARS FOR cooperation, and provide Russia with stand in relation to Russia’s general BUILDING GEOPOLITICAL ALLIANCES …’ strategy of energy asset swaps with access to India’s fast growing economy foreign players. This can be defi ned and its expanding energy needs. to an extent as an ‘upstream– were the most successful example of downstream’ model in which foreign the realization of Russia’s strategic India’s need for new sources of oil supply investors can receive access to plan. For India, a country that is emerging Russia’s upstream assets in exchange However, the fact that Russia has for fi nancing, technology transfer, as a new source of global economic also often viewed these prospective and security of supply in the form of growth and a key driver of incremental long-term business partnerships as Russian equity in the downstream growth in global oil demand, the deals pillars for building geopolitical alliances assets of its partners in their home with Rosneft are important for two has prompted accusations of using countries. Overall Russia’s strategic reasons. ‘the energy weapon’ to advance its goal is to create integrated cross- geopolitical agenda and has made First, India’s oil production has border energy value chains that can the West vary of supporting it. When essentially been fl at over the past fi ve protect existing markets and open this general sentiment merged with the years, at levels just shy of 0.9 mb/d, up new channels for Russian oil aftermath of the confl ict in Ukraine, the while demand has risen by more than and gas exports, thus underpinning overall energy relationship between 25 per cent in the same time period. the continuous and sustainable Russia and the EU became one of As a result, the country has to import development of Russia’s oil and gas mistrust and mutual accusations. about 70 per cent of the oil it resource potential. However, in spite of the obvious failure consumes, and this import Russia’s energy strategists have been to establish large-scale energy requirement is set to grow quickly promoting this idea for the past 10 partnerships in the West via the over the next decade as the years, fi rst in the West, where it ran ‘upstream–downstream’ model, its key economy develops and per capita into politically motivated resistance, principles are alive and well in Russia’s income increases. and now increasingly in the East. The negotiations with prospective new Second, in spite of current structural ‘grand design’ was initially formulated partners in Asia. Indeed, it is worth oversupply in the global oil market in 2006 and was heavily promoted noting that the upstream deals between during Russia’s chairing of the G8 and low international oil prices, a Rosneft and Indian companies are only summit in Saint Petersburg, when market rebalancing is looming on the the fi rst part of a larger transaction that Russia’s current First Deputy Prime horizon. is still in the making. Rosneft and the Minister Igor Shuvalov described a bold It is therefore critical for India, where trading company Trafi gura have been in vision of Russia’s expanding energy oil demand is extremely price negotiations to purchase 49 per cent role in an interview in May 2006 (‘Putin sensitive, to fi nd ways to ‘hedge’ each in Essar Oil’s downstream assets ne shutit’, Igor Shuvalov’s interview to against a possible increase in the in India. These include a highly Nezavisimaya Gazeta, 23 May 2006). complex and modern 20 mt/y refi nery future oil price. Securing signifi cant Essentially Russia has been seeking owned by Essar Oil in Vadinar (located upstream positions with one of the expansion on the basis of a series of in Gujarat, on India’s north-west coast), largest global oil producers, while quid pro quo commercial relationships the deep-water marine terminal for also ensuring long-term oil supply for between Russian state-owned fi rms crude oil and the largest Indian its downstream industry, provides and foreign partners. The upstream– network of fi lling stations, with a total one answer to India’s inherent energy downstream asset swaps between of 2,700 locations. Essar and the supply problems, as well as Gazprom and the German BASF group Russian consortium have reached a providing an important strategic link that were completed in October 2015 preliminary agreement to close the deal with a long-term political ally.

14 OXFORD ENERGY FORUM NOVEMBER 2016: ISSUE 107

Ukraine’s dramatic gas import diversifi cation By Simon Pirani

Ukraine is cutting direct imports of fi rst nine months of 2016 it was (except for a brief upward blip in 2011), Russian gas to near zero. It is on its 20.7 bcm, down 10 per cent year-on- reaching 50 bcm in 2013. way out of the former Soviet energy year. The beginning of a shift from energy- trading system which, within the There are some short-term specifi cs intensive industries (such as metals next few years, will start to look very refl ected in these numbers. and chemicals) to newer ones was one different. of the causal factors; as was some First, the removal from Ukraine’s Ukraine imported just 6.3 bcm of energy saving, after gas prices for gas balance of Crimea (annexed by gas in January–September 2016. In industry were brought in line with import Russia in 2014) and of parts of the October, the state oil and gas company prices in 2006. heavily industrialized Donetsk and Naftogaz Ukrainy secured a $500 Lugansk regions (controlled by High gas prices in 2009–12 led to some million World Bank loan to pay for 2.5 Russian-supported separatists). switching to coal – although, since bcm of ‘reverse fl ow’ imports over the then, military confl ict has disrupted coal winter. Naftogaz had 14.7 bcm of gas Second, a 10 per cent decline in production. Output fell from more than in storage at the start of the heating GDP in 2015, which hammered 80 mt/y (up to 2013) to less than 40 mt season and, barring freakish cold, industrial output and energy demand, in 2015. Ukraine has been compelled could get through the year with no refl ecting the toll taken by military to import small amounts of coal from Russian imports at all. Full-year imports confl ict and the international South Africa. will likely be 9–10 bcm, down from 16 economic slowdown. The economy bcm in 2015, 22 bcm in 2014, and 29 recovered to projected 1 per cent The reduction of gas consumption bcm in 2013. growth in 2016. and Russian imports is one of three Third, IMF arm twisting to raise tariffs deep-going changes in the Ukrainian All this year’s imports have been for residential customers and district energy sector. The others are the ‘reverse fl ow’ – so called because gas, heating companies to cost recovery decline of gas transit, and regulatory mostly of Russian origin, physically levels – pretty much ignored by reform. fl ows back to Ukraine from central successive governments between European countries. ‘Reverse fl ow’ has, 2008 and 2013 – has fi nally produced since 2013, offered price competition ‘RUSSIA HAS AS LITTLE ENTHUSIASM results. And that is focusing attention with direct Russian imports. During on energy saving. FOR GAS TRANSIT THROUGH UKRAINE AS the last two years of military and UKRAINE HAS FOR PURCHASING RUSSIAN political confl ict, it has been supported ‘Taking advantage of low international GAS.’ fi nancially by Brussels in the name gas prices, the authorities accelerated of minimizing Ukrainian energy the increase in gas and heating prices dependence on Russia. to full cost recovery one year ahead of schedule’, the Fund enthused in its Gas transit September 2016 review of Ukraine’s Decline in gas consumption and in Russian Russia has as little enthusiasm fi nances. From here, a quarterly imports for gas transit through Ukraine as adjustment mechanism will keep Ukraine has for purchasing Russian Ukraine’s gas import volumes are consumer prices at par with import gas. So Gazprom is pushing two falling because of a precipitous prices, and full liberalization is due in transit diversifi cation projects: the decline in gas consumption. Total April 2017. The market for industrial Turkish Stream pipeline, on which an gas demand has fallen from 42.6 bcm consumers was fully liberalized in intergovernmental agreement was in 2014 to 33.8 bcm in 2015. In the October 2015. signed in October in Istanbul, and the The fall in gas consumption in the last second phase of the Nord Stream ‘UKRAINE’S GAS IMPORT VOLUMES ARE three years is the second chapter of pipeline via the Baltic Sea to Germany FALLING BECAUSE OF A PRECIPITOUS a story that began in 2006. That year, – which European political opposition DECLINE IN GAS CONSUMPTION.’ demand hit a post-1990s high of 75 could slow down, but probably not bcm. Since then, demand fell each year stop.

OXFORD ENERGY FORUM 15 RUSSIAN ENERGY ISSUES IN A VOLATILE ENVIRONMENT

At some point after Russia’s current The breach with Ukraine is part of gas transit contract with Ukraine ‘THE LONG, TROUBLED RUSSIA–UKRAINE a larger picture of the former Soviet expires in 2019 – but not before then – GAS MARRIAGE IS OVER, AND THE states loosening their ties with each the Ukrainian corridor will likely be used LAWYERS ARE ARGUING ABOUT WHO other. In the gas sector, trading only for residual volumes that cannot GETS WHAT …’ relationships have lasted longer, in part go by other routes. One possibility because of the gas supply system, a being mooted in Brussels is to remove increase in production by non-state 1970s engineering marvel. But now regulatory obstructions to North companies; in a future of higher oil the strongest bond, with Ukraine, is Stream II in exchange for a Gazprom breaking; ties with the Baltic states commitment to take a reduced but prices and political calm, the upstream have already broken. steady quantity of gas (20–30 bcm/y?) could grow. through Ukraine. Since completion of the Turkmenistan– China gas pipeline in 2007, Russia’s In any case, much of the pipeline Russian gas and trading relationships link with Central Asia has also been system – which Naftogaz says has Whatever happens next, the long, fading: Turkmenistan’s gas trade with 302 bcm/y entry capacity and 178 troubled Russia–Ukraine gas marriage Russia has ended (imports, many of bcm/y exit capacity, including 146 is over, and the lawyers are arguing bcm/y towards Europe – will have to be which were transported to Ukraine in about who gets what (literally, at the decommissioned. the 1990s, were zero this year) and the Stockholm arbitration court, where two sides are settling their differences Naftogaz and Gazprom have made in an arbitration court. Regulatory reform $67 billion worth of claims against each Ukraine’s emerging energy system will As for regulatory reform, a mass of EU- other for breaches of contract). be more effi cient, and more diversifi ed compatible market reform legislation While European politicians tend both by fuels and by trading partners. has been passed, at the IMF’s to focus on courting Ukraine, the Russia’s system will also be more insistence, and in spite of sometimes consequences for Russia are at least stubborn parliamentary resistance. The effi cient, as a result of market reform, as important. Gazprom has lost its passage through parliament of a law and it too will diversify; international providing for a genuinely independent largest customer for gas exports – sales of oil will remain the key and, gas and electricity market regulator was in the 1990s Ukraine imported 80 in gas, Russia’s reduced trade with the most recent success. (At the time bcm/y, in 2006 it imported 54 bcm former Soviet countries will give way to of writing it was awaiting the president’s (compared with Germany’s 34 bcm) ... an expanding Asian export business signature.) Rationalization of oil and and henceforth it may directly import and, possibly, a renaissance in gas royalties has also sparked an nothing. European sales in the 2020s.

16 OXFORD ENERGY FORUM NOVEMBER 2016: ISSUE 107

The revived Turkish Stream: what, where, and when? Katja Yafi mava

Turkish Stream (an offshore Black Sea (after the Turkish government had construction of one string offshore, pipeline from Russia to western Turkey) authorized the shooting down of a and the company is expected to build refl ects the desire of both the Russian Russian military aircraft while it was and own this entire offshore section government and Gazprom to develop a on combat duty in Syria). No further while the onshore part, connecting the new route for delivering its gas to progress on the pipeline was made acceptance terminal with the Turkish southern Europe and western Turkey, until an apology was received from transmission system (for supplies to thus reducing Ukraine’s transit monopoly the Turkish president, but once this the Turkish market), would be built and over Russian gas exports to these necessary (for Russia) condition paid for by Botas. The onshore transit regions (see map on the next page). had been fulfi lled, the two countries’ pipeline (for supplies to the European As such, it is part of Gazprom’s presidents fi nally met in August 2016, market) would be built by a (yet to be transit-diversifi cation strategy, adopted and it was decided to re-activate formed) Russian-Turkish joint venture. cooperation on a number of energy in the late 1990s in response to the It is worth noting that the signing of insecurity (non-payment, debt (and other) projects, including Turkish the IGA was not conditional on the accumulation, and unauthorized Stream. resolution of the disagreement over a offtakes) associated with transit across The project has progressed smoothly gas price discount between Gazprom Ukraine and other post-Soviet countries. since then. Several permits were (re) and Botas, and indeed Gazprom and issued in September, including the fi rst Botas have not yet fully resolved their Progress made by the project construction permit and the survey dispute, although they have agreed permit for the two strings of the offshore on the price discount mechanism. Turkish Stream only made glacial section of pipeline in the Turkish This suggests that the project should progress during 2015, following exclusive economic zone (EEZ) and proceed on schedule, and given the its launch in December 2014. The territorial waters. The IGA was signed parties’ agreement on a price discount parties – Russia and Turkey – failed in October by the Russian and Turkish mechanism, it is reasonable to expect to sign a promised intergovernmental energy ministers, in the presence of an agreement on the size of a discount agreement (IGA) and Turkey delayed Presidents Erdogan and Putin, and it as well as subsequent termination of the grant of several permits necessary is understood that it provides for the arbitration proceedings in the near for the project to proceed, while construction of two strings offshore and future. cancelling some others that had been an onshore transit pipeline across the granted. The slow progress is mostly Turkish territory up to the EU border explained by the failure of Gazprom ‘TURKISH STREAM WOULD SEEM TO HAVE for supplies to the European market. and the Turkish state gas company, A GOOD CHANCE OF BEING IMPLEMENTED Furthermore, it allows Gazprom not to Botas, to resolve a number of key BY 2020.’ build the second offshore string if the commercial issues including, most onshore transit pipeline is cancelled. importantly, a request by Botas for a To this end, the Russian president, gas price discount. Indeed in October As a result, Turkish Stream would Vladimir Putin, and the Russian foreign seem to have a good chance of being 2015 Botas even submitted the affairs minister, Sergey Lavrov, have implemented by 2020, in particular price discount issue to international both stated that the onshore transit because Gazprom is interested in arbitration. Furthermore, the project section will only be built if the European increasing its direct supplies of gas has also suffered delays due to the Commission (EC) provides ‘written to Turkey, which is one of its biggest, Turkish general elections in June and guarantees’ that the project can be and fastest-growing, markets. On the November 2015 and the subsequent implemented on European territory. other hand, Turkey appears keen to government changes. Correspondingly, the IGA does not set secure further access to Russian gas In November 2015 Turkish Stream the terms for the construction of the due to a lack of realistic alternatives disappeared from the headlines latter, deferring it to a separate protocol (although it may be reluctant to completely, when it was put on hold by (which may or may not be signed). increase its dependence on Russia too Russia as part of its overall suspension Thus Gazprom’s minimum commitment signifi cantly) and it also has aspirations of bilateral cooperation with Turkey under the IGA appears to be the to make itself a gas hub in southern

OXFORD ENERGY FORUM 17 RUSSIAN ENERGY ISSUES INAVOLATILE ENERGYISSUES RUSSIAN ENVIRONMENT 18 OXFORD ENERGY FORUM

Turkish Stream pipeline and the alternative ‘Southern Route’ pipeline NOVEMBER 2016: ISSUE 107

Europe. Gazprom and Russia are likely of the failed coup). This thinking could to be cautious about encouraging this ‘THE EU WANTS TO PRESERVE UKRAINE’S increase the chances of Gazprom’s ambition, and may also have concerns TRANSIT ROLE AND IS OPPOSED TO ‘southern route’ – rather than the about Turkey becoming too large a ANY PIPELINES THAT WOULD ENABLE second string of Turkish Stream – transit route for Russian gas, but at GAZPROM TO REDUCE THAT ROLE.’ being considered as part of the EU-led present it seems that an adequate CESEC (Central and South Eastern compromise has been reached. DEPA and Italy’s Edison, on supplies Europe Gas Connectivity) initiative, of Russian gas to Greece and aimed at improving gas security in Proposed route and size onwards to Italy across the Black Sea central and south-east Europe. The and (unspecifi ed) ‘third countries’. EC’s willingness to consider this However, the newly revived project Geography suggests that Russian gas option might depend on its assessment will certainly be more modest than the could arrive in Greece across the Black of security of transit across Ukraine original proposal (which envisaged the Sea either via Turkey or Bulgaria. The post-2019. construction of four strings of 15.75 fact that the MoU did not specify a bcm each for a total capacity of 63 In any event, it appears highly unlikely concrete country via which gas would bcm). Only one string is likely to be that either a second string of Turkish be delivered to Greece, suggests that built by 2020, thus allowing Gazprom Stream or the ‘southern route’ will be either the second string of Turkish to deliver all of its contracted supplies built by 2020 (the same applies to Stream (via Turkey) or the ‘southern to the Turkish market without having Nord Stream 2 where delays beyond route’ (via Bulgaria) could be built. to transit its gas across Ukraine, once 2020 are likely after the abandonment the existing transit contract expires at of the joint venture between Gazprom Issues of timing the end of 2019. However, the outlook and its European partners). This is more uncertain for the second string The (changing) context of EU–Turkey suggests that southern European (for onward deliveries to Europe) as and EU–Russia political relations will be countries will continue to depend fully Gazprom’s ability to transport gas important in determining whether and on Ukrainian transit for their supplies of further on through EU territory (for when either the second string of Turkish Russian gas post-2019, whereas Turkey example, either via the TAP or IGI/ Stream or the ‘southern route’ pipeline will be able to escape it completely with Poseidon pipelines) would require will be built. In particular, the EU wants one string of Turkish Stream to be built a resolution of complex regulatory to preserve Ukraine’s transit role and by 2020. issues with the European Commission is therefore opposed to any pipelines (EC). Furthermore, the second string that would enable Gazprom to reduce ‘SOUTHERN EUROPEAN COUNTRIES of Turkish Stream has a potential that role. Furthermore, the EU might WILL CONTINUE TO DEPEND FULLY ON ‘competitor’ in the form of Gazprom’s not want to increase the transit role of UKRAINIAN TRANSIT FOR THEIR SUPPLIES alternative ‘southern route’ pipeline Turkey (which would happen should to Europe (see map) which would the second string of Turkish Stream be OF RUSSIAN GAS POST-2019 …’ run across the Black Sea in parallel built) beyond that which it will play in to the fi rst string of Turkish Stream respect of Azeri gas supplies to Europe Last but not least, the security but land in Bulgaria rather than in via TANAP/TAP. This is especially true environment in the Black Sea region Turkey (thus replicating the offshore given that the EU’s regulatory power is a major factor determining whether route of the cancelled South Stream vis-à-vis Turkey is non-existent (as and when any of the aforementioned project). Notably, in February 2016 Turkey does not subscribe to the EU pipelines will be built. The rapidly Gazprom signed a memorandum of acquis) and its political power vis-à-vis changing fortunes of Turkish Stream understanding (MoU) with Greece’s Turkey is decreasing (in the aftermath demonstrate this with abundant clarity.

OXFORD ENERGY FORUM 19 RUSSIAN ENERGY ISSUES IN A VOLATILE ENVIRONMENT

From Nord Stream 1 to Power of Siberia 1: a change in mind-set from Soviet planning to capitalist unknowns! Thierry Bros

The old gold plated strategy failed to without taking into consideration the from spikes in prices because he has address new risks risk of a drop in gas demand in constructed a continuous potential for Europe that has subsequently led to oversupply. However, Gazprom has Building an international pipe is the renegotiations of those contracts; at least started to adapt to this new most diffi cult part of the gas chain European situation by selling gas not as it has many requirements, not The starting of the construction of the only via traditional long-term contracts the least being a seller and a buyer South Stream pipeline across the (with reduced oil indexation) but also willing to be linked on a long-term Black Sea in 2012 without, again, via auctions, via Gazprom Marketing & basis; intergovernmental agreements; taking into consideration the risk that Trading and via its 100 per cent owned project fi nance or signifi cant free the EU Commission could ask for European utility, Wingas (Wingas was cash fl ow for the capital expenditure; third-party access, leading to the founded in 1993 by Gazprom and the high technological capability; and effective building of the now stranded BASF subsidiary Wintershall; in 2015, high security measures. This is why Russkaya compressor station. Gazprom took over all Wintershall’s we have often seen much more pipe shares and Wingas became a wholly in PowerPoint presentations than owned Gazprom subsidiary). laid in the ground (the Nabucco and ‘GAZPROM HAS 150 BCM/Y OF SPARE Galsi lines being good examples). To PRODUCTION CAPACITY AND AROUND Finally, in a new Russian world, where address those issues, in the old days, 100 BCM/Y OF SPARE TRANSPORTATION competitors (Rosneft, Novatek) are Gazprom’s strategy was fi rst to contract CAPACITY TOWARDS EUROPE.’ lobbying to access spare export with buyers on an oil indexed basis and capacity, this old strategy is becoming then to build the required infrastructure riskier as competitors may be able using state-of-the-art technology, This gold plated strategy was to convince the State to amend regardless of any other risks that could acceptable in a world where gas Gazprom’s export monopoly over materialize later. Hence, it created a demand was always growing and pipeline gas, allowing them to use very resilient infrastructure that can where Gazprom, the export monopoly the spare capacity that Gazprom has meet peak demand. A few examples of for Russian piped gas, was rich enough itself constructed. It is becoming clear this old mindset include: to bear all the costs. In this old world, that Gazprom is now anticipating this Gazprom was investing/paying and problem; for example, the reduction its customers were benefi ting from in size of the Turkish Stream pipeline ‘BUILDING AN INTERNATIONAL PIPE secured supply. However, the result is from four strings to two strings (halving IS THE MOST DIFFICULT PART OF THE that today Gazprom has 150 bcm/y of the capacity to 31.5 bcm) shows that GAS CHAIN …’ spare production capacity and around Gazprom is not willing to invest in spare 100 bcm/y of spare transportation capacity any longer. The fi rst line will capacity towards Europe. In allow Russia to completely halt the 15 bcm/y of gas that currently transits The building of Nord Stream 1 in addition, Gazprom’s problems have Ukraine to Turkey, while the second line 2010–2 without taking into been exacerbated by its failure to will meet growing Turkish gas demand consideration the EU third energy acknowledge the potential challenge and perhaps, in future, bring marginal package that is now causing this from US LNG exports, catalysed by the extra volumes to Europe by linking to pipe to be used at a maximum of shale gas revolution, which has further the Southern Gas Corridor. Gazprom’s 77 per cent of its full capacity; added to an excess of gas supply spending will be limited by reducing the available to Europe. The development of the size of Turkish Stream, and by using the Bovanenkovo fi eld and the In our new world, where markets are pipe already delivered for South Stream construction of associated export providing short-term pricing, this gold- and allowing the currently redundant pipelines after signing (in 2005–6) plated strategy is always loss making Russkaya compression station to be major European export contracts for the producer, who will never benefi t put into operation.

20 OXFORD ENERGY FORUM NOVEMBER 2016: ISSUE 107

The severe slowdown in Chinese imports 200 Net imports Consumption Production reduces the need to fast track a full speed 175 Power of Siberia 150 A similar realization that construction of 125 excess pipeline capacity is no longer 100 a viable strategy is also dawning in bcm 75 the east. Here, Gazprom’s dominance started in 2002, when it was nominated 50 as coordinator of Russia’s Far East Gas 25 Programme and selected as the single 0 gas exporter. Government approval 1970 1980 1990 2000 2010 of this position was formally given China: net imports are slowing down sharply… on 15 June 2007, and in May 2014 Source: BP Statistical Review June 2016, thierrybros.com Gazprom and CNPC signed a Sales and Purchase Agreement for gas to be supplied via the eastern route (Power but in 2015 this fi gure was only norm is what we witnessed in 2014/15, of Siberia gas pipeline). The 30-year 4.5 per cent. This implies that forecasts then a similar growth in Chinese net agreement provides for Russian gas of future import requirements need imports would take a decade deliveries to China at a peak rate of to be revised down, with potentially (2020e–2030e). Unfortunately for 38 bcm/y. signifi cant implications for Russia and Russia it would now seem that the Gazprom (see the graph reproduced more likely outcome is rather on the above). lower side than on the upper side of ‘CHINA SHOULD, IN THE NEXT 15 YEARS, these forecasts. Two future scenarios are shown in the OVERTAKE RUSSIA AS THE THIRD- second graph (below), and the difference As a result, it would seem that the risk BIGGEST GAS CONSUMER …’ between them is stark, especially when for Gazprom is that a similar story to compared to the potential capacity of that seen in Europe could emerge, and the Power of Siberia pipeline. In the the company could fi nd itself having This export project was catalysed by high case, if we assume that the growth over-contracted to sell gas at high the fact that Chinese gas demand rate seen between 2007–15 was to prices only to fi nd that demand does grew by an astonishing 15.1 per cent continue for both consumption and not meet expectations and customers per annum in 2005–15 (although this production, Chinese net imports would start to re-negotiate once pipeline growth has recently slowed, to increase by more than 38 bcm (the capacity has already been built. If +4.7 per cent in 2014/15). In the last 10 years, China has overtaken Mexico capacity of Power of Siberia) in only history repeats itself then the new norm (in 2007), Saudi Arabia (in 2008), two years (between 2020e and 2022e). in China could again lead to contract Canada and Japan (in 2010), Iran (in In contrast, if we assume that the new renegotiations and legal arbitration 2013), and is now the fourth-biggest gas consumer after the USA, the Net imports Net imports old forecast Net imports new forecast EU, and Russia. China should, in the 800 next 15 years, overtake Russia as the 700 third-biggest gas consumer, but its 600 compound average annual growth rate 500 (CAAGR) for demand is likely to stay

bcm 400 close to the rate witnessed last year; 300 the growth in China’s gas imports is 200 therefore also slowing, even though its domestic production growth has 100 slowed (to 4.8 per cent in 2014/15). 0 Since becoming a net importer in 2007, China’s net imports have grown by … and should grow much more slowly in the future 60.8 per cent per annum (2007–15), Source: BP Statistical Review June 2016, thierrybros.com

OXFORD ENERGY FORUM 21 RUSSIAN ENERGY ISSUES IN A VOLATILE ENVIRONMENT

will put the eight compressors ‘GAZPROM NEEDS TO BE WARY OF needed to achieve full capacity on ‘EUROPE WILL NOW ALSO HAVE TO COMMITTING TOO EARLY TO MAJOR line more slowly during the 2018–25 SHARE THE BURDEN OF SECURITY OF PIPELINE CONSTRUCTION THAT COULD period in order to limit upfront capital TRANSPORT.’ CREATE MORE OVERCAPACITY.’ spending and also to avoid creating spare capacity (otherwise Rosneft, its Gazprom will always overinvest in emerging competitor, could make a cases with the goal (for the buyer) transport capacity to guarantee security claim to use it to export its own gas to being to achieve lower prices (and of supply to its European clients could China). Moreover, the second potential possibly volumes) in an oversupplied also prove wrong in the future. Security pipeline to China, Power of Siberia 2 world. As a result, Gazprom needs of transport should not be borne only from West Siberia to western China, to be wary of committing too early to by the supplier. The good old days is now unlikely to be needed anytime major pipeline construction that could when European contractors were paid soon and negotiations appear to have create more overcapacity. by Gazprom to lay pipes for the benefi t ceased. As a result, it would seem of European consumers are over; that, even if a price war takes place Europe will now also have to share Gazprom has learned and will be smarter in Europe due to Gazprom’s spare the burden of security of transport. going forward capacity and the emergence of US The stress test will take place on However, unlike the situation in LNG, a similar situation appears less 1 January 2020 as Russia has stated Europe, it would appear that Gazprom likely in China post 2020. that it will not renew its transit is learning its lesson. Anticipating contract via Ukraine that expires on lower Chinese gas import growth, 31 December 2019, leaving Europe ‘THE OLD ASSUMPTION THAT GAZPROM Russia appears to be slowing its short of Russian gas post 2020e unless export ambitions. The 2954 km Power WILL ALWAYS OVERINVEST IN a Nord Stream 2 solution is found soon. of Siberia 1 could be operational TRANSPORT CAPACITY TO GUARANTEE The EU Commission therefore has from 2019 (45 km were laid in 2015 SECURITY OF SUPPLY TO ITS EUROPEAN some interesting choices to make as it and the 2016 target is 400 km), but CLIENTS COULD ALSO PROVE WRONG …’ seeks to balance its political desire to it now seems that the ramp-up to diversify away from Russian gas with its full capacity will take more than the commercial need to ensure security of originally planned fi ve years. Gazprom Furthermore, the old assumption that gas supply for Europe.

Novatek leads the advance of Russian LNG James Henderson

Russia’s LNG industry is set to take progress next year, with a plan to take that Novatek’s promise, which had a signifi cant step forward in 2017, a fi nal investment decision (FID) on the been greeted with much scepticism in although this step will be made not by third train at Sakhalin 2 and, possibly, to recent years, that the 16.5 million tonne Gazprom but by one of its emerging also confi rm the development of Baltic (mt) Yamal LNG project would come competitors, Novatek. The Yamal LNG LNG in the west. However, the constant online in 2017, is set to be fulfi lled. project is set to come on line by the delays and postponements that have Concerns over fi nancing to cover end of the year, providing Russia’s fi rst marked Gazprom’s LNG strategy to the project’s $27 billion cost, which new LNG output since the Sakhalin date suggest that it is more likely that were exacerbated by the inclusion of 2 project sent out its fi rst cargo in Novatek will become the leader of Novatek on the US sanctions list, were 2009. Gazprom is also planning some removed earlier in 2016 when Chinese Russia’s LNG strategy over the next banks fi nally confi rmed that they would decade. ‘… LIKELY THAT NOVATEK WILL BECOME provide $12 billion of project fi nance. This was combined with offers from THE LEADER OF RUSSIA’S LNG STRATEGY Novatek’s Yamal project Russian banks and the Russian state OVER THE NEXT DECADE.’ It is becoming increasingly apparent to reach $20 billion of lending, with the

22 OXFORD ENERGY FORUM NOVEMBER 2016: ISSUE 107

remaining $7 billion being provided it is much lower than many competing 5–10 mt scheme aimed at markets in by the shareholders. Indeed, with the projects and should encourage both the west – by 2021 may also be diffi cult shareholders now including CNPC and lenders and investors to proceed. to keep. Meeting this target would also the Silk Road Fund, it was always likely require an FID in 2017, but it remains However, the key dilemma for Sakhalin that funds would ultimately be provided unclear why such a large project close 2 is accessing a secure source of from China for this project, in stark to the European market would be supply, as both the obvious options contrast to the lack of fi nancial support needed when Gazprom already has have problems. Rosneft and for Gazprom’s projects in the east of an excess of gas to export via pipeline. ExxonMobil have excess gas potential Russia. In addition, 3 mt of LNG per Potential access to new markets in at the Sakhalin 1 project, where 8 annum has been contracted by CNPC, South America and the Middle East bcm/y is currently being reinjected to again underlining the Chinese interest could be one response, but with the support oil production and where the in the project. global gas market being oversupplied development of the gas sections of the at present it seems very possible that Chaivo fi eld can provide even more Baltic LNG could also be deferred, output. This would be more than ‘THE FIRST TRAIN OF YAMAL LNG IS NOW especially as its main international suffi cient to supply a 5.5 mt train at VERY LIKELY TO BE OPERATIONAL BY THE supporter (again Shell) has a large Sakhalin 2, but the dispute over a fair END OF 2017 …’ number of other LNG options following price for the gas has been running now its recent acquisition of BG Group. for a decade. The Sakhalin 1 partners Although the fi rst train of Yamal LNG originally planned to export the gas via Gazprom’s dilemma is now very likely to be operational by pipe to China but were blocked by the end of 2017, the timing of trains 2 Gazprom, with its pipeline export Delays in both these projects, when and 3 is slightly less certain, with the monopoly, and since then neither side added to the postponement (or 2018 and 2019 start dates having the has found a way to agree on a transfer cancellation) of the Shtokman and potential to slip depending on market price for the gas to Sakhalin 2. Rosneft Vladivostok LNG schemes, leave conditions. Nevertheless, Novatek has even gone so far as to propose its Gazprom’s plans to become a major will still become Russia’s largest own independent LNG project on force in the global LNG business LNG producer by the end of 2020 as Sakhalin (Far East LNG) and although looking very unfulfi lled. Furthermore, Gazprom, which currently supplies the economics of this appear dubious, the Russian government will be 10.5 mt/y out of Sakhalin 2, has no new the concept is retained as bargaining disappointed that the country’s position projects that could be on stream before leverage. as a global energy superpower is being 2021 at the earliest. This refl ects not Meanwhile, Gazprom itself continues undermined by Gazprom’s relative only the general struggle for all LNG to pursue the development of its failure. developers to justify new projects when own gas resources in the Sakhalin 3 This may well explain why the Kremlin global gas prices are so low, but also licence, where three fi elds have been has been keen to support alternative the political and corporate problems discovered. Unfortunately, the largest of projects, with Yamal LNG at the which Gazprom faces as it seeks to these, South Kirinskoye, has signifi cant forefront. Not only does Novatek respond to domestic and global gas technical challenges and it has also appear to be a more effi cient and market challenges. been sanctioned by the US authorities, motivated company, but its project meaning that Gazprom’s plans to is located in a strategically important The Sakhalin project develop in partnership with a foreign oil area (the Arctic) and can help with company (most likely Shell) have been the economic development of one The expansion of the Sakhalin 2 put on hold. As a result, the company’s of Russia’s poorest regions (the Far project with a third 5.5 mt train would commitment to take an FID in 2017 is at North). When combined with the appear to be one of the most logical risk due to domestic and international benefi t of close personal relations and commercially sensible new LNG politics, as well as the operational projects in the global gas industry at diffi culties faced by Gazprom. present. A brownfi eld expansion close ‘… THE COUNTRY’S POSITION AS A to the key markets of north-east Asia, GLOBAL ENERGY SUPERPOWER IS BEING Baltic LNG the project should breakeven at a price UNDERMINED BY GAZPROM’S RELATIVE of $6–7/MMBtu. Although this is higher At the same time a promise to develop FAILURE.’ than the current spot LNG price in Asia, the Baltic LNG project – a possible

OXFORD ENERGY FORUM 23 RUSSIAN ENERGY ISSUES IN A VOLATILE ENVIRONMENT

between Novatek’s owners and the been included in the list of technical Kremlin, it is perhaps not surprising that ‘… ONE OF THE KEY RISKS FOR ALL parts that cannot be supplied under fi nancial and fi scal support, as well as RUSSIAN LNG SCHEMES … THE US or EU sanctions, but worries that infrastructure development, has been MAJORITY OF THE MOST IMPORTANT it might be in future have inspired a provided. When this help is added to TECHNICAL EQUIPMENT NEEDS TO BE drive by the Russian authorities to the natural advantages which the Yamal IMPORTED.’ encourage domestic manufacturing LNG project enjoys (very low upstream of the key elements of the LNG chain. costs and low LNG operating costs due The vast bulk of the equipment for the source of gas would be fi elds already to the low temperatures in the region), Yamal LNG project has been fl oated discovered there which are similar in the breakeven price of the project can in from the USA or Asia on huge nature to the South Tambey fi eld which be very competitive despite the remote barges, but plans for a manufacturing is the foundation of the Yamal project. geographical location. On a full cost centre in Murmansk are now starting basis, the project can breakeven at One signifi cant difference with this to emerge, with Novatek at their heart. $7–8/MMBtu in Europe, while on a cash new project, though, would be that it The company’s Arctic LNG project basis this falls to below $4/MMBtu. would aim to address one of the key is currently planned to be based on risks for all Russian LNG schemes, gravity-based platforms that would Arctic LNG and risks relating to imported namely that the majority of the most be manufactured in Russia, and the technical equipment important technical equipment hope is that indigenously produced needs to be imported. Indeed, it is liquefaction equipment will also be So confi dent is Novatek becoming in interesting to note that much of the key available. If a Novatek-led project can the positive outlook for Yamal LNG liquefaction equipment for Yamal LNG help to achieve this goal ahead of any that it is already talking confi dently has been provided by US companies, new Gazprom scheme moving forward about a second project nearby. Arctic in particular by Air Products, and this with a similar strategy, then Novatek LNG would be located on the Gydan has been a major source of potential could indeed become Russia’s peninsula opposite Yamal, and the risk. To date LNG equipment has not undisputed LNG leader.

Russian power sector approaching the next investment ‘wave’ but power companies are still mulling the key decisions Fedor Veselov, Andrey Solyanik, and Irina Erokhina

Domestic and export demand mostly focused in the domestic demand within the main grid areas market, with export volumes not was close to 1036 TWh, while an The Russian electricity sector is one of exceeding 10–15 TWh. In addition additional 25 TWh was produced the largest in the world with an installed to these CIS exports, supply is and consumed as self-generation. capacity in 2015 of 243 GW and provided to Finland and the Baltic Over the longer term, demand growth production of 1048 TWh of electricity states (totalling near 7 GW in 2015), within the centralized (on grid) area of is expected to be in the range of while in the East, electricity exports to energy supply. Furthermore, even 1.3–1.5 per cent per year, meaning China are increasing and reached though there is technical integration that by 2035 electricity consumption 3.3 TWh in 2015. Overall, though, with the power systems of neighbouring will have increased by 30–35 per cent, total exports account for less than CIS countries, the Russian system is whereas GDP is expected to grow by 2 per cent of electricity generation in up to 45–75 per cent. This gap refl ects Russia. the energy effi ciency improvements ‘THE RUSSIAN ELECTRICITY SECTOR IS While domestic demand is on the rise, that are expected in the Russian ONE OF THE LARGEST IN THE WORLD it has still not recovered to its level in economy due to a structural shift WITH AN INSTALLED CAPACITY IN 2015 1990 – after the economic crises in towards less energy intensive OF 243 GW.’ 2008–9 and 2014–15 slowed growth industries, as well as upgrading of the rates. In the last year, electricity power system.

24 OXFORD ENERGY FORUM NOVEMBER 2016: ISSUE 107

Power plants and investment plans life in excess of 25 years and heat nationwide, state-controlled power losses generally around 30 per cent. company United Energy Systems (RAO Most of the generating capacity in UES). Then a series of reforms, initiated Russia consists of thermal plants This situation has led the Russian 10 years ago, aimed at improving (165 GW, or 67 per cent of the total government to launch a number of both the operational effi ciency and the capacity, in 2015), and 55 per cent of investment initiatives over the last fi ve investment attractiveness of the sector. these thermal plants are combined heat to seven years. and power (CHP) units that also A transition to a competitive electricity The fi rst initiative is aimed at the produce heat for the country’s market, as opposed to state-controlled commissioning of 26 GW of modern extensive centralized heating system. tariff regulation, was considered to be thermal capacity (mostly CCGT and The non-fossil fuel generation capacity the main tool to improve operational CHP) under Capacity Supply is mainly made up of hydro (51 GW, effi ciency. A spot (day-ahead) Agreements (CSA). These special or 21 per cent) and nuclear (27 GW, or electricity market with hourly nodal investment contracts encourage 12 per cent) plants. Non-hydro pricing was launched in 2007, and energy companies to build new renewable sources are currently very was fully liberalized in 2011 (except power units in return for a 15-year for regulated supplies to households, limited, with less than 800 MW of capacity tariff based on an estimate which account for 15 per cent capacity (although some biomass of each company’s regulatory asset of demand). The spot market is plants are accounted for as thermal base (such a tariff is known as an supplemented by a balancing market, generation). In terms of fuel inputs, gas RAB-based tariff). is the dominant fuel for electricity and has become very responsive both The second is focused on support for production (its share of total fuel to variations in power demand as the nuclear sector given its crucial consumption in the power sector well as fuel input prices. For example, role for energy security and low- already exceeds 70 per cent); most spot prices in north-west Russia grew carbon development. Currently fi ve gas-fi red plants are located in rapidly until 2012 in response to the nuclear units are under construction European Russia, along with most of sharp increase in gas prices over the and approximately 13 GW of nuclear the nuclear plants. In contrast, same period, until parity was reached capacity are set to be commissioned electricity in the eastern regions is with prices in Finland, at which point in the next two decades. In part, mainly generated from hydro and electricity export volumes fell from these new units will replace existing coal-fi red plants. 10 to 4 TWh. Since 2014, however, units that will be retired, but they will as demand and gas prices have also increase the overall installed stabilized, spot electricity prices have nuclear capacity to 35–37 GW. ‘… ONE OF THE MAIN PROBLEMS IN THE also become much less volatile. In The third initiative is related to the SECTOR IS THE DETERIORATING QUALITY 2015 spot prices were 1100 and development of renewable sources, OF MANY OF THE GENERATING ASSETS.’ 870 RUR/MWh in European Russia again using capacity supply (the 1st price zone) and Siberia (2nd agreements to encourage the price zone) respectively, with the development of wind and solar However, one of the main problems in price gap mainly being driven by plants. Initially support is being the sector is the deteriorating quality the difference in marginal fuel costs provided for 5.8 GW of new of many of the generating assets. The between gas (in the 1st price zone) and renewable plants, but it is planned average age of thermal plants in Russia coal (in the 2nd price zone) plants. that by 2035 total renewable is 32 years (the age of coal plants is generation will rise to 30–45 TWh even higher at 37 years); in addition, (2–3 per cent of total electricity most of the existing thermal power ‘THE ESTABLISHMENT OF A COMPETITIVE production), compared with 2 TWh at plants use steam cycle for generation MARKET WAS FOLLOWED BY THE present. with low effi ciency (an average of LARGE-SCALE RESTRUCTURING AND 38 per cent overall and only 34 per cent Reform of the power market PRIVATIZATION OF THE POWER SECTOR.’ for coal-fi red plants). The transmission and distribution system is also rather Until the mid-2000s the Russian old and as a result electricity losses are power market functioned as a set of The establishment of a competitive high (10 per cent in 2015), while the regional vertically integrated energy market was followed by the large-scale country’s heat supply system has also supply companies and large power restructuring and privatization of the become less effi cient, with an average plants acting as subsidiaries of the power sector. The government retained

OXFORD ENERGY FORUM 25 RUSSIAN ENERGY ISSUES IN A VOLATILE ENVIRONMENT

fi xed operating and maintenance unlikely to decrease signifi cantly in the ‘… DESPITE THE PRIVATIZATION costs of generators and was applied next fi ve years. INITIATIVE, THE RUSSIAN GOVERNMENT to all existing capacity, as new However, as of 2016 the zonal STILL REMAINS THE LARGEST OWNER …’ capacity has its own special capacity market has been modifi ed remuneration (described later). In to encourage generators to 2015 generators obtained nearly control of the grid companies and the decommission ineffi cient capacity. RUR150 billion, or 35 per cent of total System Operator, as well as the hydro They can either bid lower capacity capacity payments, from this KOM, and nuclear plants, while the thermal four years ahead at a higher cap and even some capacity which did generating assets were transferred to price or retain existing capacity but not qualify for the KOM payments new owners, both Russian and foreign at the lower (–25 per cent) price. also received guaranteed (including Enel, E.On, and Fortum). Initial experience has shown that this remuneration at regulated tariffs, However, consolidation since the initial approach has worked to an extent, because it was defi ned as ‘system- sales has meant that 30 per cent of as some generators have decided required’ or ‘must-run’ generation. thermal capacity is now once again to close several units. However, this concentrated in state-controlled Thirdly, as mentioned above, almost pricing model does not solve the more companies, while the state-controlled all new projects are now developed strategic problem of the need to fi nd gas company, Gazprom, also controls under the Capacity Supply appropriate price signals to encourage a further 20 per cent of thermal plants. Agreement regulations. The investment in the modernization of As a result, despite the privatization Government is therefore obliged to existing capacities. Therefore, the initiative, the Russian Government still accept all the relevant capacity into development of a new capacity market remains the largest owner in the the supply balance and to pay it the mechanism to encourage investment restructured power sector. RAB-based capacity price (adjusted activity by replacing the administratively for the spot margin). The volume of driven CSA contracts is still on the Alongside the privatization process, this remuneration has increased by a agenda, and further action is also which provided the fi rst wave of new factor of fi ve in the last fi ve years and required to introduce demand response investment, the government reforms in 2015 it reached RUR170 billion, mechanisms in the capacity market. also included the introduction of accounting for 40 per cent of total mechanisms to support long-term capacity payments (in other words, Prices for electricity and pricing policy investment via RAB-based regulation of exceeding the payments from KOM). transmission and distribution services, The development of new market models, The main problem with this complex as well as capacity payments for investment incentives, and effi cient capacity payment system is that it generation, both of which are outlined regulation measures are also closely has led to a signifi cant oversupply of below. related to the more general priority of generation capacity due to the slow pricing policy in the power sector. demand growth that has resulted During the period when new (both Capacity payments from the weakness in the Russian competitive and tariff) pricing economy. The regulated tariff-based Capacity payments currently form mechanisms were being introduced compensation mechanism (CSA) was almost 30 per cent of the total revenues (up to 2011–12) prices rose rapidly, focused on capacity additions, but for suppliers in the wholesale market, although slightly more slowly than gas the competitive year-ahead capacity but these payments have a complex prices. However, over the past four market did not provide an adequate structure. years, prices have become more stable, mechanism to encourage the phasing with the average retail price in 2015 Firstly, special regulated prices are out of existing old and ineffi cient plants. being 3460 RUR/MWh, while the level in applied to 15–20 per cent of capacity As a result, between 2008 and 2014 European Russia was 5 per cent higher in order to ensure the supplies of the maximum load increased by 5.5 than this and in Siberia 20 per cent households and other preferred GW (+3.7 per cent), while the installed consumers. capacity increased by almost 22 GW Secondly, a competitive zonal (+10.4 per cent). Indeed, the actual ‘OVERSUPPLY AND EFFICIENCY capacity market (KOM) was launched capacity surplus (over the reserve IMPROVEMENTS IN GENERATION in 2010 as a year-ahead market with margin) in the market is estimated to WERE NOT TRANSLATED INTO PRICE strong price cap regulation. It was be almost 25 GW (or 15 per cent of EFFECTS …’ developed to compensate in part the the total capacity requirement) and it is

26 OXFORD ENERGY FORUM NOVEMBER 2016: ISSUE 107

Actual wholesale and retail prices in Russia, 2015 (RUR/MWh)

European Russia Siberia January June December January June December Spot price 1000 1130 1080 920 700 860 Wholesale price 1400 1525 1553 1233 1117 1296 (spot+capacity payments) Retail price 3390 3420 3730 2550 2490 2780 Source: Market Council database lower, due to relative fuel input costs. improvements in generation were not be complemented by a mechanism The implied average wholesale price translated into price effects because of of ‘renovation certifi cates’ (similar to (spot plus capacity payments) in 2015 the steady growth in capacity the ‘green certifi cates’ in the EU) to ranged between 1550 RUR/MWh in payments. create additional market drivers for the European Russia and 1250 in Siberia. investment decisions that are needed. Nevertheless, the overcapacity does For the future, the government is provide a unique opportunity to currently assuming that real growth in improve competition in the capacity prices will not exceed 1–2 per cent in ‘… PLANNED CHANGES IN THE market and to start the next investment the period out to 2035, mainly due to a MARKET WILL ENCOURAGE THE ‘wave’. In contrast with the fi rst one, this desire to restrain infl ation as part of the DECOMMISSIONING OF UP TO will be focused on the substitution of country’s macroeconomic policy. old and existing plants (in other words, 7–10 GW PER YEAR TO 2020, WITH it will not involve any net capacity SOME SUBSTITUTION BY NEW UNITS.’ The approach of a new investment ‘wave’ input). Indeed, over 120 GW of existing thermal plants must be retired and The recent results of market reform can It is anticipated that planned changes rehabilitated due to their age, but these be deemed successful from an in the market will encourage the decisions are currently being investment perspective, as they have decommissioning of up to 7–10 GW per postponed due to current market stimulated activity. However, many year after 2020, with some substitution conditions decisions were driven by administrative by new units. This trend, coupled with action rather than market activity, so Details of future changes in capacity moderate growth in system capacity they did not refl ect the fundamental prices and payments that would requirements, will result in a reduction change in electricity demand growth provide a stimulus for the required of the capacity surplus from around 25 rates. This has led to overcapacity in large-scale renovations are still being GW in 2020 to 5 GW or lower in 2025 the system, an excessive price burden discussed, but should be approved and to zero by 2030. At that point a on consumers, and dangerous levels of in the near future. One conceptual third investment ‘wave’, beyond 2030, debt in many energy companies. idea suggested by the authors is will be directed once more towards the Furthermore, oversupply and effi ciency that new capacity pricing rules may development of new capacity.

OXFORD ENERGY FORUM 27 RUSSIAN ENERGY ISSUES IN A VOLATILE ENVIRONMENT

NEW OIES PUBLICATIONS

Recent book LNG Markets in Transition: The Great Reconfi guration Edited by Anne-Sophie Corbeau and David Ledesma September 2016 (published jointly with KAPSARC)

Recent Research Papers Floating liquefaction (FLNG): potential Unconventional gas in Argentina: will European gas grid through the eye of for wider deployment it become a game changer? the TIGER: investigating bottlenecks by Brian Songhurst by Ieda Gomes and Roberto Brandt in pipeline fl ows by modelling history November 2016 October 2016 by Beatrice Petrovich, Howard Rogers, Harald Heckling, and Florian Weiser Energy subsidy reforms and the The low-cost OPEC cycle: the big September 2016 impacts on fi rms: transmission elephant in the room channels and response measures by Bassam Fattouh GCC–East Asia relations in the fi elds by Jun Rentschler and Martin Kornejew October 2016 of nuclear and renewable energy: October 2016 opportunities and barriers Advancing renewable energy in by Makio Yamada South American gas markets and the resource-rich economies of the September 2016 role of LNG MENA by Anouk Honoré by Rahmat Poudineh, Anupama Sen, and Lithuania’s strategic use of EU energy October 2016 Bassam Fattouh policy tools: a transformation of gas October 2016 market dynamics by Vija Pakalkaite˙ September 2016

Recent Energy Comments OPEC deal or no deal? This is not the Energy subsidy reforms and the Not all oil supply shocks are alike question impacts on fi rms: transmission either – disentangling the supply by Bassam Fattouh and Amrita Sen channels and response measures determinant October 2016 by Jun Rentschler and Martin Kornejew by Andreas Economou October 2016 August 2016 Can Iraqi oil production surprise again on the upside? by Richard Mallinson October 2016

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EDITOR: Bassam Fattouh CO-EDITORS: James Henderson Annual Subscription (four issues) £90.00 Oxford Energy Forum. ISSN 0959-7727. Published by Oxford Institute for Energy Studies, Registered Charity 286084. © Oxford Institute for Energy Studies, 2016.

28 OXFORD ENERGY FORUM