Russian Gas in Europe: End of Dependence?

Europe’s dependency on Russian energy is sometimes presented as a largely unalterable fact of life when in reality there is much that Europeans can do to reduce this dependency and indeed have already begun to do so.

Commentators are also apt to overlook the extent to which market conditions are making Gazprom, the major government-owned and government-regulated gas producer in Russia, more like a conventional commercial entity, one which is less likely to be influenced by political considerations in contract negotiations today than in the past.

 When Europeans complain about dependence on Russia’s politicised energy supply they refer to Russian natural gas, which in 2013 constituted 39% of the EU’s total natural gas imports and about one third of its gas consumption. Few observers remember that imported oil is also 33.5% of Russian origin and imported coal is 28.8% Russian. The import of these energy commodities from Russia provokes neither concern nor resentment because a disruption of oil or coal supply can easily be compensated by switching to non-Russian sources.

The problem with gas is the fact that no alternative sources of this commodity exist in many European countries. A Gas Stress Test study performed in 2014 by experts contracted by the European Commission1 demonstrated possible effects of Russia’s decision to terminate gas deliveries either via Ukraine or via all ongoing pipeline routes from Russia. The worst-hit countries under both scenarios were Hungary, Romania, Bulgaria and the countries of the former Yugoslavia. Hungary, concluded the experts, would experience a deficit of 26% in its demand for natural gas at the peak period of consumption in February if Gazprom interrupted the supply flow.

The ways and means of decreasing dependence are pretty obvious. Unfortunately for Europe, indigenous gas production is shrinking and cannot serve as a reliable method of achieving energy security. Annual production in Europe (beyond the borders of the former USSR) has plummeted from 325 billion cubic metres in 2008 to just 266.7 billion cubic metres in 2014, and the downward trend continues without any hope of recovery.

Energy saving and energy efficiency are better options, and the EU seems to be determined to continue applying these measures, as well as adding an increased share of renewables in the energy balance (solar, wind, bio, hydro and geothermal).

For decreasing the dependency on Russian natural gas supply, solutions are also evident. Mario Mehren, the new CEO of Wintershall AG, a German company that is an old and trusted partner of the Russian gas monopoly, told the author in May in Tübingen, Germany: “If I were Gazprom, I would help the EU countries build as many LNG (liquified natural gas) regasification terminals and as many cross-border pipeline interconnectors as they wish. It would make the Europeans feel secure and independent – and Gazprom would conquer the market by winning plenty of tenders for gas delivery because it can offer a better price than any competitor.”

This is exactly where the EU energy regulators are moving to,2  by encouraging not only alternative means of gas delivery (pipelines from the Caspian area and Middle East, Mediterranean supply possibilities, etc.) but also LNG terminals and interconnectors. An extremely important factor would be a higher degree of solidarity and coordination between EU member states, especially in times of distress when supply disruptions become a real peril.

The strategy works. For the past four years net imports of natural gas have been decreasing in the EU and no significant growth is expected through 2035, as analysts of BP envisage.3

Until December 2014 Gazprom based its European export strategy on wrong assumptions. The managers of the company kept assuring President Vladimir Putin that annual gas demand in Europe would increase by 200 bcm by 2020 (the deficit, they argued, would be covered by Russia) and insisted that it was possible therefore to disregard the antimonopoly attitude of the European Commission and insist on special terms for Russian gas sales through separate deals with specific companies and governments in the EU.

By the end of 2014 it dawned on the Russian leadership that Gazprom needed to adapt to the antimonopoly feelings of Europe if the company wanted to maintain its marketing niches at all. Alternative markets for Russian gas, such as domestic consumption, China or LNG sales, have proven to be either stagnant or having no actual prospects. Driven by warnings from energy experts at the Russian Cabinet of Ministers’ analytical pool and some of his aides, such as former Minister of Economic Development Andrey Belousov, Putin had to dramatically alter his policy and announce a new strategy of gas deliveries to the EU.

According to the Russian president, since the Europeans insist so ardently on their “harmful document”, the Third Energy Package, Gazprom will deliver gas only to the borders of the EU and allow European traders and consumers pick it up from there. The Russian company has abandoned its former idea of controlling the whole chain of gas sales from a well in Siberia to a kitchen stove in a European town.

In fact, Gazprom had started adapting to the Third Package well before Putin’s announcement, made on 1 December 2014, when the South Stream pipeline project was officially terminated. Since 2007–2008 the company has not insisted on its ban on re-exports of Russian gas (apart from “virtual” re-export before gas is delivered to the contract party – as was the case in Ukraine or Poland). Such clauses in gas contracts were recognised as illegal by the European Commission and Gazprom has had to comply with this.

The company has curbed monopolistic activities of its shadowy subsidiaries, which used to buy gas at a low price and resell it with huge profit. For example, its subsidiaries Overgas and Gazprom Germania bought gas for Bulgaria and sold it to the local distributor, Bulgargas, through a non-transparent scheme even as the price for the consumer was ratcheted up to almost triple the original figure.

Gazprom has already reported 65 cases of revisiting its contracts with European buyers – in some cases amicably and sometimes in court. Contract terms are being altered to benefit the European counterparts. In July 2013, for example, RWE (Rhine-Westfalia Power Plant) won the right to amend its contract with Gazprom in the Vienna court of arbitration, and the Russian company was forced to pay one billion euros to retroactively compensate the buyer of overpricing for deliveries dating back to May 2010. In 2014 Gazprom admitted it was reserving about $6 billion in its annual budget for such rebates.

The determination of the EU regulators, frequently defied by some members of the bloc who prefer to strike shady deals with Gazprom, was the main factor that made this change possible. In 2012 Gazprom faced a new challenge in Europe when the regulators launched an investigation into its allegedly monopolistic practices and managed to prove that the complaints of consumers were justified. Gazprom was breaking Article 102 of the TFEU (Treaty on the Functioning of the European Union), which prohibits the abuse of a dominant position that may affect trade between EU member states.4

The Russian government and Gazprom managers immediately became aware of the imminent sanctioning of their monopolistic practices (the penalty was estimated by the media in the range between $6 billion and $12 billion) and launched many rounds of non-publicised negotiations with the EU regulators to avoid the penalty or trim down the sum of the fine.

By the time the West introduced sanctions for Russia’s annexation of the Crimea and military involvement in eastern Ukraine, the Russian negotiators had managed to eliminate most of the charges by dropping the monopolistic practices and compensating clients for overpriced deliveries. The talks were interrupted by new political tensions and international sanctions in 2014 and the European Commission said in early 2015 it was going to publish a final report of the investigators and summarise the final charges against Gazprom. In September 2015 Gazprom announced it was aiming at an out-of-court settlement of the case and would like to resume the negotiations.

The Russians are now avoiding politicised issues in their negotiations on future contracts. Even in the dealings with its political adversary, the Ukrainian regime, Moscow is demonstrating some sort of a pragmatic commercial approach. The Russian government agrees to provide a partial exemption from the export tax to gas sales to Ukraine to make the price acceptable for the impoverished client. The softness of the treatment is another example of the new strategy of the Russian gas giant and its patron, the president of Russia.

In its new practice of compliance with the requirements and norms of the Third Energy Package of the EU, Gazprom has modified its policy vis-à-vis new pipeline projects that target consumers in Europe. While the ultimate political goal of Moscow is to deprive Ukraine of its revenues from the transit of Russian gas by building bypasses in the Baltic Sea and the Black Sea, the Nord Stream and South/Turkish Stream, Gazprom no longer insists on the ownership and operator rights to gas transportation infrastructure within the EU and on allocating the full capacity of any pipelines to transportation of Russian gas only.5

In the south, the Turkish Stream pipeline project is expected to reach a still hypothetical hub on the Turkish–Greek border, and European traders are invited to build their own infrastructure to pick up Russian gas from that hub and deliver it to consumers. In the north, Gazprom is reportedly considering a virtual hub in the Baltic Sea on the planned Nord Stream 2 pipeline (lines 3 and 4 of the existing Nord Stream route). Gas would be purchased by European traders before it reaches the shores of Germany via the underwater pipeline and the EU regulators would not be able to accuse Gazprom of monopolising or misusing pipelines in Europe.

Promoting its new image as a purely commercial company rather than a political instrument of the Kremlin, Gazprom is testing new methods of gas sales in Europe. In early September 2015 the company launched its first public gas auction on spot price terms. The volume of the offer was not large, 3.2 billion cubic metres for delivery in the coming winter season, a mere two per cent of Gazprom’s annual sales in Europe. Only one billion was actually sold, but Gazprom officials said it was just the beginning. The company intends to trade more gas on the free market beyond its traditional long-term contracts where the price is usually oil- indexed. Alexander Medvedev, a Deputy Chairman of Gazprom, commented: “The European gas market changes constantly and, meeting its challenges, we want to test the new form of trading the gas and see what benefits it can bring to seller and buyers.”

Officials at Gazprom Export, the foreign trade arm of the Russian gas giant, assured the author that the company would welcome requests for specific contracts from new customers in Europe with the price formula based on gas hub prices, also a significant retreat from former practices.

It would be wrong, however, to ascribe the new commercial strategy of Gazprom to just the pressure of the Third Energy Package and the peril of punishment by the European Commission’s antimonopoly investigators. The company’s natural gas production is shrinking at a tempo that threatens the very existence of Gazprom as a single business entity.6

The principal reason of Gazprom’s poor performance as a gas producer is the shortage of marketing room. In 2014 the company boasted an annual producing capacity of 617 billion cubic metres but was able to sell only 444 billion cubic metres (including 174.3 billion cubic metres of exports).7 The extra capacity equalled 173 billion cubic metres of gas.


Gas production of Gasprom, bcm (Source: Gasprom)

To conclude, it is the scarcity of new marketing opportunities that makes Gazprom treat its European customers with more respect. The times when political considerations made the company destroy its largest foreign market niche in Ukraine (the country bought 59 billion cubic metres of Russian gas in 2006) are over. Europe is beginning to see in Gazprom a reborn commercial partner rather than a permanent political bully.