How great is the chance that Iran goes nuclear any time soon?

I think the chances are much lower now than Autumn 2012. There is a two-fold reason for this. First, Iran has been severely hampered by stiff economic sanctions imposed by the West, so now it is desperately seeking to get some relief and restore its people’s living standards. Second, after Russia annexed Crimea and its relations with the United States and Europe became challenged, the West turned to Iran with more than just a non-proliferation agenda. Geographically, Iranian gas is located much closer to Europe than Russian gas delivered to Europe from the remote gas facilities in the Yamal Peninsula. It is estimated that over the course of 10 years Iranian gas could replace Russian gas in the European market. In fact, today, Iranian gas can be transported through a gas pipeline in Georgia, that is built but not yet in use.

Hence, the West is taking incremental steps to rebuild its relations with Iran. Thus, for instance, Great Britain opened its Embassy in Tehran, and the US has suspended certain sanctions. Iran, in exchange for relief from painful restrictions, has allowed the International Atomic Energy Agency (IAEA) to have daily access to its nuclear sites and enrichment facilities. In compliance with an interim agreement between Iran and the P5+1 (US, China, France, Russia and the United Kingdom plus Germany) from last November, Iran has stopped producing 20%-enriched uranium (HEU) and converted almost a half of its stockpile to low-enriched uranium (LEU) with concentration of 5%. During the latest talks in June between the P5+1 and their Iranian counterparts, Kerry said substantial gaps still exist between what Iran’s negotiators say they are willing to do and what they must do.
Even though the negotiations are still far from a final resolution to the Iranian nuclear program, hypothetically, once the West removes the embargo on Iranian exports, Iran will immediately start selling its oil and gas to Europe and Asia. This uptick in supply will help eventually bring down the world prices for hydrocarbons, which, in the long run, would be catastrophic for Russia.

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South Stream pipeline and the EU double standards

Naftogaz, Ukraine’s gas company, owes its Russian-owned counterpart, Gazprom, an estimated $4.46 billion for previous deliveries of gas. Gazprom demands prepayment for future supplies to Ukraine now and files an arbitration claim in Stockholm. On June 16, Naftogaz missed a deadline to pay part of that debt (about $2 billion), which entails three consequences. First, even though the new president was elected, Ukraine has yet rendered to be an unreliable client who fails to pay bills and thereby prompts another cut-off. Second, Ukraine has repeatedly proved to be unable to provide a reliable transit for Russian gas to Europe. Third, the need for diversification of gas supplies has become even more obvious and relevant.

No wonder, Russia has become even more bullish about South Stream, a pipe-line project designed to pipe 63 billion cubic metres of gas per year from Russia to Central and South Europe bypassing Ukraine. The pipeline will go across the Black Sea bottom from Russia to Southern Europe. Its length will be 900 km. The project is being implemented by South Stream Transport, of which Gazprom owns 50%, Italian ENI 20%, French EDF and German Wintershall 15% each. To build the land part of the pipeline, Russia has stricken agreements with the governments of Bulgaria, Serbia, Hungary, Greece, Slovenia, Croatia, and Austria.
Thus, the project will cement Russia’s hold on the European gas market and diversify the gas supplies. However, the European Union seeks to diversify the gas suppliers (in other words, to give other gas suppliers access to the pipeline), not the methods of its supply. As a result, the European Commission postpones the final approval of the pipeline and applies pressure on the key-members of the South Stream chain. With solely a political purpose – to punish Russia.

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On the one hand, Brussels sharing its part responsibility for the ongoing events in Ukraine (namely, the so called Euro-Maidan was inspired by hopes to join the Economic Association with Europe), cannot let the situation be taken over by Russia. Once the situation is under Russia’s control, Ukraine (who is physically unable to pay the debt back, because its economy is gruesomely broke) is no longer the gas-transit country, Ukraine is no longer Russia’s client at all. Russia will build a new gas pipeline bypassing Ukraine, and leave the country in oblivion. That being said, why does not the EU bail out Ukraine and helps it redeem the debt to Russia? Once the debt issue is settled, there is a chance for a new round of talks regarding further cooperation in gas supplies between Ukraine and Russia, between Putin and Poroshenko, who have numerously demonstrated their eagerness to diplomatically solve the conflict.

The European Union is not so much interested in bailing out Ukraine and even less so in its admission to the Union. It would entail further subsidies, humanitarian and financial aid, all that burden that the German taxpayers have already been pissed off by dragging Greece, Spain, and Portugal out of their debts. The problem is that there are actually two Europes: the European Union as a huge bureaucratic machine, and Europe as a conglomerate of nations. Those two Europes appear to be different. What’s more, those two Europes appear to be pursuing different interests and goals, if not conflicting goals. The European Commission is acting from a position of a universal judge who seeks to pursue justice and punish the hot-headed game-breakers. The European Commission is a “stronghold” of morality that cannot allow its members to do business with someone who violates international norms and neglects other country’s sovereignty. Fair enough. Such an approach is quite understandable from the rule of law and the world-system perspective. But the reality is more complex. The reality is that Europe is still (whether it likes it or not) highly dependent on import of hydrocarbons. The price it pays for these imports matters too – now even more than ever, given the stagnation in the eurozone. Thus, the cheapest and the most reliable gas supplier to Europe is still Russia. In fact, Russia has never let Europe down since the 1960s in terms of the energy supplies. Again, 2006 and 2009 were the transit zone blackouts. The Middle East could potentially be accounted too, but at the moment it’s major client is Asia and it’s undergoing another wave of terrorist coups and civil war turmoils. EU countries get about 30% of their gas from Gazprom, and half of that is piped through Ukraine. If Europe had alternative energy suppliers such as LNG from Qatar, Algeria, and the U.S available right now (by “available” I mean ready-installed refineries, de-liquification facilities, special storages, the money, after all, to pay for the gas shipments across the Atlantic), or if Europe had alternative energy resources (wind, solar power, water energy, etc) that could easily replace natural gas, the Brussels talks would make more sense. Sadly, the fact of the matter is that Europe does not have those alternatives handy as of yet. Nor is it going to have them available in the next two-three years. Thus, no matter how unlawful and rogue Russia’s bahavior is, Europe is nowhere near ready to wean itself from Gazprom. To sum it up, Brussels acts from its supranational, hyper-idealistic perspective and makes decisions based on the same premises that drives the EU committees to set cucumber shape regulations or obligations to put a sticker on non-GMO food-items. Meanwhile, individual European states, being guided by sheer energy security interests, have to think pragmatically and act individualistically. They need to make sure that the gas supplies are guaranteed and there is no such a situation when their citizens have to burn woods to keep their homes warm on cold winter days (as it used to be the case in 2009).

Thus, Italy’s Saipem, for instance, signed a contract worth 2 billion euros with Gazprom regarding the construction of the first submarine section of South Stream and is now ready to start the work. Right at the rise of the Ukrainian crisis, in April, Austria and its biggest energy firm OMV enthusiastically supported the South Stream project. Hungary, another land route of South Stream, is also teaming up with Russian state companies for a €10 billion deal involving the construction of two nuclear reactors.
Serbia finds itself caught between its ambitions to join the EU, with which it has started accession talks, and historical ties with Russia. Nevertheless, Ivica Dacic, Serbian Foreign minister confirmed that the South Stream project is in their best national interests. After all, whether Serbia shifts to the EU or not, does not really matter. Serbia is not the key player in the project. What does matter though is Bulgaria. The gas pipeline goes through its territory, thus its approval of the project and commitment to it are crucial for the entire venture. The European Commission figured it really quickly and started pressing Bulgaria. In the very beginning, since 2010 (long before the Ukrainian crisis, by the way) the Bulgarian part of the South Stream has been criticized by the European Commission. The latter was skeptical about the transparency of the tender. Meanwhile, the tender was won by the Bulgarian Gasproject Yug and Gennady Timchenko’s Stroytransgas. Timchenko is already on the sanctions list after Russia took over Crimea in February 2014.
In April and May, the situation in Ukraine deteriorated which only strengthened Brussels’ stiff position against Russia and elevated its desire to punish it. The Bulgarian socialist government (very loyal to Russia) was holding a staunch resentment against the EU threats – until the EU reminded Bulgaria of the 15 billion euro it promised in subsidies for the Bulgarian agricultural sector and infrastructure. On June 8, Bulgarian Prime Minister Plamen Oresharski announced the suspension of the project till matters with the EU clears up. The Bulgarian head of government made his decision shortly after meeting a US troika delegation – John McCain, Ron Johnson and Christopher Murphy. The meeting came after a public statement on the 6th of June by American Ambassador in Sofia Marcie Ries, warning that Bulgarian companies participating in South Stream maybe part of US sanctions against them due to their collaboration with the Russian Stroytransgaz. This caused the Bulgarian government to split into pro- and anti-Russian factions, and they announced early elections scheduled for September this year. Boiko Borisov, who leads the centre-right Citizens for European Development of Bulgaria (GERB) party, is the most likely prime minister to be, given that his party scored the largest number of seats (representing Bulgaria) in the European Parliament elections in May.

It is fair to say that Russia tries to manipulate Ukraine and tells it what to do. It is also fair to say that Russia wants Europe play by its rules and buy its oil and gas the way Russia offers them. Paradoxically, criticizing and punishing such misdeeds, the European Union acts by exactly same token. It disregards national interests of its individuals members and uses threats and blackmails to force them to do what the EU deems appropriate. Abusing the weak points of other states (such as bad economies or chances for future membership in the EU), Brussels is actually playing by the same rules it’s been fiercely opposing.

Why has Europe had difficulty imposing sanctions on Russia?

Annexation of Crimea, Russian military posturing along the border with Ukraine, demonstrations in Eastern Ukrainian cities, Donetsk’s declaration of its independence – all these sweeping revolutionary metamorphoses in Ukraine prompted the West to respond with a series of economic sanctions against Russia. The sanctions banned around 33 Russian and Ukrainian top officials and businessmen from traveling to Europe and the US, froze their foreign bank assets, and disabled processing Bank Rossiya and SMP Bank Visa and MasterCard transactions, and expelled Russia from G-8. Despite such pressure, so far, the Kremlin continues to dismiss the sanctions as inappropriate and shows no sign of giving in under pressure.

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On the contrary, Moscow increased its pressure on the interim Kiev government, which it views as illegitimate. Meanwhile, Russia’s major power – its energy resources and ability to export them – still remains untouched. Targeting this economic sector would seriously, if not fatally, hurt Russia, since 60% of its state revenue comes from oil and gas exports and constitutes more than a half of its federal budget. But would the gas export ban be only fatal for Russia?

Europe remains dependent on Russian energy
Russia is, by far, the largest supplier of energy to Europe. According to the Energy Information Administration (EIA), European countries import 84% of Russia’s oil exports, and about 76% of its natural gas. The degree of energy dependency on Russia varies across European countries. The Baltic States and Finland are 100% dependent on Gazprom, Bulgaria, Slovakia and Hungary– 80%, Slovenia, Austria, Poland, Turkey, the Czech Republic and Greece –50%. Obama suggests replacing Russian gas in Europe with Liquified Natural Gas (LNG) imports from North America, Australia and/or Papua New Guinea. So far, this idea is but an amusing fantasy for at least two reasons: first, neither European countries nor Ukraine are able to use American LNG because they lack essential terminals to regasify LNG. It might take at ten years or more to technically prepare European terminals to fully utilize American gas, including installation of new pumping systems and other expensive facilities to decompress and store gas. Second, the cost of the LNG gas will be markedly higher than traditional gas piped from Russia – accounting for both its transatlantic shipment and associated infrastructure. The project per se is plausible but unrealistic in the near-term. Given the size and scale of these projects, it will to take years before LNG begins moving from the Gulf coast in substantial volumes. Additionally, the United States is not ready to export sufficient amount of gas to Europe yet – largely accounting for its own needs. In 2013, the US used 736 billion cubic meters of gas (98% of its total) on its domestic consumption, whereas Russia domestically consumed only 456 billion cubic meters (68%). The domestic consumption level inevitably impacts the amount of gas slated for export. Over the past year, Russia exported 190 billion cubic meters of gas, while the US only 44 billion.

 

Europe is looking forward to breaking free from Russia’s dependence on fuel supplies and has enthusiastically started to explore its own potential shale gas reserves. Poland is estimated to possess 346-768 billion cubic meters of shale gas, Bulgaria may host 481 billion cubic meters, Germany has technically recoverable shale gas reserves of 481 billion cubic meters. According to U.S. EIA estimates, Europe could have as much as 13 trillion cubic meters of recoverable shale gas. However, due to regulations on fracking and the generally high cost of European Shale, by 2020, the total annual production of shale gas in Europe is only expected to be 4 billion cubic meters, according to energy consultancy IHS. Regardless of how optimistic or pessimistic one views Europe’s potential production in 2020,  2020 is still 6 years away. Where will Europe get gas to keep its houses warm and lit this coming winter? Another impediment with fracking gas in Europe is its possible impact on the local environment. Probe shafts drilled in Poland have suggested that Europe’s ground structure differs from that of America, making it harder to cost-effectively extract natural gas. Also, political pressure from environmental groups in countries like France and Bulgaria has resulted in the imposition of outright bans on fracking. As a result, Europe is unlikely to experience the sort of “shale gas revolution” that is transpiring in North America.

 

Another energy source that will replace some Russian gas is coal. The US has plenty of excessive reserves of coal and its producers are looking for foreign customers. Because of the low demand over the past three years, the prices on coal have fallen – from $130/ton in 2011 to $75/ton today. In 2014, America is expected to send 100 million tonnes of coal abroad, mainly to the EU. By 2015, Eni predicts, Germany will shut its gas stations that cumulatively produce 10 gigawatts and open coal stations with 7 gigawatts power. According to the EIA, to produce 1 gigawatt hour (GWh) of energy needs 225,000 cubic meters of gas or 490 tonnes of coal. By contrast, for 650 terawatts produced from Russian gas, Europe pays Gazprom $60 billion a year. The equivalent amount of coal (around 340 million tonnes) would cost Europe half as much- $30 billion. On the other hand, a coal plant is still a coal plant, producing roughly twice the CO2 emissions of a natural gas plant, regardless of how much is invested in its emissions control system. WWF estimates the new coal plant planned in Greifswald, Germany, will produce 6.9m tonnes of carbon emissions a year, an amount equivalent to the entire emissions of the country of Tanzania. Coal is not the environmentally-friendly energy source of the future.

Europe could step up imports of Middle Eastern energy, however, this is fraught with issues as well. First, Europe has never fully entrusted its energy security to the Middle East and has no plans to start now. Second, although increasing oil tanker shipments is straightforward, importing Middle Eastern and Caspian Zone natural gas would require construction of thousands of miles of additional natural gas infrastructure. Currently, many of the European refineries in Czech Republic, Poland, Slovakia and Germany still get their crude oil via the Soviet-era pipeline network “Drouzhba” running through Ukraine and Belarus to Europe. In the event of an embargo, those refineries wouldn’t be able function until the logistics are adjusted. Third, OPEC could potentially leverage Europe’s situation to gouge it on pricing. Obama is currently trying to manipulate world oil prices. He has paid visits to Saudi Arabia, to speak with its 80-year-old king about the development of Saudi facilities to extract gas and deliver it to Europe in exchange for reduced oil prices. The idea that jawboning Saudi Arabia into reducing prices will have any lasting impact on the world market is a complete farce.

The most draconian policy Europe could impose would be an embargo on imports of Russia’s oil and gas. However, even with such a policy, the embargo is not going to destroy Russia. There could be cuts (say, by 20% or by 50 million tons) in volume of oil imports by European states. In that case, Russia’s loss would be $35-40 billion a year. At the same time, once Europe introduces the embargo, Russia would look for new customers. Fortunately, there are many potential oil-importers out there – notably, Central Asia and China and oil itself is fungible. Russia will refocus both economically and strategically towards Asia, thereby strengthening China – obviously, to no great thrill to the West.

All of these facts indicate that Europe can’t simply ignore its energy relations with Russia and cut itself from Russian supplies. Energy security in Europe is quite a sensitive matter, which requires a delicate approach to its resolution; in an attempt to screw Russia over, Europe could be shooting itself in the foot.

How could Russia and Europe solve the dilemma?

Europe fears the repetition of the gas supply disruptions in 2006 and 2009 when Russia simply switched the gas flow off in response to Ukraine’s fail to pay its gas bills. Who was to blame in that – Russia’s supply or Ukrainian transit? European governments were collectively blaming Russia and its aggressive rulers, whereas German, Italian, and French leading energy firms were in agreement that it was primarily Ukrainian transit crisis. Who to trust? Well, governments do politics and employ much rhetoric to justify their deeds as well as to attract more votes, whereas companies do business. The current situation in Ukraine has put European countries under the threat again, and has repeatedly shown who has been the major hurdle on the road.
When then pro-Russian president of Ukraine Victor Yanukovich chose not to sign the association agreement with the EU, Putin graciously offered him a $15 billion package of loans plus a generous discount on gas supplies. Now, when Yanukovich fled the country and the new interim government (whose legitimacy Russian authorities refuse to recognize) is assertively anti-Russian and explicitly leaning toward the EU, Russia does no longer feel obliged to provide Ukraine with any subsidies. What’s more, Russia claims Ukraine has not settled its previous gas debts. Naftogaz, Ukrainian national gas company, still owes Russia its unpaid gas bills for March, thereby totaling the debt to $2.2 billion. If Russia suspends the gas supply, Ukraine will need to turn to Europe for loans to pay off its debt in order to continue the transit of gas from Russia to Europe. In other words, Europe will have to take care of Ukraine’s debt, which Ukraine herself can’t reimburse. “Russia is not obliged and no longer going to bail out the Ukrainian economy through discounts and gas and forgiving debts, and through the subsidies to pay off Ukraine’s trade deficit with the EU countries,” said Putin in his letter to the 18 European leaders on April 10. “According to the current contract, Gazprom will have to switch to the system of preliminary payments for gas supplies and in the event of violation of the payment obligations, will have the right to fully or partly suspend the supply of gas. In other words, Russia will provide gas as longas Ukraine pays a month ahead.”
Earlier in March, Alexey Miller, head of Russia’s Gazprom, announced that starting from April 1st, the gas price for Ukraine would be $385.50 per 1,000 cubic meters in the second quarter of 2014 as the conditions of payment had been violated. On April 3, Russia announced the raise of the gas price as high as $485 due to the cancellation of the discount that was included in an old agreement concerning the deployment of the Russian fleet in the Black Sea. To compare, the initial price Ukraine used to pay for Russia’s gas was $268.50 for 1,000 cubic meters of gas (as of December 2013). In addition, during an April 3rd meeting with Mr. Miller, prime minister Dmitry Medvedev announced the cancellation of the so called “zero tariff” on gas for Ukraine. The “zero tariff” was adopted after the signature of the 2010 Kharkiv agreements in exchange for the permit to keep Russia’s Black Sea fleet in Sevastopol after 2017. The agreement implied that if the gas market price is $333 and beyond per 1,000 cubic meters Ukraine is granted a discount of $100, if the price is below $333 – Ukraine gets 30% of that level. Russia authorized this discount through the “zero tariff” on the amounts of 40 billion of cubic meters a year in 2011-2019, which the prime minister has cancelled now after the annexation of Crimea and denunciation of the Kharkiv agreements. The Kremlin now is planning to charge Ukraine for the missing incomes from the exploitation of the “zero tariff”.
Whether Ukraine pays its debt off and buys Russia’s gas at the reviewed prices or it doesn’t, Russia is committed to its European relationships and long-term contract obligations to provide Europe with gas. So far, Russia can’t bypass Ukraine in terms of gas delivery to Europe. However, it is under Gazprom’s control to decide who are his clients. Once Ukraine refuses to pay the full price, Gazprom cuts it off from the gas supply. The way out of such a troublesome situation Ukraine sees in reverse gas supplies from Hungary and Poland. The European pipe-line system can potentially be upgraded so that it can stream gas in the opposite direction – from the West to the East. According to the Slovak gas-transmission operator Eustream, the pipeline will allow “the supply of gas to Ukraine in reverse flow mode already in October of this year, with a volume of 3.2 billion m3 a year. Later on, in March 2015, this capacity could be increased to as much as 8-10 billion cubic meters a year.”
To reverse gas flow from Europe to Ukraine the pipeline needs an interconnection that would connect the pipe in Slovakia with the one that Eustream and Ukrtransgaz are planning to set in reverse mode – in Ukraine. Thus, the gas should physically cross the border with Slovakia, otherwise Gazprom may legally appeal because during the pumping of gas in Ukraine Gazprom is still the owner of that gas and any manipulation with it can’t be done without Gazprom’s permission. Eustream suggests that Ukraine build this technical solution because in addition to its functional effectiveness it will also legitimize the reverse supply of gas. The cost of the project is expected to be €20 million. The construction can be finished by the beginning of this winter. However, the Ukrainian authorities criticize this project as overly time consuming and insist on immediate revers supplies, notwithstanding the warnings from the Eustream that such a deal could violate the contract with Gazprom.

Gazprom to renegotiate the prices

It is not only Ukraine and Europe who have found themselves in an uneasy situation with Russia, Gazprom too has to reconsider its policy in response to the changing gas market reality. European market has been in stagnation since the 2008 crisis and the demand for gas has been relatively low. Hans-Peter Floren of the Austria’s OMV AG board of directors is speaking about oversupply of natural gas in Europe for the next couple of years. He expects the demand on gas in Europe to stagnate till 2020, thus, he suggests the provisions of the long-term contracts should be reviewed, the gas-suppliers should cut the price in order to restore the competitiveness of gas in the energy market. Energy Information Agency (EIA) says that the demand in Europe fell by 7.5% in 2010, and by 3.5% more in 2012.
Despite the tensions and hostile political environment between Russia and the West, European companies still view Russia as their business partner, particularly with regard to its energy sector. In the past two months alone, three major energy deals have been negotiated or signed between European and Russian companies. On April 1st, Hungary signed a 10 billion Euro credit agreement with Russia for an upgrade of its nuclear plant in Paks.
Russia’s Lukoil holds talks with France’s Total regarding the exploration of shale gas in Russia. Italy’s Saipem has signed a $2.8 billion contract to build Gazprom’s new South Stream pipeline. In March, Germany’s RWE sold its oil and gas exploration and production unit to Russian oligarchs for $7.1 billion.
Gazprom now is in a position when it can literally save the situation from rolling further downhill and maintain trust and good partnership with the West. For that it needs to become more flexible and willing to renegotiate its long-term contracts with European clients. Gazprom’s long-term contracts’ price formation mechanism is based on oil indexation. According to Sergei Komlev of Gazprom Export, such a mechanism lays down fair trading conditions in which neither supplier nor costumer can manipulate the price. The gas price is determined by the energy market. Another reason Gazprom does not want to abandon its long-term contract system is that it guarantees minimum annual purchase of gas (“take-or-pay” contract) by a client given the falling demand for energy due to the crisis in the Eurozone. However, being known for its legendary sturdiness, Gazprom has actually started reconsidering its policy: the long-term contracts are no longer unchangeable throughout decades, they are reviewed every 2-3 years and as a result have become framework agreements rather than a decade-long contracts. Eventually, Gazprom has brought its gas prices close to spot prices. If we look at a chart drafted by Thierry Bros of Societe Generale, we will see that in early 2013 the Gazprom prices were different from the NBP (gas hub in the UK, with the highest liquidity in Europe) prices by no more than 5-6%.Moving Gazprom towards market-based pricing and contract terms has served to depoliticize, to an extent, Russian-European energy trading.

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Energy-supply routes diversification

Given that this is not the first time when relations between Ukraine and Russia achieve a boiling point, Russia is seeking to avoid Ukrainian transit in its energy supplies to Europe by all means. The most feasible way out of this conundrum for Russia would be to move gas westwards using routes bypassing Ukraine, whereas for Europe it is both to diversify the pipeline routes and its energy sources.
In 2003, then-President Putin signed an agreement with the German government to construct the Nord Stream pipeline. The two pipelines of the project run almost parallel to one another through the Baltic Sea and provide Russian natural gas to Germany – from Russia’s Vyborg to German port at Greifswald. The lines were completed and set online in 2011. While the construction of a pipeline along the seabed is over three times as expensive as the construction of a similar overland pipeline, Russia benefits immensely from its investment, as Nord Stream bypasses Ukraine, Belarus, and Poland, reducing transit costs and consolidating Russian control over the energy supply to Germany and the center of Europe.

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In 2007, the Kremlin and the Italian government signed a memorandum of understanding regarding the construction of a Russian pipeline to supply natural gas to Italy. South Stream, scheduled to begin transport of gas in 2015, will travel from Russia across the Black Sea, Bulgaria, Serbia, Hungary, Slovenia, and finally to Italy. Its capacity is estimated to be 63 billion cubic meters. It is over 930 km long and 2 km deep. The pipeline is in its early phase of construction as Gazprom is laying down pipe in Russia, Bulgaria, and Serbia. The European Parliament is looking to use the South Stream as a tool to put pressure on Russia and freezes talks on its further construction. This is clearly rhetoric, yet who knows how far this rhetoric might go. Once the Nabucco project turned a failure, Europe might also want to make stake on Azerbaijan’s Southern Gas Corridor, which is underway and designed to pump gas via Georgia and Turkey to the Balkans. Once its construction is completed, the 1,250-mile pipeline will supply gas to Bulgaria, Montenegro, Bosnia and Herzegovina, Croatia, and Albania. As a result, it will make this part of Europe far less dependent on Russia.

Bottom line

No matter how desperately Europe would like to punish Russia for its truculent actions in Ukraine, European countries are to varying degrees dependent on Russia’s energy supplies. Thus, sooner or later, Europe will have to get back to the negotiating table. The interdependence between Russia and the European Union means that crippling economic measures against Russia’s key sectors may turn out a double-edged sword – strongly impacting both Russia and Europe.  Even before the outbreak with Ukraine, the Kremlin’s energy policy in Europe was aggressive and ruthless rather than cooperative and respectful of its costumers. Throughout the years Russia has systematically acquired a significant amount of influence over the countries of Eurasia and the European Union, benefiting from their dependence on Russian natural gas. As a result, it has been hard to find economic sanctions that would harm Russia without hurting other states’ economies. For example, Cutting off European imports of natural gas from Russia would leave them scrambling for other resources. Now, however, the Western states’ desperate eagerness to switch to non-Russian sources of energy strongly suggests that Russia’s energy hegemony won’t last much longer. If Russia remains in a political confrontation with Europe, Europeans will diversify their energy supply away from Russian fossil fuels, either by switching fuel sources (e.g. coal) or by country of origin (e.g. U.S. LNG)  rendering Russia’s most potent source of leverage impotent. Taking a long-term perspective, European states will need to reconsider their energy security priorities and develop them into a more coherent and harmonized policy, which will reduce Europe’s vulnerability in the event of a broken relationship with Russia.

Russia’s Oil and Gas Economy

Today, Russia is the world’s largest oil producer and also one of the leading exporters of the fuel, nearly five million barrels a day. Russia alone accounts for 12% of world oil output. Very recently, it yielded its leading position in natural gas reserves to the United States. Unsurprisingly, Russia’s economy is highly dependent on the oil and gas exports. “More than 40% of Russia’s budget comes from oil-and-gas related duties and taxes”, says Tatiana Mitrova of the Russian Academy of Sciences’ Energy Research Institute. The Russian Federation relies on oil prices to remain at or above $110 dollars per barrel to balance its federal budget. The combination of high production and relatively high world oil prices have propped up both the Soviet and Russian economies for decades, however, such a situation cannot last forever. The country’s “known oil reserves”—primarily located between the Ural Mountains and the Central Siberian Plateau—are enough to sustain current production levels for just 20 years, according to a study in December by the European Bank for Reconstruction and Development (EBRD), vs. 70 years for Saudi Arabia and 90 years for the United Arab Emirates. Many experts have suggested that falling energy prices could prove fatal to Russia’s economy. Until Russians adopt a smart approach to managing its energy sector and start developing new sources for sustainable economic development, the future of Russia’s economy remains highly uncertain.

Price Fluctuations

On October 28th, North American Brent crude oil on the spot-market closed at $108.90 a barrel, reported Reuters. Russia’s Urals oil has been balancing at $107.60 per barrel. Texas WTI traded modestly lower at $96.70. Germany’s BND intelligence agency said it is possible that crude oil prices will fall to about $80 per barrel. In the next three years, “black gold” will cost around $100 per barrel, said experts at Russia’s Ministry for Economic development. With regard to the 2014-2016 budget, the Ministry of Finance estimates rely on $93-95 oil prices. Energy Research Institute at Russian Academy of Sciences predicts that Russian oil exports could fall 25% to 30% after 2015, reducing gross domestic (GDP) product by more than $100 billion.
The price declines anticipated are mostly the result of newly unveiled oil reserves in the United States. The American Petroleum Institute (API) recently summarized the growth in energy fuel reserves in the country. According to the API, the oil reserves in the U.S. have increased by 2.9 million barrels in October alone. According to the EIA report, “since 2008, U.S. petroleum production has increased by 7 quadrillion Btu, with dramatic growth in Texas and North Dakota. Natural gas production has increased by 3 quadrillion Btu over the same period, with much of this growth coming from the eastern United States. Russia and Saudi Arabia each increased their combined hydrocarbon output by about 1 quadrillion Btu over the past five years.” The surplus production in the energy market can be observed from the increasing oil stockpiles in China. As the Chinese information agency Xinhua reports, in September, China increased its oil stockpiles by 1.43%, up to 237.6 million barrels, as compared to August this year. “Steven Pifer, a Russia expert at Brookings Institute and a former U.S. ambassador to Ukraine, says that Gazprom is becoming increasingly wary of the changes taking place around it in the global energy market.”

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According to predictions by BP, the U.S. will outpace the world’s largest oil-producers, Russia and Saudi Arabia by the end of 2013. The catalyst for this change is American adoption of new technology enabling the exploitation of non-conventional oil. Thus far, over the past five years, oil outputs from low-permeability shales in the U.S. has increased by 20% and is now 2.1 million barrels a day. The cumulative daily oiloutput in the U.S. in 2012 was 8.9 million barrels. Thanks to horizontal drilling and hydraulic fracturing technology, the U.S. oil production would increase by 46%, equivalent to the entire output of Nigeria, says Daniel Yergin, vice chairman of consulting firm IHS. “Think of it like a non-OPEC country appearing in North Dakota or southern Texas,” Yergin told executives at the St. Petersburg forum in June.

Similar trends have been seen in gas industry. The U.S. last year tapped more natural gas than Russia for the first time since 1982, according to data from the International Energy Agency. America’s unexpected return as an energy superpower with its rapidly developing pipeline-free liquefied natural gas (LNG) market may cause a drastic shift in pricing power from suppliers to consumers. The latter poses a direct threat to Russia’s interests in Europe. Gazprom, the state-owned energy giant, is seemingly losing its grip on the European energy market, where it used to supply about 25% of the gas. According to a recent Bloomberg Business Week interview, “Yergin predicts natural gas, both conventional and liquefied, will be the No. 1 energy source by the end of 2030.” Meanwhile, Russia has only one operational plant with LNG capacity – in Sakhalin. Any potential competition in the energy supplies market would lower prices and thus cause Europe to seriously consider other options to its not-so-friendly gas supplier, Russia. Europe has not forgotten the freezing winters of 2006 and 2009, when Russia tried to gain the upper hand in pricing negotiations with Ukraine by cutting off natural gas exports for days. “Europe is certainly looking for alternatives,” says Pifer.
The European Commission recently approved a list of 250 projects in energy infrastructure, that qualify for funding of €5.85 billion in 2014-2020. None of the projects from Russia got nominated, says the Kommersant, Russian business newspaper. Thus, two major Russian pipeline projects, Nord Stream and South Stream received no grants from Europe. The European Union is switching its policy toward the South, yielding preference for three projects – “the Southern Corridor” (annual supply of 23 billion cubic meters of gas from Turkmenistan and Azerbaijan), the Algeria-Italy pipeline (7.5 billion cubic meters), and the Cyprus-Greece pipeline (8 billion cubic meters). However, Turkmenistan has already agreed to sell significant supplies of gas to China, and the idea to build the pipeline westwards, across the Caspian seabed , has been vociferously opposed by Russia. Thus, only Azerbaijan will be able to supply gas via the Southern Corridor, and its volume will be restricted to 10 billion cubic meters a year. Meanwhile, the European Union’s natural gas production is falling due to the exhaustion of the North Sea reserves. By 2020, production is expected to drop by more than 40 billion cubic meters per year, down to 250 billion cubic meters, according to the International Energy Agency. Europe is going to compensate for this decline by importing large quantities of liquefied natural gas (LNG) and some coal.

Former Russian Energy Minister Igor Yousoufov, currently a member of the board of directors of Gazprom, believes that there is nothing to worry about. Gazprom can satisfy domestic consumption and export needs without turning to shale gas. 28 trillion cubic meters of gas under Gazprom is sufficiently enough to last for decades – to satisfy both the domestic needs of Russia’s economy and to comply with our obligations to our allies and foreign partners. While Russia’s position as a dominant energy player has been undermined by the West, the country needs to at least secure its stance in faster-growing Asian markets. “We are really behind the curve and need to accelerate,” says Ildar Davletshin, an oil and gas analyst with Renaissance Capital.

China – Cooperate and Be Alert

Even though Russia still controls the majority of Central Asia’s energy exports, its strategic position is being overtaken by China. Russia, which for years has tried to exploit the former Soviet republics using exclusive contracts and unfavorable oil and gas prices, has effectively pushed those countries into China’s arms. Kazakhstan and Turkmenistan with their ample energy reserves are now more prone to cooperate with China over their gas supplies. In this context, Russia’s recent $85 billion deal to supply oil to China comes as quite a surprise. Instead of concentrating its own efforts to build strong industry in the remote eastern regions as a counterweight to China’s rapid expansion north- and westward, Russia’s government agreed to jointly construct an oil refinery, in which 49% will be owned by the Chinese and 51% by Russians, and to jointly extract oil in Eastern Siberia. Under the agreement, Russia’s biggest oil producer, Rosneft, will supply an additional 70 million barrels of crude oil a year to China for 10 years. The Chinese government, for its part, is eager to obtain Russian supplies, as it fears a potential security weakness coming from the current China’s reliance on crude oil supplies from unstable Persian Gulf. In June, the two countries signed an agreement for Russia to supply 2.5 billion barrels of oil valued at an estimated $270 billion to China over the next 25 years. Russia’s second-biggest natural gas producer, Novatek, also announced a deal to supply liquefied natural gas (LNG) to China’s largest oil and gas company, CNPC, for the next 15 years. Most importantly, the terms of the deal, including pricing, are being kept secret.
At first glance, it might look like Russia has a giant client who is eager to consume its oil and gas and is willing to pay hard currency, lessening its reliance on exports to Europe. However, if we look at the structure of exports from Russia to China in 2012, we will see that the share of technology and machinery was only 0.7%, with the rest being mineral resources (such as hydrocarbons – around 69%). In hindsight, the first significant agreement between Rosneft, Transneft and CNPC to supply 300 million tons of oil until 2030 ended in scandal. The two parties each calculated the transportation rates differently. The potential loss for Russia’s Rosneft and Transneft could have amounted to $16.9 billion and $11.3 billion, respectively. The parties could not settle the dispute for over a year, during which CNPC underpaid for the Russian oil. In the end, the Russian companies agreed on an intra-state discount of $1.50 per barrel. Thus, given the aggregate volume of Russian oil supplies to China at the rate of 760 million tons per annum until 2038, Beijing could technically save up to 56.8 billion.

So, for now, the both parties seem to be in a win-win situation: China secured supplies of oil (lessening a reliance on maritime routes the U.S. could easily blockade) and Russia has found an offset to the new reality in Western Europe (including “gas conflicts” with Belarus and Ukraine). However, Russian government should not get too excited about the new contracts with China and millions of dollars they got from China in loans. Given the persistent presence of Chinese business in Central Asia and its further expansion to the north and west, the Russians should look two or three decades ahead and think where the current dynamics could ultimately bring the country. One of the possible perspectives is that Russia will gradually yield its economic sovereignty to China’s ambitions, turning into its mineral resource fringe in the East and into an object of Chinese expansion overall. The Chinese have already started exploring Russian market. The largest construction corporation, China State Construction Engineering Corporation (CSCEC), won a tender to build 1.5 million square meters of housing in the Far Eastern city Khabarovsk. China massively invests both human and economic capital in Russia’s Far East, and the Russian government endorses such investments since it itself has no available funds for the region’s development. As Sergey Sanakoyev, responsible secretary at the Russian-Chinese chamber for assistance in trade of machinery and innovations, says “as we can see from the current debate around the sources for the Far Eastern region development, there is no 5 billion ruble available in the budget as it requires. This means that the budget funding is going to be less while the remaining expenses could be covered by private funds. The only place the state could borrow money is Asia”. For all its profitability, such a close cooperation with China could result for Russia in both financial dependence and total loss of control over the remote territories.

Russia’s Oil Industry is in Decline

Given that Russia views its natural gas and oil as the main gears for its economic development, it should probably ensure that its energy industry infrastructure should always be modern so that its resources could be most efficiently utilized. However, the reality is the opposite. “The industry’s traditional core, the giant West Siberian fields inherited from the Soviet Union, has been in decline since 2007.” The reason that oil production still goes upward (by about 1.6% in 2012 and 1.4% in 2013) is that Russia continues infill drilling in the older fields and developing new sites on Russia’s periphery. The domestic energy market in Russia appears to be scarce. As Maxim Barskiy, a joint holder of an independent company Matra, says “almost all more or less attractive assets have gone over the past few years, whereas the Soviet reserves have been running short, yet the new sites are not being developed”. He says that there are only two or three assets in the market that could be of interest to an investor.
Russia has not started extracting oil from low-permeability formations as the preparations are still in progress. Large oil reserves, about 22 billion barrels, are in the Bazhenov shale in Western Siberia. Rosneft holds a license for 50% of the reserves. In 2012, Rosneft started cooperating with ExxonMobil, using its technology and experience.
At a high level, Russia’s oil and gas industry is its main resource, yet its infrastructure remains in dire condition and needs to be renovated, in addition, new sites and technology should be exploited. With the notable exception of the military and defense sector, most other areas of the Russian economy have been poorly maintained and are in need of modernization. Worse, few new industries have grown at all. Such a situation is dangerous for the country’s economy. Oksana Dmitrieva, economist, deputy chair of the Just Russia party (Spravedlivaya Rossiya), says “if the Federal budget’s zero growth is balanced by the oil export revenues, regional budgets do not get “oil money”. Hence, “the current stagnation causes a huge budget hole of $12.5 billion in regional budgets. The Federal budget has no solutions to how to make up this regional budget deficit yet,” says Oksana.

Russia needs to innovate and modernize

Since the country’s economy is still predominantly commodity-driven, Russia’s oil-rentier state is in urgent need of dramatic modernization. The most sustainable and safe new oil sites should be prioritized in terms of investments; oil development in climate-impacted and geologically more complex zones demand more knowledge and sophistication. The government should therefore channel investments into research and technology, including partnerships with other energy-rich states, subsidize the development of energy efficient and less carbon-intensive fuels. Russia could start exploring offshore Arctic fields and develop unconventional sources like oil sands, shales and deep marine shelves. According to some estimates, if Russia takes this path, it will potentially be able to extract 1.4 million barrels of shale oil per day by 2030.

By and large, the next generation of Russian oil will have to be extracted from places that are colder, deeper, less accessible, and more complex. To be able to tackle these challenges, Russia should stimulate the innovations in the industry today. Alas, innovation is a long-term business that rarely brings quick profits, and often results in failures that never pay back. Russian oil oligarchs show little incentive to invest their oil income back into the modernization of the oil industry. This is a notorious example of short-time preference whereby they would rather invest in offshore ventures, foreign real estate, bonds and gold, etc., all things that would bring relatively quick benefits. “The major demand for innovations will most likely take place when the oil prices are no longer high,” said Russia’s vice-president Igor Shouvalov at the World Economic Forum in Moscow in October 2013. Thus, consistently high energy prices have allowed the country to survive but not to develop. In fact, high commodity prices have created stagnation in Russia’s economy: by propping up the ruble, they have rendered Russia’s non-oil exports less competitive and hampered increases in productivity. triggered inflation. In other words, high oil prices have held the country off the path toward advancement and innovation.
Another mechanism to encourage Russian shale oil activity is a more favorable taxation system. In September 2013, the government introduced long-awaited tax breaks. As Platts, McGraw Hill Financial reports, “the stimulus gives oil producers a reduction of between 20% and 100% in the mineral extraction tax (MET) rate, depending on reservoir permeability and layer thickness. In particular, crude produced from the most promising Bazhenov oil play in West Siberia will enjoy an MET rate of zero. Other shale and more broadly tight oil reserves will see tax reductions at between 20% and 80% from the standard rate.”
In the long run, Russia’s economy should stop being dependent on favorable oil prices. Hydrocarbons should gradually become a back-up plan. Russia, as well as all other oil-producing nations, should start thinking about a post-oil economy and diversify its economy into high-tech industries (e.g. renewable energy, semiconductors, chemicals, and aerospace). Innovation is important not only in the energy sector but also in manufacturing where Russia lags far behind the countries with developed economies. Investment in advanced manufacturing and increasing labor productivity would render Russia’s economy more sustainable and competitive. Siberia, besides its oil and gas reserves, is rich in other natural resources (timberland, fresh water reserves, etc.) that could be practically utilized if efficiently organized and managed. Thus, Russia has large potential for economic growth based, not necessarily on its hydrocarbons, but other forms of capital (human, intellectual, land) in which Russia is rich.