From Nord Stream 1 to Power of Siberia 1: a change in mind-set

From soviet planning to capitalism unknowns, Thierry Bros looks at the change is mind set.

The old gold plated strategy failed to address new risks. It is important to bear in mind that building an international pipe is the most difficult part of the gas chain as it needs:

• to link on a long-term basis, a seller and a buyer
• high technology capabilities (especially for deep or long offshore sections);
• high security measures (especially for onshore);
• intergovernmental agreements (and approval by the European Commission of the inter-governmental agreement if signed by an EU country);
• project finance (the pipe needs to be profitable) or high free cash flow for the capex.

This is why we've seen much more pipe PowerPoint presentations (Nabucco and Galsi, for example) than real pipes being built in the past. To address those issues, in the old days, Gazprom strategy was first to contract with buyers on an oil-indexation and then to build the required infrastructure using state-of-the-art technology, regardless of any other risks that could materialise later. Hence a very resilient infrastructure that can meet peak demand. A few examples of this old mind-set:

The building of Nord Stream 1 in 2010-2012 without taking into consideration the EU third energy package that is now leading this pipe to only be used at 77% of its nameplate capacity;
The development of the Bovanenkovo field and producing pipe decided after signing in 2005-2006 major European export contracts without taking into consideration the risk in a drop in gas demand in Europe that lead to re-negotiations of those contracts (with now a lower oil slope and some spot indexation);
The starting of the South Stream construction in 2012 without again taking into consideration the risk that the EU Commission could ask for third party access, leading to the effective building of the now stranded Russkaya compressor station ($335m capex for this turn-key contract)…

This gold plated strategy was acceptable in a world where gas demand was always growing and where Gazprom, the export monopoly for Russian pipe gas, was rich enough to bear all those costs. In this old world, Gazprom was investing / paying and the customers were benefiting from secured supply.Today Gazprom has 150 bcm/y of spare production capacity and around 100 bcm/y of spare transportation capacity towards Europe. On top, Gazprom’s dismissal in 2005-2015 of the US shale gas production (by for example not reducing prices in Europe), is allowing liquefaction plants to be built in the US, that could from 2016 compete vs Russian gas…

In our new world, where markets are providing short term pricing, this gold plated strategy is always loss making for the producer who will never benefit from spikes in prices as it has, by construction, a huge spare capacity.

Gazprom started to adapt to this new European gas demand by selling gas not only via the traditional long term contracts (with reduced oil-indexation) but also via auctions, via Gazprom Marketing &Trading and via Wingas, its 100% owned European utility.

The fact that on 12 August 2016, the signatories of the Nord Stream 2 shareholders’ agreement have withdrawn their application for a merger clearance proceeding in Poland shows that Gazprom takes into consideration new risks (concentration, restriction of competition, anti-monopoly laws, etc.). The decision affects the acquisition of the existing project company’s shares by Gazprom’s five Western partners (Engie, OMV, Shell, Uniper and Wintershall). The implementation schedule of the Nord Stream 2 project remains unchanged according to Gazprom.

The failure of Lithuania in June 2016 to win compensation from Gazprom over gas pricing at Stockholm's international arbitration court, shows that the Gazprom didn’t violate the contract to supply gas at a fair price.

After the failed coup in Turkey, Gazprom is now in the process of reassessing all its pipes projects to figure out the best option for the company (on a risk-profit basis). The old assumption that Gazprom will always over invest in transport capacity to guarantee security of supply to its clients could prove wrong in the future. Security of transport should not be borne only by the supplier. The good old days when European contractors where paid by Gazprom to lay pipes for the benefit of European consumers are over; Europe will now also have to share the burden of security of transport.

Finally, in a new Russian world, where competitors (Rosneft, Novatek) are lobbying to access spare export capacity, this strategy is becoming riskier as competitors could convince the State to amend the pipe gas export monopoly, allowing them to use this at the expenses of Gazprom… And it is worth noting that Rosneft’s market cap is now bigger than Gazprom’s one and Rosneft is now the biggest contributor to the Russian state budget ahead of Gazprom.