“Crisis of Confidence" Afflicts Russian-European Gas Relationship

"Crisis of Supply" Can be Averted, according to Cambridge Energy Research Associates Report

LONDON (11 September 2007, 12:00 a.m. BST) — A growing “crisis of confidence” threatens the Russian-European natural gas relationship, which has been integral to the economies of both Europe and Russia over several decades, according to a new study by Cambridge Energy Research Associates (CERA).

While there is much focus on specific issues, the reason for this crisis is the combination of fundamental changes in Russia, Europe, and in the gas business itself that are unsettling the relationship, according to the study “Securing the Future: Making Gas Interdependence Work.” The CERA study is a comprehensive examination of the changes taking place that alter the basic assumptions that have underpinned the European-Russian gas relationship for many years. It focuses on the current stresses and threats, and on ways to reduce the tensions and keep the relationship on a solid footing. Its timeliness is underscored by the new legislation on gas liberalization expected from the European Commission on September 19.

“The crisis of confidence need not translate into a crisis of supply in the future,” says the report. “It is important that the issues of gas interdependence between Russia and Europe be seen simultaneously through the critical lenses of competition, security and environmental sustainability. While attention may focus at any given time on one source of tension or friction or another, a larger perspective shows why a strong spotlight is now on this relationship today.”

“The broad conclusion is that the sustainability, efficiency, and security of European energy supply will best be achieved not by hastily deciding to reduce dependence on Russian gas, but through the creation of a carefully and cooperatively managed ‘interdependence’ between Europe and Russia,” said Simon Blakey, CERA Senior Director, European Research.

The study demonstrates the importance of the relationship both to Europe and Russia. Although Europe accounts for almost one-fifth of the world’s annual consumption of gas, its own reserves represent less than two percent of known global gas reserves. Russia is the world’s biggest holder of natural gas reserves. Russia provides 26 percent of Europe’s total gas, and the largest share of imports, while natural gas is Russia’s second largest export earner. In addition, the increased penetration of natural gas into the primary energy mix for Europe – critically supported by Russian supply – has been the key factor in lowering CO2 emissions in Europe since 1990.

The study examines issues that go to the core of the gas relationship between Europe and Russia:

• Is there enough gas available in Russia to supply Europe’s future needs?
• Can the next generation of Russian associated gas and the transportation infrastructure in both Russia and Europe be financed in a timely way?
• How much dependence on Russian gas is consistent with European security?
• What alternatives exist to diversify Europe’s sources of energy?
• Where are Russian policies on energy and energy diplomacy headed?
• How will the gas trade be affected by the European Union’s evolving policies on energy security, sustainability, and competitiveness?

Three Fundamental Changes

Gas exports from Russia to Europe have benefited both seller and buyers, and the scale of the business has been a significant achievement considering the complexity of the relationship and the political changes that have taken place. The gas continued to flow even during the frostiest years of the Cold War. Central to the current rising anxieties are changes taking place in Russia, Europe, and the gas industry.

Russia is changing: Russia for the first time since the Soviet era needs large-scale investment in the next generation of gas fields and pipelines. There is also increasing competition from the domestic market, as Russia’s economic recovery continues. In addition, the economy has bolstered a strong central state, which views energy as a key element of foreign relations.

Europe is changing: The European Union has evolved from a customs union of 15 members, to a supranational entity with 27 members that sets the economic and regulatory agenda of member states. This agenda includes a strong push towards liberalization in the gas and power sectors. Environmental sustainability is also a major policy objective, with the recent commitment to more renewables, more energy conservation and lower emissions of greenhouse gases.

The gas industry is changing: the industry is becoming global, rather than regional, as a result of advanced trading and balancing systems, the growing global liquefied natural gas (LNG) market, and the evolution of pipeline financing models.

In addition to the changes that have already occurred, more lie ahead, including new legislation in Europe to further alter gas markets, and the coming change in Russian leadership.

“A constructive way forward will recognize both the significance of the changes and the far-reaching stakes in the relationship,” said CERA Senior Director Thane Gustafson, Russian and Caspian Energy. “This will provide the basis for managing the stresses and forging a framework that assures that gas interdependence will continue to deliver the economic and environmental benefits for both Europe and Russia in the decades ahead.”

What are the risks?

“It is not interruptions or cutoffs,” says the study, “or even the threat of them, that poses the greatest danger.” Rather, “the more significant risk” is the “degradation” and “corrosive undermining of a relationship that is a fundamental pillar of both Europe’s and Russia’s economies…and that has contributed to a lower carbon intensity.”

• “European concerns” include transit risks, perceived “over dependencies,” worries about the future supply of gas from Russia and Central Asia, and concerns about export monopoly.
• “Russian concerns” focus on “the regulatory risks from liberalization policies evolving in Europe, perceived discrimination against Russian interests in Europe, and the extension of EU policies and rules outside the present territory of the European Union.”

As the Russian-European gas relationship has become more complex and uncertain, some have looked to alternatives to alleviate the pressure. On the European side, where domestic gas production has entered a sharp decline, with a drop of almost 30 billion cubic meters over two years since 2004, liquid natural gas (LNG) is the most attractive and immediately-realistic alternative. For Russia, it has been suggested that gas exports can be diverted to East Asia, turned into “embodied gas,” consumed domestically, or just left in the ground. However, for Europe, CERA has concluded that, while LNG will provide diversification, natural gas by pipeline will remain the “fuel of default,” and that for Russia the only viable alternative is the Russian domestic market, which may be a competitor to the European market as a source of value for Russian gas producers.

A way forward

CERA’s study concludes that exporting Russian gas to Europe is still cost-effective, reliable, and beneficial for all parties. It is important, however, that steps are taken to protect and sustain the relationship in order to achieve realistic and sustainable “interdependence” between Europe and Russia through:

• Careful management of the European Union’s liberalization agenda, with the European Parliament and Council of Ministers paying particular attention to the implications for security of supply and environmental sustainability of the European Commission's September 2007 proposals
• The likelihood of a review by the incoming government of Russia after the 2008 election of the objectives and structure of the Russian gas industry
• Maintaining a respect for national sovereignty in order to support favorable conditions for cross-border investment and to manage third-country transit issues
• Cooperation to manage and diversify transit risk, including reviving the idea of a multilateral consortium with Ukraine, to manage the Ukrainian pipeline and storage system
• Allowing markets to do their work. There is strong evidence that the new market structures and market opening practices that are already in place will evolve quickly to the benefit of the gas industry’s customers.

For more information about the study contact Bethany Genier at bgenier@cera.com.

About CERA

Cambridge Energy Research Associates (CERA), an IHS company (NYSE: IHS), is a leading advisor to energy companies, consumers, financial institutions, technology providers, and governments. CERA (www.cera.com) delivers strategic knowledge and independent analysis on energy markets, geopolitics, industry trends, and strategy. CERA is based in Cambridge, Massachusetts, and has offices in Bangkok; Beijing; Calgary; Dubai; Johannesburg; Mexico City; Moscow; Mumbai; Oslo; Paris; Rio de Janeiro; San Francisco; Tokyo; and Washington, DC.

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