The Magazine

Pipeline Politics

Is Putin running out of gas?

May 27, 2013, Vol. 18, No. 35 • By ALEX ALEXIEV and STEVEN F. HAYWARD
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The Cold War is now so over that it might as well be grouped with the ancient ice ages, but there is one echo rolling across Europe from East to West: the Russian attempt to dominate the natural gas market on the European continent. As the energy sector accounts for 25 percent of Russia’s economy, any large changes in energy markets present major challenges for Vladimir Putin. Those old enough to recall the Soviet gas pipeline controversy of the early 1980s​—​a high-profile fight of the Reagan administration to deprive Moscow of hard currency​—​are right to have a feeling of déjà vu, as Putin’s motives transcend honest commerce.

Gary Locke

Gary Locke

Despite huge gas reserves waiting to be tapped, most of Europe lags the United States in the shale gas boom for several reasons: a lack of mineral rights on private land, bureaucratic obstacles, the usual intransigent opposition from Europe’s potent green lobby, and, perhaps most important, the lack of adequate pipelines to connect new gas fields to the market. Hence, natural gas prices in Europe are several times higher than U.S. prices. Since natural gas and oil are Russia’s principal export commodities, the prospect of newly abundant oil and cheaper gas outside of Russia is a grave threat to Russia’s economic and political might in the region. Russia can’t do much about global oil trends, but Putin and the state-controlled Gazprom are doing everything they can to throttle new gas development in Eastern Europe, rerunning the same kind of behind-the-scenes propaganda against shale gas that the KGB ran against new NATO missiles back in the Cold War. Propagandists in Russia are promoting every translation possible for the message fracking=bad. The second prong of Putin’s strategy is to control pipeline development as far as possible. But things are not going well for him.

Gazprom is the linchpin of Putin’s political and economic strength. The state-controlled natural gas conglomerate is a huge source of revenues for the Russian budget, but also a slush fund for Putin’s clan—the corrupt network of power-political and economic relationships that rules Russia today. Immediately after coming to power in 2000, Putin moved to put the company under his direct control. In short order, he made his protégé and current prime minister, Dmitry Medvedev, chairman of Gazprom’s board and appointed another protégé, Alexey Miller, as CEO. According to a book by two prominent former Russian politicians, 11 of the 18 executive positions in Gazprom were quickly filled with Putin cronies. He then moved to make the company a “national champion,” giving it an exclusive license for the export of the country’s gigantic gas wealth. It is widely believed that Putin makes all of the key Gazprom decisions himself.

Putin’s energy cronyism is vertically integrated, as he ensures that infrastructure projects such as pipeline construction go to his friends’ firms at lucrative prices. Gazprom pipelines typically cost two to three times more than those built by Western companies, despite the much lower wages paid to Russian labor. While the German portion of the Nord Stream pipeline, for instance, cost $2.8 million per kilometer, the Russian portion built by one of Putin’s handpicked companies cost $6.5 million/km. This is one reason Putin likes pipelines, even if he can’t guarantee they will be fully utilized.

Sitting on 18 percent of the world’s current proven gas reserves (a percentage that shrinks with each new discovery elsewhere), Gazprom became one of the largest companies in the world. At the 2008 peak of the bubble in oil prices, to which Russian gas prices were indexed, Gazprom’s hubris overflowed. With a market valuation of $365 billion at the time, Alexey Miller confidently predicted that his company would become the largest in the world, with a market cap of up to $1 trillion by 2015, and that it would dominate the huge Chinese market as well as 10 percent of the American market with shipments of liquefied natural gas (LNG). Gazprom’s optimists thought it could command 30 percent of the world market.

Only five years later, this radiant vision of Gazprom’s future is just a mirage. Its market cap is $90 billion, neither China nor the United States is buying any of its gas, and its share of the world market has fallen under 20 percent. Moreover, the company is losing market share in its key European market, which accounts for nearly 80 percent of its export revenues. Last year, exports to Europe fell 7 percent to 138 billion cubic meters (bcm), but profits plummeted 23 percent because the company was forced to cut prices to major clients, often retroactively, after losing arbitration court judgments.

If Gazprom’s present is less than cheerful, its future looks worse. Company officials have maintained for years that they’ll be supplying 359 bcm of gas to Europe in 2020. Yet existing contracts for supplies in the period 2020-2025 call for only 158 bcm, and there are reputable analysts who doubt Gazprom will deliver even that much. Political problems loom: In 2011, the European Commission antitrust office raided 20 Gazprom offices in Europe, and last September it opened an investigation against the company for price fixing and other monopolistic practices. Informed observers believe that Gazprom will eventually have to pay billions in fines and may be forced to cut prices drastically.

Two other threats to Gazprom’s fortunes must also be mentioned. For years Gazprom and Kremlin propaganda have done their level best to scare the Europeans away from shale gas exploration. Alternatively dismissing it as a Hollywood invention or conjuring up an ecological apocalypse, the Kremlin seemingly believed that it can wish this threat away, despite evidence of the massive impact of the shale gas revolution in America. Early on, things seemed to go their way, with France and Bulgaria imposing a moratorium on shale gas exploration. No longer. With Great Britain now allowing fracking and Germany’s government submitting a draft law to do the same, the genie is out of the bottle. It’s only a matter of time before European countries begin exploiting their domestic shale gas fields, posing yet another challenge to the Russian monopolist.

 

What accounts for this dramatic turn for the worse in Gazprom’s prospects in just a few years? The short answer is that Gazprom is not and has never been a genuine commercial company interested in creating value for its shareholders. But neither is it a real state company. The prominent Russian expert Mikhail Krutikhin, from the independent energy consultancy Russ-energy, has put it succinctly: “Gazprom is not a state company because the interests of the national economy are completely alien to its leadership. It is an instrument for a limited circle of people to receive profits.” Thus, a look at Gazprom’s policies may give us real insight not only into the arcana of Russian energy policies, but into the much larger subject of what makes the Kremlin’s boss tick.

Vladimir Putin may have dreamed of becoming the J. R. Ewing of Europe, but his recent moves are more in the mold of the hapless Cliff Barnes. His signature initiative at the moment is the proposed South Stream pipeline, which would run under the Black Sea and through Bulgaria to points west. Putin was hoping Gazprom could retain monopoly control of the pipeline, but because it runs through European Union territory, it is subject to the EU’s market regulations (known as the “Third Energy Package”), which require that all pipelines be available for use by competing suppliers and overseen by an independent EU regulator. These conditions are unacceptable to Putin and make it unlikely that South Stream will be built.

South Stream seems to have been Putin’s personal project from the beginning. Touting it ceaselessly at international forums, twisting Eastern European arms as needed to sign on, claiming that it was exempt from European law, and staging bogus construction inauguration celebrations, Putin invested a tremendous amount of effort and prestige to make sure the project went forward. Its apparent demise is a bitter personal defeat, apart from wreaking havoc with his plans to use gas as a strategic instrument for securing Moscow’s political and economic desiderata in Europe.

That strategy envisaged South Stream as achieving two key political objectives. In bypassing Ukraine, heretofore the key transit country for Russian gas to Europe, it would provide the Kremlin with a powerful weapon for continued economic and political blackmail of Kiev. And, just as important, it would preempt the realization of the competing Nabucco pipeline project, designed to bring non-Russian gas from the Middle East and Central Asia into Europe. The Nabucco pipeline will run to Europe either by way of Greece and Albania into southern Italy, or through Bulgaria, Romania, and Hungary to a hub at Baumgarten, Austria. A decision on the final route is expected in June. The defeat of South Stream holds dire implications for Russia’s standing as the indispensable gas supplier to Europe and for the political fortunes of Putin.

Putin’s emphasis on new Russian-controlled pipelines makes little economic sense given that Gazprom’s current pipeline capacity to Europe is twice as high as the market will bear. The story of the Nord Stream pipeline, which runs under the Baltic to deliver gas directly to Germany while bypassing Poland and Ukraine, is another good example. From the beginning Poland decried Gazprom’s political motive in the Nord Stream route, calling it the “Molotov-Ribbentrop” pipeline. Fortunately for the Poles, Putin appears to have miscalculated. The twin-pipe Nord Stream came online in late 2011 and has 55 bcm capacity, but Gazprom has been able to utilize only a third of its capacity and is bleeding red ink. Moreover, the overland continuation of Nord Stream in Germany, called OPAL, brought the entire pipeline under the EU’s regulatory authority, despite Kremlin protestations, which means that it is no longer controlled by Russia. Half of its capacity is reserved for Gazprom competitors. Like Ukraine, which cut its Russian gas imports by 27 percent last year, Poland has embarked on a determined effort toward energy self-sufficiency. It is actively drilling for shale gas, building an LNG terminal at Swinoujscie on the Baltic Sea, and already importing 10 percent of its gas needs from Germany. Undoubtedly aware of this trend, Gazprom recently gave Poland a 20 percent price cut, retroactive to 2011.

Putin’s grand scheme of strong-arming Ukraine, Poland, and others and making Europe ever more dependent on Russian gas has not only failed but seriously endangers the gas monopoly’s very existence. Well-known experts such as Mikhail Korchemkin, head of East European Gas Analysis, believe that Gazprom has only a few years before bankruptcy. With Russia’s future oil exports looking soft​—​the Russian Academy of Sciences’ Energy Research Institute in early April forecast that oil exports could drop by 20 percent over the next 30 years​—​weakness in gas exports will deliver a double-whammy to Putin’s power base. The financial flop of the Soviet gas pipeline in the 1980s contributed significantly to the eventual collapse of the evil empire a few years later; the prospective collapse of Putin’s energy strategy may similarly hasten the demise of his evil empire lite.

Alex Alexiev is chair of the Centre for Balkan and Black Sea Studies in Sofia, Bulgaria, and a senior fellow at the International Assessment and Strategy Center in Washington. Steven F. Hayward is the Thomas Smith fellow at the Ashbrook Center at Ashland University.

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