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Russia-China Gas Deal Proves Costly for Both Sides

An analysis by Michael Lelyveld 2020-07-10 -- Russia's natural gas prices for China have started to drop amid signs that the contract for supplies from the Power of Siberia pipeline will prove costly for both countries.

Last month, Interfax reported that the price of gas from Russia's giant pipeline project fell 10 percent in April to U.S. $182.70 (1,290 yuan) per thousand cubic meters (tcm) from over U.S. $200 per tcm (1,413 yuan) in the first quarter, based on Russian and Chinese customs data.

The first deliveries from the newly-opened 3,000-kilometer (1,864-mile) pipeline began last November at a price of U.S. $212.20 per tcm, the Russian news agency said.

Price changes take place under an agreement between Russia's Gazprom and state-owned China National Petroleum Corp. (CNPC) that tracks the cost of competing products including fuel oil with a nine-month lag for adjustments, according to Interfax.

While the trend has been down along with all energy prices during the pandemic crisis, the Power of Siberia gas is still far more expensive than supplies of liquefied natural gas (LNG), which have hit record lows on the Asian spot market.

Pricing disparity

But a separate Interfax report indicated that Gazprom's prices for China are also far higher than those for its other customers.

In April, the average price for European markets fell 13 percent from a month earlier to U.S. $109 per tcm, over 67 percent cheaper than the charge for China's supplies.

The reports suggest that China's price for Russian pipeline gas is the highest by far and is likely to remain so in the near term barring renegotiation, although Gazprom has been talking up the possibility of increasing supplies.

The pricing disparity has come to light at a time when Gazprom's exports to Europe have fallen sharply with reduced demand due to the pandemic.

In April, the volume of gas exported to 26 European customers plunged 29 percent from a year earlier, while revenue slipped 25 percent from a month before.

In May, exports slid 28 percent while Gazprom's average export prices fell further to U.S. $94 per tcm, Interfax said.

But Edward Chow, senior associate in the Energy Security and Climate Change Program at the Center for Strategic and International Studies in Washington, said the price premium for China would have to be even higher to compensate for the huge U.S. $55-billion cost of field development and pipeline construction in remote East Siberia.

"Under current market conditions, the Power of Siberia deal does not look commercially attractive to either Gazprom or CNPC," said Chow. "CNPC is locked into a 30-year supply contract for gas that may be too expensive."

In a subsequent report this week, Interfax said that Power of Siberia gas was cheaper for China than alternative pipeline supplies from Central Asia or Myanmar, based on calculations from Chinese customs figures.

Prices in April from the other pipelines ranged from U.S. $194 to $365 per tcm, according Interfax.

"These figures are consistent with comments made by Gazprom earlier. However, the company presented them in terms of competitiveness rather than in terms of profitability," the report said.

Gazprom officials have previously declined to disclose specific prices of Power of Siberia supplies.

"Now every housewife wants to know the price of the gas, but this is inappropriate," Gazprom deputy CEO Alexander Medvedev said after the contract was signed in 2014.

In February, CNPC's PetroChina subsidiary tried to suspend gas imports during the COVID-19 lockdown by declaring force majeure, a legal exemption from contracts due to circumstances beyond a party's control.

Gazprom denied receiving a force majeure notice but responded in mid-March by closing the newly-opened pipeline for two weeks of maintenance. In April, the company announced that two more maintenance shutdowns would interrupt service this year.

While CNPC's costs are high in the current market, it may be unable to simply refuse the Russian gas under the "take-or-pay" terms of its contract with Gazprom. The agreement calls for payment of 85 percent of scheduled deliveries in case of import shortfalls, according to previous reports.

The Power of Siberia pipeline is expected to deliver 5 billion cubic meters (bcm) of gas this year, reaching capacity of 38 bcm (1.3 trillion cubic feet) per year by 2025.

Commercial viability

But the rough start for the project has raised questions about the commercial viability of the agreement between the two countries, which took years to negotiate, and the ability of the two companies to sustain losses.

"Given that these are majority state-owned and controlled companies, it is difficult to assess what political premium their governments are willing to pay or what else Presidents Vladimir Putin and Xi Jinping traded at the time that deal was signed in 2014," Chow said.

But the price pressures may be only part of the troubles for the deal between Gazprom and CNPC.

In a lengthy investigative report, the Russian website lenta.ru raised doubts about Gazprom's ability to meet supply commitments for the pipeline from its main resource, the Chayanda gas field.

The publication in May, citing Gazprom internal documents and tapes, charged the company and a key subsidiary with overestimating the recoverable reserves of the field and "intentional suppression of the scale of problems with the development."

Similar problems have been found at the Kovykta gas field, the second major source of supply for the Power of Siberia project, lenta.ru said.

The setbacks threaten to cost Gazprom 1.5 trillion rubles (U.S. $21 billion, 148 billion yuan), according to the

Gazprom and CNPC have not commented, but development at Chayanda has also been slowed by the evacuation of some 8,000 workers after a COVID-19 outbreak at the field.

A quarantine imposed on April 17 was lifted on June 1, according to separate reports.


But instead of addressing the development and supply problems, Gazprom has focused on its ambitious expansion plans.

In an online interview last month, Gazprom CEO Alexei Miller glossed over the near-term setbacks in supplies for China, highlighting previously reported talks to increase peak flows of the Power of Siberia pipeline from 38 bcm to 44 bcm per year. Miller gave no date for the capacity boost.

Miller also said talks are taking place on supplies from the Russian Far East, a "Power of Siberia 2" pipeline passing through Mongolia and a "western route" through the Altai Mountains to Xinjiang, which Gazprom has been promoting without success for years.

"Taken together, this makes it possible to speak of pipeline gas exports to China in the foreseeable future in the amount of over 130 bcm, which is comparable to our current supplies to traditional markets," Miller said.

At that level, Russia's supplies would more than double the current capacity of China's gas pipeline system from Central Asia and would exceed China's imports from Turkmenistan, Uzbekistan and Kazakhstan last year by 171 percent.

While the projected volume would fall short of the 199 bcm that Gazprom exported to Europe last year, it could create competition for Russia's resources, in keeping with Miller's long-held strategy for developing markets in the East.

But after years of negotiations, Beijing is well aware of Russian strategies and likely to be wary of new megaprojects aimed at dominating its import market, particularly because its own energy security relies on diversity of supply.

China is also likely to be cautious about financing Russian expansion plans after resisting Moscow's appeals to underwrite the Power of Siberia pipeline for years.

Given the glut of gas on world markets, China is seen as having the upper hand in dealing with Gazprom for some time, despite the high prices it is now paying for Power of Siberia gas.

"When new supply contracts are negotiated, it would not surprise me if the Chinese side tries to obtain concessions on pricing terms before China buys more Russian gas since it will be a buyer's market for gas in the next few years," said Chow.

"Any new gas deals between Russia and China will contain large financial risks for both sides, as did the deal in 2014 which took 10 years to negotiate," he said.

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