The last few weeks have been a real throwback to Cold War years for both Russia and UK, as Prime Minister Theresa May accused Moscow of poisoning a Russian ex-spy with a rare nerve agent in Salisbury, England. The Kremlin rejected the accusation and insisted the UK must prove Russia’s role in the attack or apologise.

The response of the European Union to the event arrived on Tuesday, remarking to its ally that it was ready to support Britain if asked to do so, showing solidarity with British Prime Minister Theresa May, and ensuring a collective effort to punish those responsible.

But before the EU could take a clear stand against the Kremlin, imposing restrictive measures and sanctions as it happened in the past, Russia moved to remind to Europe that its gas is the most flexible and reliable source of energy needed by the continent. Energy Minister Alexander Novak urged policy makers not to allow the diplomatic dispute to seep into the commercial relationship with Europe, which gets about a third of its gas from Russia.

Is Novak’s warning something Europe should worry about? And exactly how much is EU (still) relying on Russian gas?

Gazprom’s Anni Mirabiles

Well, if we have a look at the numbers we realize Novak is tragically right: Gazprom has enjoyed two stunning years of gas export sales to Europe, delivering record volumes both in 2016 and 2017.

This outcome was rather surprising since Gazprom’s sales to Europe underwent some pressures in the years before, and competitive and political drivers were all pointing to a strong reduction of Russian supply to the continent.

However, several external factors have contributed to the strong rebound, including delays in new LNG start-up projects, higher coal prices, restrictions on gas production at the Groningen field in Holland, a recovery in overall European gas demand, and Gazprom’s marketing strategy itself which has been adjusted to ensure that its gas remains competitive while it also, increasingly, complies with European gas market regulations.

After a decline in gas demand between 2010 and 2014, in 2015 Europe start to grow a renewed appetite for gas, that accelerated in 2016 and 2017 touching an increase of 6 and 7% respectively. The economic recovery across Europe, cold winter temperatures and an increase coal to gas switching are some of the reasons behind this trend.

In particular UK, was strongly affected by the coal to gas switching, after the approval of a reform about carbon floor price. The rest of the European countries followed the same steps, putting great emphasis on the importance of carbon emission reduction and the closure of coal-fired power plants.

The coal-to-gas switching was accelerated by the rising trend of coal prices which have risen from a low of below 40 $/ton to 90$/ton in 2018, combined with a significant rise of the EUAs.

The bullish trend of coal is mainly due to the policies China implemented last year, in order to reduce its coal domestic supply, shutting down inefficient mines, and increasing import instead.

Considering, the rise in European gas demand, and after the increasing pressure coming from the European Commission, Gazprom decided to adjust its pricing strategy. The historic oil-linked formula preferred by the Russian, has been overtaken by the hub-based pricing that is now prevalent in Europe. At the moment, one third of Gazprom contract are linked to oil, one third are hub-price linked, another third is based on hybrid contract that offer the lower oil or hub-linked prices.

Truth to be said, Gazprom did not really have a choice when it comes to readjusting its pricing strategy: the European Commission pressured the Russian energy giant through the implementation of the Third Energy Package, and at the same time, proceeding with the DG COMP investigation regarding the company’s business activities in Central and Eastern Europe.

Finally, Gazprom acceded to many of the Commission’s demands and, by doing so it turned its gas more attractive to many consumers of the European Unions.

The European Context

Considering the supply side, it is also important to notice that European domestic production has been declining in the past years. The problems at the Groningen field in Holland, where activity was limited to reduce the risk of seismic activity, caused an unexpected shortage in supply, that increased the need for import. A similar situation occurred in UK, after the shut down of the Rough field and storage facility.

The two events were not perceived extremely problematic by the market makers at the time, since at the beginning of 2016 a wave of new LNG projects from the US and Australia appeared imminent. LNG cargos were seen as the new source of European imports, that could cause significant competition to pipeline gas from Russia and potentially generate a price war.

 

It did not quite go that way: delays in key LNG projects and higher gas demand in Asia reduced considerably the flow of LNG to Europe. Regarding the fabled flood of US LNG, as Russia did not miss the chance to underline, it seems to have failed to materialize. Gazprom recently compared its gas supply to EU to a full cup of tea, while the US LNG supply appeared to be for the continent as few sporadic drops f water.

On a policy side, Russia is not an EU friend, but on the energy side Gazprom is the cheapest and most flexible gas supplier Europe can rely on. Although during the past years the EU claimed wanting to limit its dependence on Russian gas, reality looks different: Europe cannot do without Russian gas, at least not now.  So how is Europe going to deal with its own schizophrenia?

Gazprom stated it wants to increase its market share in the European continent (currently set at 35%) to 40% in the foreseeable future. Given its low cost of supply and its flexible pricing strategy, it is easy to believe the Russian giant could compete with almost any source of new LNG coming to Europe.

Irrespective of any political issues, this outcome leads to a security of supply question for European policy makers, as having any supplier take such a significant share, while domestic production is declining, means Europe will be forced to commit to a locked-in relationship.

European politicians must now decide whether they wish to limit the supply of one of the continent’s cheapest source of gas to preserve its freedom in terms of diplomatic and political decisions

Maria Mura | Energy Consultant

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