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By Anthony Harrington

For years now, despite Russia coming a horrible second out of the Cold War, and despite the endemic corruption that led one U.S. Ambassador to call Russia "a Mafia State," the Russians have been able to control the price at which Europe buys its energy. The reason why European gas prices are pegged, quite unjustifiably, to the price of oil, is simply because Russia wills it so. Being able to keep the price of gas artificially high has been an absolute trump card for the Russian economy.

According to the IMF, deep structural issues in the Russian economy have constrained the economy to the point where it is now doing just about as well as it can. It is, in other words, at near full capacity. This is a problem because there is nowhere else for growth to come from, other than from either pumping and exporting more oil and gas, which means running through its vast reserves that much quicker, or from windfall increases in the price of oil. Dr. Kent Moors, an oil and energy analyst, who advises the Russian Energy Ministry, argues that unconventional sources of oil and gas (by which he means the vast shale reserves across Europe, the U.K. and Asia) are absolutely bound to remove Russia's pricing advantage, with potentially dire consequences for Russia's economy.

Russian oil and gas sales, he points out, have always emphasized long term, 20 year, "take or pay" pipeline contracts, with the cost of gas based on a basket of crude oil and oil product pricing. "Take or pay" means that the client country has to contract to take a fixed volume of gas every month, and has to pay at least 80% of the value of that contract even if it doesn't use that much gas:

"Yet with the advent of new unconventional availability, combined with an acceleration of liquefied natural gas (LNG) exports, the Russian preeminence in the availability of hydrocarbons is now under threat. Here's why [...] Both shale gas and LNG are providing new opportunities for local spot gas markets to form in places that used to be dependent upon Russian pipelined product. As these localized markets begin to have assured volume, the spot nature of the transactions will undercut the price needed by Russian companies to make a profit on their exports."

Gazprom's (OTCQX:GZPFY) reaction to shale gas, until recently, has been to dismiss it as a short lived phenomenon while pushing ahead as hard as possible with the extraction of coal bed methane and going full steam ahead with the game changing vista of Arctic oil and gas, which I will look at in a separate blog.

A fascinating article on Gazprom's website does a comprehensive trashing job on the very ideas that Moor is putting forward: namely that spot markets are about to form, based on copious volumes of shale gas and LNG shipments, and that that will be on a sufficient scale to dent Russia's pricing power. The Gazprom article clearly has the intention of panning the whole shale gas phenomenon, but actually ends up as a kind of fairly accurate catalogue of the problems associated with shale gas, which is, obviously, not quite the same thing as saying it won't happen! Gazprom points out that Uncle Tom Cobley and all have jumped on the shale gas production bandwagon in the U.S., resulting in bankruptcy for many hopeful producers through massive overproduction. Each shale gas well yields around 90% of its production potential in the first year, so you get a rush of gas to the market, and more and more wells have to be drilled to keep supply going. The real beneficiaries, the article's unnamed authors sneer, are gas service companies - the ones who provide the rigs - who have been enjoying a veritable El Dorado.

Then, there is the mounting environmental backlash against fracking, without which shale gas has no future. Plus, the fact that the U.S. government has been remarkably slow to license the building of new LNG terminals to ship shale gas abroad in LNG tankers. The reason for this foot dragging, the authors suggest, is that U.S. industrialists are loving the bonanza of low energy costs associated with the supply glut in the U.S. gas market, courtesy of shale gas. As such they - and their lobbyists - have no interest in seeing new LNG terminals built, so don't expect large numbers of US LNG tankers to start sailing into European ports any time soon.

There are other very substantial reasons for thinking that the impact of shale gas on the Russian economy may be pretty well cushioned after all. The entire potential output of the first and second strings of the Nord Stream pipeline, which connects the Russian Unified Gas Supply System with the Trans-European Network (gas pipeline system) via the Baltic Sea, and which will amount to 55 billion cubic meters per year when complete, is already fully contracted out, according to Gazprom. Since the contracts will presumably be under Russia's normal take-or-pay 20-year contract arrangements, that is an awful lot of high priced gas already bought and paid for, for years ahead.

The first string of the Nord Stream pipeline was completed on November 8, 2011, and began pumping 27.5 billion cubic meters of gas a year. The second string was commissioned on October 8, 2011 and on the same day the Nord Stream consortium announced that it had successfully completed the technical and economic feasibility studies on a third and fourth string to the Nord Stream pipeline. And then there is Arctic oil and gas, about which, more in my next blog.

Source: Could Shale Oil And Gas Sink Russia's Economy?