From Stockholm to Sofia, Europe is sleepwalking its way into far greater dependency on Russian gas

Having been on the road of late at various energy bashes, it was fascinating to get closer insights into how “opposite poles” on the European map see energy security playing out, namely in Stockholm and Sofia. Both capitals are key players in the future pipeline complexion of Europe. Nord Stream = up North in Scandinavia and the Southern corridor = down South in South East Europe.

It was rather interesting to note that nobody is fully convinced that European energy policy is actually working. Yes, capacity margins are high, supply is plentiful, prices are low, and emissions have been dropping of late, but this is a result of the economic crisis and weak fundamentals, not properly aligned policy. If anything, Europe is sleepwalking its way into far greater dependency on Russian gas by failing to take proactive measures to diversify supply when times are good. As one diplomat in Bulgaria put it, ‘when the Russians come to town, price and quantity are put to one side, so long as you sign up to the right pipelines. If you do, you can more or less name your terms.’ With offers like that, we can hardly blame Sofia for looking East.

Such goings-on underline the fact that external energy relations in Europe are still predicated on a bilateral basis towards Moscow .This works well for some, but extremely badly for others. Politicized pipelines will undoubtedly come with political costs down the line for Europe, not least because Russia’s strategy remains as clear as it is rational: exert maximum economic and political leverage from its energy assets, and limit alternative competitive supplies to European markets to enhance rents. Why wouldn’t they do that?

The two key pipelines designed to achieve this are Nord Stream and South Stream. As the names rather suggest, these two pipelines have diametrically opposed geographical routes, but share an identical strategic intent: tighten Russia’s grip over supplies. It will also come as no surprise that transit states are being handpicked for political ends rather than from economic considerations. As everyone knows, for the Nord Stream link, Moscow (and Berlin) have gone to great lengths to bypass every single

Politicized pipelines will undoubtedly come with political costs down the line for Europe
inch of Polish, Czech and Lithuanian territory. The preferred political ‘option’ was to route it under the Baltic Sea once Sweden and Finland buckled to German pressure. Despite feeble claims from Stockholm and Helsinki that Nord Stream will have ‘limited’ geopolitical impact, the reality will prove to be profoundly different. Many of those attending the Stockholm conference, where I was present, were willing to concede that Nord Stream might be problematic without a decent ‘backhaul’ capacity to send excess gas supplies in Western markets back to Central & Eastern Europe in times of crisis. However, just as many couldn’t see the political wood for the trees. Surely more gas to Europe through Nord Stream is good for everyone, right? Well no actually, wrong. Not unless the ‘backhaul’ capacity is actually built.

Without it Moscow will inevitably use Nord Stream as leverage over former Soviet states, including Ukraine, either to exact higher gas prices or greater political influence. Russia will be banking on EU members to look after their own bilateral energy security interests rather than safeguarding the autonomy of post-Soviet states in times of crisis. This is exactly what happened in 2006 and 2009; it will happen again in countries where Russian cuts can be made without affecting broader European supplies.

The upshot is that a key geopolitical artery linking Europe to post-Soviet space will have been severed, and severed largely at German connivance. This is a strategic reality the EU, and more importantly individual Member States, must face up to. Yet the current pre-occupation across Western European states is not how to salvage Central and East European countries from future Russian energy pressures, but how to secure downstream stakes in Nord Stream. France, Holland, and the UK are all in the queue.

Lousy execution

Further South things don’t look all that much better. Since 2002 South East European states have looked to Brussels to provide political and financial support for the EU-inspired Nabucco pipeline. The idea is a good one: open up supplies from Central Asia and the Middle East to increase elasticity of supply and reduce Russian dependence. Moscow would have little choice but to stay on the straight and narrow with regards to price.

Unfortunately, the execution has been lousy. Europe has failed to secure any serious reserves from either region. Even if gets its hands on upstream stakes, it would potentially have to transit highly sensitive routes via Georgia (or more tangentially the legally contested Caspian Sea). Settling transit terms and fees are no less sensitive. Turkey may have agreed cooperate with Nabucco, in the longer term it will inevitably try to leverage its position as an energy hub between the Middle East and Central Asia to Europe. Another omission is a chronic lack of funding for physical infrastructure further downstream. This is a common complaint, for example, in Sofia. The EU has basically failed to grasp

The writing is thus slowly appearing on the wall. If Nabucco fails, Russian pricing power will inevitably increase
that if Nabucco is to work, they have to turn pipeline economics on its head. Pipelines are normally built from the ‘upstream down’ – from source to consumer. In Nabucco’s case, the pipe will probably have to be built from the ‘downstream up’ to ensure that producers can see tangible evidence of European willingness to buy in for the project. Muddling Nabucco up with lots of smaller pipeline projects, such as the Italian-Greek Interconnector (IG), the Trans-Adriatic Pipeline (TAP), White Stream and recently even an LNG-based Azerbaijan-Georgia-Romania Interconnector (AGRI), clearly doesn’t really help in this regard, although Brussels of course can hardly be blamed for these initiatives.

This has left the door wide open for the competing Russian South Stream pipeline. Despite only being launched in 2007 as a counterweight to Nabucco, Moscow has made considerable progress signing up Austria, Hungary, Bulgaria, Serbia and Greece. France has also come onboard with EDF striking a memorandum of understanding with Gazprom and Eni to purchase a 20% stake in the project. Many of the same states are of course putting a ‘spread bet’ on the Nabucco pipeline to cover both bases.

The same scenario applies upstream where Azerbaijan has notionally struck supply deals with Russian and European buyers. Turkmenistan has gone ‘two better’, adding China and Iran to its export mix. Turning potential reserves into actual output has always been a tricky business, but the gas simply isn’t there, or likely to be there any time soon in Central Asia east of the Caspian, to make European projects a credible prospect compared to exports flowing East towards China. What is not in doubt, though, is that Russia can draw on its own reserves to fill the prospective 66bcm South Stream pipeline – which with a projected capacity of 66 bcm (billion cubic metres) per year is larger than either the 31 bcm Nabucco or the 55 bcm Nord Stream pipes. In the long term this gives Russia a critical advantage, and what’s more, in South East Europe they know it. Even RWE, the main utility backing the Nabucco pipeline, has yet to fully reject an offer from Gazprom to ditch Nabucco and join the South Stream ranks. The writing is thus slowly appearing on the wall. If Nabucco fails, Russian pricing power will inevitably increase.

On the ropes

Many analysts in Sofia and Stockholm argued, not unreasonably, that this is all a bit melodramatic. Demand is down, LNG will give Brussels ample elasticity of supply, and shale gas could take off in Europe, just as it has in the US. If anything, Russia is on the ropes. Wholesale gas prices are tumbling, oil indexation is being broken up, and competing Atlantic and Pacific Basin markets are playing ‘arbitrage’ with Moscow to drive down prices further. Worrying about Russian gas dependency was a tune played several years back, the record is broken. You need to change it.

Much of this is of course absolutely true, at least for now. But being sanguine about supply dependency when times are good could be a major mistake. Europe’s ‘four corridors’ strategy to tap into Russian, Scandinavian, MENA and Central Asian reserves was always politically shaky, but a physical lack of demand presents formidable problems on two levels.

The first is that producers will inevitably hold back on upstream investments until fundamentals tighten. Russia is pulling back on Yamal and Shtokman. Qatar is holding fire on developing any more LNG. Algeria is extremely nervous about squandering precious reserves in a buyer’s market while politics (for differing reasons) is unlikely to see Iraqi or Iranian gas production increase any time soon, despite the fact that the two Middle Eastern nations are arguably more credible long term supply options for Europe than their Central Asian counterparts.

The second problem is that producers are diversifying export routes away from Europe towards Asia-Pacific where demand remains reasonably firm. The latter point clearly has a direct resonance to Russia where major capital investment decisions need to be made on liquefaction and new pipelines, not only to western, but eastern markets, and made quite soon.

Europe may have finally realised that Moscow really has no interest in signing the Energy Charter, but it hasn’t woken up to the reality that Russia has half an eye on perfecting its arbitrage potential between East and West. This penny should have dropped as increasing energy supplies to Asia is official state policy in Moscow. On the plus side for Europe, the sheer geographical size and the existing

This penny should have dropped as increasing energy supplies to Asia is official state policy in Moscow
infrastructure deficiencies make it close to impossible for Russia to literally switch gas flows between West and East. Rather like North African supplies, Moscow’s pipelines are hardwired towards European consumers. But the bad news is that Gazprom’s ability to influence the lion’s share of European gas supplies through price instruments and internationalisation strategies is arguably growing.

Players in the Middle East, North Africa and Latin America are considering their options too. For example, falling gas prices have prompted Sonatrach to call for supply restraints on spot and traded markets. Producers in Central Asia and West Africa are sympathetic to such concerns. Now this is hardly the stuff of ‘gas cartels’ just yet, but the prospect of ‘gas on gas’ competition (i.e. a decoupling of oil and gas prices) could be the glue needed to start sticking bilateral price collusion together for suppliers, and it’s something that few Europeans are thinking about.

Whether or not this scenario ultimately pans out remains to be seen; the logic is certainly there should gas prices continue to set their own benchmark prices independent of oil. But the real concern for Europe is its inability to make the right moves now in the midst of a lax gas market. Investment in storage is low; liberalisation to reduce future pricing pressures is tepid, integration of grids remains at best, regional, if not localised. Brussels hasn’t even been able to apply the “third party clause” in the Third Package to stop Gazprom getting into downstream transmission in Europe. Vertical integration could still beckon for Moscow should swap agreements for upstream assets entice European utilities to cut such deals.

Thus if we imagine a scenario of rising Asian demand, economic recovery in Europe, creeping supply side constraints, unconventional gas flopping, and environmental imperatives favouring gas consumption over coal, then gas markets will assuredly tighten, and tighten very quickly. If Russia has managed to increase its share of European and Asia gas supplies in the interim without Europe having developed its own new-found reserves or having tied in upstream producers to credible downstream projects, then it will not just be the unfortunate losers from Nord Stream and South Stream littering Central and Eastern Europe that feel the pinch, but European consumers as a whole. That would certainly apply to those in Sofia and Stockholm alike.