Russian threats are just gas

When European leaders met to discuss how to respond to Russia’s aggression in Georgia, they appeared to find themselves between a rock and a hard place. Punish Russia and the EU will risk goading its large neighbour into following through on threats to divert gas and oil supplies from Europe to the Far East. Do nothing, or merely stick to tough-sounding rhetoric, and the EU will find itself out of sync with its own aspirations for a larger role in the world and especially in its eastern neighbourhood. No wonder the results were less than forceful.

But the EU is in a stronger position than it realises, as far as energy is concerned. Vladimir Putin’s threat to divert Russia’s energy exports away from Europe is not new: Russia has been using it for at least a decade, especially to put pressure on the EU not to pursue liberalisation of its gas market. But this threat is as irrelevant today as it ever was. Oil and natural gas are very different products with different markets, but in each case, the Russian threat is overdone.

Take oil first. Like Saudi Arabia, Venezuela and other exporters, Russia does not sell its oil to Europe, China or the US, but to the world market. If Russia decides to ship more of its oil to the East – using the uneconomic Japanese-sponsored pipeline, the construction of which Putin’s recent trip to Siberia was intended to highlight — this would reduce the Pacific basin’s call on oil from the Middle East(and elsewhere), which would then be freed for Europe to import. Oil is a fungible commodity, and is easily transportable by pipe, barge, train and even trucks. In other words, there is no such thing as the ‘oil weapon’.

What about the ‘gas weapon’? Gas is far from being as fungible a commodity as oil, and the gas that Europe imports from Russia could not be easily substituted if Gazprom were to divert it to Asia; 25 percent of European gas consumption comes from Russia. But what infrastructure would Russia use for this diversion? Apart from the ex-USSR republics, the EU is the only export market for Russian gas and it is supported by a huge, dedicated infrastructure. There is simply no pipeline available to make Asia compete directly against the European market for Russian exports.

Russia could, of course, build the necessary infrastructure; and Moscow has announced that it intends to do just that. There are massive gas reserves in Eastern Siberia that could support a commercial relationship with China and South Korea. There development would be squarely in Europe’s interest as it would reduce Asian pressure on the Liquefied Natural Gas (LNG) market and assuage China’ energy supply challenges. Yet since Moscow expropriated TNK-BP earlier this year — the British-Russian joint venture that used to own the license over the Kovytka gas field — Russia’s leaders have made it clear that developing the field is not a priority. Instead, they want to build a small, uneconomic pipeline from Siberia to China.

The pipeline is another illustration of Russia’s revealed preference for uneconomic, politically divisive energy projects over economic, consensual ones; its rationale is clearly to try and create direct competition between Europe and China for West Siberian gas.

But the West Siberia-China project is undermined by Gazprom’s increasingly challenging supply situation. With its West Siberian fields in steep decline and development work on the new generation of fields on the Yamal Peninsula five years behind schedule, Gazprom will find it difficult to meet its existing contractual commitments to Western European importers, as well as its obligations to supply the Russian market and will therefore increasingly have to rely on imports from Central Asia.

Developing a serious gas relationship with China from West Siberia is not a realistic proposition unless the Russian government manages to drastically raise prices on the internal market to curb consumption. Existing long-term contracts with German, Italian, French or Belgian importers will have to be serviced — or Gazprom would be sued for billions of dollars before international arbitration tribunals.

A further problem for Russia is that Gazprom sells Europe a commodity that is substitutable – both short and long-term – in almost all of its usages. With the current high prices for gas, European demand is contracting by almost 2% a year.

The collapse of trust between Europe and Russia can only add a hidden premium to the price of gas, providing a further incentive for Europe to wean itself off imports from Russia. In the 1980s, natural gas imports were key to the diversification of Europe’s energy supply away from oil – but today Europe is actively working to diversify away from gas. Some of the largest European gas companies already have to re-sell their supplies of LNG to the international market to make room for the Russian gas they are contractually obliged to take. While Russian leaders talk about exercising their energy powers against Europe, their policies are destroying demand in the only export market for Russian gas – in effect, killing the goose that lays the golden egg.

Why, then, are European leaders afraid? The EU’s weakness comes from the fragmentation of its gas market, which allows Russia to discriminate among European importers and leaves small countries in Central and Eastern Europe highly exposed. This is why gas market integration should be the real strategic priority for the EU’s energy security policy. As for those very small, highly dependent energy economies with no prospects of full integration into a pan-European market — essentially the Baltic states — they should move away from natural gas altogether.

So Russia’s bark is, in truth, worse than its bite. Its oil weapon does not exist. Its gas weapon is a function of the segmentation of the European gas market, and, in the medium term, is self-defeating. The EU should not fear the Russian paper-bear – at least as far as gas and oil are concerned.