Ilya Zaslavskiy
Academy Fellow (2014)
Russia’s gas deal with China, its biggest to date, lacks a comprehensive development strategy to ensure the country’s long-term interest and contains multiple risks. At best, the contract with China will barely allow Gazprom to cover costs. At worst, it could expose its monopoly and result in huge losses. It is Chinese energy entities - now dominant in regional gas price formation - and President Vladimir Putin’s inner circle that are the main beneficiaries of this deal.
Ice sits on a valve control wheel connected to pipe work at OAO Gazprom's Bovanenkovo deposit. Photo by Alexander Zemlianichenko Jr/Bloomberg/Getty Images.Ice sits on a valve control wheel connected to pipe work at OAO Gazprom's Bovanenkovo deposit. Photo by Alexander Zemlianichenko Jr/Bloomberg/Getty Images.

A poor deal for Gazprom

Gazprom has been in protracted talks with the China National Petroleum Corporation (CNPC) over gas supplies for over a decade. The price range under discussion had been between $380 and $590 per thousand cubic metres(mcm).  Now, Gazprom has refused to reveal any details of the 30-year $400 billion contract signed on 21 May, other than that Russia is to supply 38 billion cubic metres per annum (bcma) with an oil-basket price link (without specifying the proportion that oil and spot markets play in the formula).  Alexander Novak, the Russian energy minister, confirmed an average price of $350/mcm, only hinting at links to fluctuations in the oil price.

However, prominent experts say reaching $350/mcm and breaking even is the best case scenario for Gazprom. The minimal ‘take-or-pay’ requirements (gas volumes that China is obliged to take or pay for under any circumstances) and future price negotiation clauses (which remain undisclosed), are likely to be less favourable than in Gazprom’s long-term European contracts. This is because China already has multiple alternatives (such as piped gas from Central Asia, Myanmar, LNG supplies and its own coal and gas output) and so enjoys a strong bargaining position. Nor is there any indication of how much interest Gazprom will have to pay on the $25 billion loan China has agreed to provide. It is, though, likely to be higher than that which Russia used to get from international banks in 2013 as it has effectively been cut off from Western borrowing under the recent sanctions over Ukraine.

Production, processing and transportation costs

Curtailing expenses could prove to be even tougher for Gazprom than reaching a desirable market price. Prime costs (direct expenses on production, processing and transit) even without taxes could go beyond $300/mcm. The company’s own estimate of production and export pipeline costs needed for them to reach their full development is $55 billion. However, upstream costs for developing the Chayanda and Kovykta fields in eastern Siberia (the main sources of gas for the China deal), total at least $30 billion, resulting in production costs of about $100/mcm. The cost of constructing the ‘Power of Siberia’ pipeline has been calculated at $40 billion but, given Gazprom’s track-record of cost overruns, the price tag could end up much higher. Gazprom will also need to build a gas- and helium-processing plant with a petrochemical facility in Belogorsk with an estimated cost of $20 billion, and to expand the Sakhalin-Khabarovsk-Vladivostok (SKV) pipeline at $10 billion. These two additional projects are a pre-requisite for fulfilling volume obligations to CNPC and will raise total transportation costs to at least $150-200/mcm.

Giving away tax revenue

Simple arithmetic shows that Gazprom is left with a negligible profit margin for the $350/mcm price scenario even before tax. However, in order to push the deal through, Putin decided to suspend the Mineral Extraction Tax for China’s piped gas ($30/mcm from 2015), thus essentially depriving the Russian budget of at least $30 billion of revenue for the duration of the contract. It has been suggested Putin could go as far as to remove the other major tax – export duty – to help Gazprom break even. Further details of the contract may soon surface and it is probable that Russia will have to allow Chinese companies to enter parts of its upstream and midstream assets in eastern Siberia.

The deal will also divert gas volumes and money from the previously announced Vladivostok LNG and Sakhalin-2 and -3 projects. In addition, the comparatively low price vis-à-vis current LNG pricing, the lack of capital and the need for expedited delivery of the maximum volume of piped gas all undercut the deal’s economic rationale for Russia. All these developments are contrary to Gazprom’s Eastern programme which, according to its plans in 2007, was meant to ensure that Russia plays an independent and predominant role in the Asia-Pacific region.


So why has Putin signed this contract? As a political opportunist with diminishing options, he needed the deal because creating an Asian outlet for Russian gas became his overriding geostrategic goal due to deteriorating relations with the West.

Who benefits? As with recent energy deals, the contract with China should prove lucrative for Putin’s inner circle. Rosneft, chaired by Igor Sechin, plans to supply up to 18 bcma of gas to China and thus break Gazprom’s monopoly on piped export. Construction contracts will likely be picked up by companies controlled by Arkadiy Rotenberg and Gennadiy Timchenko or other similar sub-contractors who feel the heat of US sanctions in their European projects but are well-connected to Kremlin. The CEO of Summa Capital, Alexander Vinokurov  (foreign minister Sergei Lavrov's son-in-law), has stated that his company is planning to develop Yatek - a major gas asset in Yakutia that can benefit from export access to China. If necessary, Gazprom’s losses can always be nationalized - i.e. covered by the National Wealth Fund or through increased gas tariffs for the wider population - while profits will surely be pocketed by select producers and pipeline constructors.

China is the real winner. By forcing on Gazprom the same price that it pays for Central Asian and Burmese gas, China has confirmed its status as a regional gas price setter. The latest annual figures show that these countries receive $355/mcm on average, practically the same price that Gazprom has now agreed to. The deal has also put China in a much stronger bargaining position against LNG suppliers in the United States, Canada, Australia and the Middle East, and opened doors for a relatively smooth transition to a more liberalized internal energy market. 

In sum, this deal is exactly what you would expect when an ex-KGB operative micro-manages energy policy - a desperate geopolitical gambit trumping all economic rationale.

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