The Rising Price of Russian Natural Gas
Most observers will be forgiven for assuming that the Russian gas industry can be summarized with one word: ‘Gazprom.’ Recently, however, a series of exogenous changes combined with developments inside Russia have caused the picture to become slightly more nuanced. Externally, depressed European demand for natural gas due to the economic recession of 2008-2009, together with a global supply glut brought on by a U.S. shale gas boom and increased LNG shipments to Europe weakened Gazprom’s market position, as the company chose to take a hit on its export volumes instead of renegotiate prices. Including Turkey, from 2008-2009, Gazprom’s share of total European gas imports fell from 42.7% to 37.9%, an absolute dropoff of 23.6 billion cubic meters (bcm).[i] In addition, with the European spot gas trade taking off, the debate about natural gas supply contract fundamentals – long-term oil linked prices, and take-or-pay provisions – has intensified. At the same time, at home in Russia, there has been a renewed push to monetize associated gas (instead of flaring it), and as recently as July 2011 President Dmitri Medvedev signed into law rules regulating third-party access to Russia’s gas transport network to accommodate the growing production of non-Gazprom actors.[ii]
Mark Mozur holds a Master’s Degree in Energy and Environmental Studies from Columbia University, with a specific focus on Eurasian Affairs. He is a recipient of a US Department of Education FLAS Award for Turkish language and area studies, and has worked as a consultant in the hydrocarbon sector in Turkey and Russia for nearly three years. He currently lives in Moscow, Russia, where he is participating in the Alfa Fellowship ProgramThese developments have been well-documented: in his 2010 book Natural Gas Pricing and its Future, Anthony Melling discussed Gazprom’s response to the economic downturn. The company maintained its support for oil indexation and long-term contracts while modifying its volume requirements with some key customers. In a March 2011 paper, Jonathan Stern and Howard Rogers explained how a move away from oil price linkages does not necessarily imply cheaper gas, as gas-on-gas competition may also lead to price swings.
Analyzing Russia, James Henderson in his 2010 book Non-Gazprom Gas Producers in Russia surveyed the position of independent hydrocarbon actors, noting that although Gazprom remains dominant, companies such as Novatek are growing rapidly and are seeking innovative ways to market their gas.[iii] Finally, Simon Pirani in a 2011 article assessed Russia’s plans for domestic gas sector reform. At the time, the government had optimistically announced projected domestic gas price increases of 15% per year, reaching European netback equivalence by 2015. More specifically, the gas sector reform is based on the principle of “equal profitability” of domestic sales and exports, and some analysts put domestic price increases as reaching 40% of European Union (EU) levels by 2014.[iv]
This article seeks to add to the discussion by focusing on one individual piece of the puzzle: Russia’s domestic gas transit tariffs. Russia’s Unified Gas Supply System (UGSS) is owned and operated by Gazprom, which currently determines capacity access and transit tariffs in an opaque manner in collaboration with the Federal Tariff Service (FTS). As gas sector liberalization continues and the possibility of independent producers gaining significant pipeline capacity access becomes less remote, anticipating levels of transit tariff payments could be instructive in considering export scenarios. That is, how likely is it, given plans for domestic gas sector reform and the subsequent effect on transit tariffs, that independent producers will gain a share of Russian gas exports in the coming years?
The Role of Transit Tariffs in Gas Trade
Gas transit tariffs in Russia are relatively new. While Gazprom – the single owner and operator of the UGSS – is required by law to provide access to the pipeline network to third-parties such as Rosneft, Novatek, and TNK-BP, reality is much murkier. As Henderson writes, “potential users of the system have historically often complained that lack of transparency on key issues has allowed Gazprom to operate in an ad hoc fashion.”[v] To access the system, in 2009 third-parties had to pay a capacity charge of approximately $0.93/mcm (28 rubles) and a transit tariff of $1.34-1.47/mcm/100km (41-45 rubles).[vi]
The transit fees are charge on a per unit volume per unit distance basis (per mcm per 100 km). This is known as a ‘distance-based tariff’. In markets where gas supply infrastructure is well-developed, transit fees are regulated and meant to reflect upkeep costs and asset value at a reasonable rate of return to the network owner (usually a monopoly). Distance-based tariffs, which are sometimes expressed relative to booked capacity (per m3/h), are widespread in the EU, and especially so for cross-border gas trade (with limited take-off). According to the Energy Charter Secretariat, however, distance-based tariffs are not necessarily cost-reflective and in fact have been replaced in domestic gas supply by entry-exit tariffs. Other tariff setting methodologies, including postage stamp and point-to-point tariffs, are discussed in the Energy Charter’s 2006 work Gas Transit Tariffs.
At any rate, as noted above, distance-based tariffs are the norm in cross-border gas transport, and in the 2000s transit tariffs came into the spotlight as an increasing number of gas supply disputes and disruptions crept closer to the EU’s eastern border. Such conflicts, or at least the language used while posturing in these conflicts, maybe should have been seen as inevitable; the construction of pipelines and the extraction of natural gas predated the emergence of national boundaries, and so in the years after the Soviet collapse a complicated international gas trade with a mixture of Comecon remnants such as bartering, frequent non-payment, and artificially low prices prevailed. Presciently, Gregory Krasnov and Josef Brada titled a 1997 paper “Implicit Subsidies in Russian-Ukrainian Energy Trade.” This title reflected the fact that while Ukraine paid remarkably low prices (by European standards) for natural gas imported from Russia and Central Asia, Russia, in turn, paid remarkably low prices (by European standards) for access to Ukraine’s 920 km of gas transit pipelines, built in the Soviet period.[vii] This would become a sticking point a decade later.
Indeed, during the most significant gas supply disputes (Russia-Ukraine 2006, Russia-Ukraine 2009, and Russia-Belarus 2010), gas transit tariffs remained crucial to the picture, despite the fact that the immediate causes were non-payment for imports and theft of technical gas. In Ukraine, for example, transit tariffs were increased 46% in 2006 then approximately 20% in 2009, as part of the move to netback pricing for gas imports in Ukraine. In Belarus, the figures are 93% and 20%, respectively.
As the chart shows, transit tariffs in both countries have risen steadily over the past several years, with the largest spikes occurring after negotiations to resolve gas supply disruptions. While transit tariffs in principle are agreed upon on a long-term basis, they are in fact renegotiated frequently as part of larger gas import price agreements. Despite the fact that Belarus and Ukraine have experienced different outcomes in the gas, the underlying principle remains the same: increases in transit tariffs are used by states as a chip in the larger game of gas import price negotiations.
As an upstream producer, one of Russia’s (that is, Gazprom’s) strategies has been to circumvent the issue by obtaining ownership stakes in transit companies. This worked in the case of Beltransgaz and remains an ongoing drama with Naftohaz Ukrainy. For comparison’s sake, in Poland Gazprom owns nearly half of the transit pipeline via Europolgaz, but the pipeline is operated by Gaz-System, and responsibility for tariff setting lies with the independent energy regulator URE (in accordance with the EU’s Energy Directives). In the latest round of pricing negotiations in Poland, the tariffs themselves were not necessarily used as leverage, though the deal reached in the end did feature discussions of a possible extension of the transit agreement from 2019 to 2045, as favored by Gazprom.
Transit Tariffs and the Russian Gas Sector
In Russia, the future of gas transit tariffs is interesting and important (for different reasons). On the one hand, Russia has long itself been a transit state as gas supplies originating from Kazakhstan and Turkmenistan and destined for Ukraine have passed through Russia’s territory. These rates are opaque, and the Central Asia – Russia – Ukraine gas triangle is too complicated to cover here. It is enough to note that for many years Russia was reluctant to take the high downstream prices prevalent in the EU’s oil-linked contracts and pass them on further upstream, instead exploiting a widening price differential between upstream and downstream. As prices rose and pressure mounted from competing exporters, Russia repeatedly increased the purchase price of Turkmen gas on a one-off basis, though not via oil-linked contracts.
At the same time, transit tariffs are interesting in Russia as a policy indicator and a guide for the further liberalization of the gas sector.
Together with the electricity sector, the gas industry has long been a target of reform: gas prices for domestic consumers have been kept low for political reasons, subsidized by high export revenue, but the sustainability of this has long been under question. In a World Bank paper of 2004, David Tarr and Peter Thompson estimated Russian domestic gas prices at only 37.5% of long-run marginal costs.[viii] In 2006-2007 plans were announced to fully liberalize domestic gas prices by 2011, but the severe economic downturn of 2008-2009 postponed the process. The policy discussion has since been revisited. In December 2010, Prime Minister Vladimir Putin signed into law Decree No. 1205 “On Improvement of State Regulation of Gas Prices,”[ix] and in July 2011 Dmitri Medvedev signed federal legislation on access to the UGSS, as mentioned earlier. The law Medvedev signed calls for domestic natural gas prices levels to reach “market” levels by 2015.
More specifically, Gazprom Chairman Alexei Miller said that by 2014 domestic gas sales would be equivalent to gas exports in terms of net revenue. In his words, this means that industrial consumers in Russia can expect prices that are 60% of European levels (based on netback), which would be a 150% increase over current prices.[x]
The chart shows that while European gas prices have fluctuated based on oil price movements, Russian gas prices have moved upwards in stages. In order to reach 60% of European levels (say, $400/mcm) by 2014, Russian domestic prices would have to increase by around 27% per year, compared to historical growth rates between 15-25%. This comes at a time when any price increases will have political ramifications, and when it has been publicly stated that annual increases will not exceed 15% (see below).
What does this have to do with gas transit tariffs? First, as Henderson points out, hand in hand with gas price liberalization, “the Russian administration is gradually moving towards an independent regulator for the gas transport system … Gazprom has been ordered to split its transport business into a separate subsidiary that can ultimately provide arms-length transport services to Gazprom and third parties.”[xi] This move towards transparency in capacity allocation could lead to greater efficiency in the Russian gas sector, and also, via a nominally independent regulator, could enable the government to adjust policy to achieve certain outcomes, such as mandatory levels of investment in the UGSS, or creating incentives to independent gas producers.
Thus, reform of the transport system is being observed concurrently with plans to liberalize gas prices and, taken together, these developments will impact opportunities for independent gas producers.
This chart shows increases in gas prices of 15-25% per year and transit tariff increases of 15% per year (in ruble terms). The table below lists the actual tariff-setting legislation and the average exchange rate used to create the chart. Clearly, Russia’s gas transit tariffs started from an exceptionally low base. The 2006 Energy Charter study quoted earlier has Russian tariffs at a unit cost 44% of German rates and 30% of Belgian rates.[xii]
Table 1: Tariff-Setting Legislation in Russia
Об утверждении тарифов на услуги по транспортировке газа по магистральным газопроводам ОАО “Газпром”, входящим в Единую систему газоснабжения, для независимых организаций
|No.||Date||Capacity Charge (Rub/mcm)||Customs union (Rub/mcm/100km)||Non-customs union (Rub/mcm/100km)|
|404-e/2||4 December 2007||20.01||28.90||32.03|
|414-e/12||24 December 2008||January: 20.97
|441-e/3||18 December 2009||28.45||41.09||45.52|
|497-e/2||30 December 2010||40.00||44.92||49.75|
And with gas prices set to further increase, two questions arise: how will this impact transit tariffs and, relatedly, how will this affect marketing opportunities for independent gas producers?
Gas Marketing Opportunities for Independent Producers
In terms of marketing opportunities, independent gas producers currently have three basis options:
- Sell gas at the wellhead to Gazprom at regulated prices (currently very low)
- Use to gas to generate power at their own production sites (this is done by Rosneft and TNK-BP)
- Negotiate direct contracts at flexible prices, dependent on obtaining pipeline access, and preferably outside Gazprom’s customer base. In this framework, the recent Novatek-OGK-1 deal seems to be the glaring exception, rather than the rule.[xiii]
With (2) the dominant mode, it is immediately clear that to find new gas marketing opportunities, the growth of regulated prices must outpace the tariff increases. For example, a basic calculation provided in Henderson shows that Novatek, with core productive assets at the Khancheyskoye and Tarkosalinskoye fields in West Siberia, would pay approximately $42.50 in transit fees to transport 1 mcm of gas to the Moscow region, where 2010 regulated prices were only $85-90/mcm. In contrast, Gazprom, which pays no domestic transit fee, would have paid approximately $18.4 to transport gas across Ukraine’s 920 km transport network to the European border, where the price of gas averaged around $400/mcm.[xiv] Given this state of affairs, it is easy to see why pipeline export sales are not yet even considered in the strategies of independent producers.
Near-term Trajectory of Gas Prices and Transit Tariffs
As to the impact of further liberalization of gas prices on transit tariffs, in July 2011 the Ministry of Economic Development presented three proposals for gas price increases: inflation, inflation-plus, and the standard prevailing rate of 15%.
Pegging gas prices to inflation would lead to the lowest year-on-year increase. The Russian government estimates inflation at 5.5-6% per year, significantly less than the previous gas price increases and therefore unfavorable to domestic energy producers. The ‘inflation-plus’ proposal, on the other hand, as advocated by Finance Minister Alexei Kudrin, would see only a 5% rise in prices by the time of the March 2012 presidential elections, and then a subsequent 9.5% increase. The net effect is that by mid-year 2012 gas prices will have risen 12%, and thereafter 15% per year until 2014. The only alternative proposal is to increase gas prices by 15% per year. These three proposals are compared below in a table, and then the gas price projections are presented below in a chart.
Table 2: Growth in Natural Gas Prices to 2014 (Vedomosti)
|Annual Growth, %||2012||2013||2014|
With a European border price of $400 (i.e. the price preferred by Gazprom and in particular, Valeriy Yazev), Russia remains a number of years away from reaching their policy goal of 60% of European prices by 2014.
Given these proposals for gas price liberalization, as well as the policy goal of equal profitability of sales, however, it is possible to construct scenarios for gas transit tariff growth. These scenarios are depicted in the graph below. The first scenario is straightforward: tariff growth at the historic rate. The second scenario is based on data from Henderson: a reasonable rate of return to an independent gas transport system is 8%, “with the consensus view being that a tariff above $2/mcm/100 km would be needed to meet this requirement.”[xv]
The third scenario is more complicated. Revenue equivalence implies the following equation:
(European Sales Price) – (Cross-border Transport) – (Export Tax) = (Regulated Price in Russia) – (Transport in Russia)
In order to ensure that the principle of revenue equivalence is met by 2015, assuming an independent UGSS operator, transit fees have been calculated from West Siberia to Moscow given the extreme case of 15% annual growth in gas prices. A table showing all gas price and transit tariff growth variations is presented below.
Table 3: Gas Transit Tariff Growth Scenarios, $/mcm/100km (Author)
|8% rate of return||1.7||1.87||2||2||2|
As a final piece to the puzzle, it is possible to construct a basic calculation for gas sales, including export taxes and VAT (which are fixed at 30% and 18%, respectively):
Finally, using the projected transit tariffs calculated above, it is possible to calculate the trajectory of netback margins for domestic vs. international sales of Russian gas.
Chart 6 uses the average European sales price reported by Gazprom from 2003-2010 to calculate the basic netback margins on gas sold by an independent producer within Russia compared to export margins. Gas is assumed to originate at Novatek’s West Siberian fields and is sold either in Moscow or transited across Ukraine. The transit costs are calculated based on the methodology described above. In order for margins on domestic gas sales and exports to converge in accordance with the Russian government’s stated goal, domestic transit fees must increase at remarkably fast growth rates.
What these simple calculations show is that even not only will gas price liberalization weaken Gazprom’s argument in favor of maintaining a monopoly on Russia’s gas exports, the planned increase in transit fees could provide an incentive for independent producers to market their gas outside of Russia. Therefore, in the coming years, direct sales to consumers (OGK-1) or LNG production may in fact be exceptions, rather than dominant strategies. That is to say, the structural changes in Russia’s gas sector of 2010-2011 may have sped up liberalization, and in the near- to mid-term (2011-2015), there is a small window for independent producers to base their marketing strategies on negotiating capacity access to the UGSS. One consequence of this is that the timeline for full gas sector liberalization is actually a moving target, and the policies stated in summer 2011 may not be realistic given other constraints. Clearly, the 2014/2015 goal for convergence is extremely optimistic.
As a concluding note, there is one case study that may prove interesting in coming years: Gazprom’s 6 bm gas supply contract to Turkey via the Western pipeline is set to expire in 2012 (the other Turkish contracts will not expire until 2021).[xvi] Gazprom has long enjoyed tax-free gas export arrangements with Russia’s Black Sea neighbor. In terms of pricing, Turkey has some of the highest gas import prices of Eurasia, making up in one sense for the loss of tax revenue because Gapzrom’s relationship with Turkey has been stable and reliable.
In July 2011, however, Russia’s Finance Ministry stated that national gas extraction taxes (НДПИ) could be affected by negotiations with Turkey. The Ministry had announced a planned production tax increase on Gazprom from 237 rubles per mcm to 536 rubles, though it said that if the tax-free export regime with Turkey were eliminated, this would lead to a windfall of 41-45 billlion rubles, and a tax increase to only 509 rubles per mcm.[xvii] What this means is that the gas export contract to Turkey is becoming, inside Russia, an area of strident negotiation that impacts the issues discussed here. Given the speed with which Turkey itself has opened her gas sector, in terms of allowing new importers, it is entirely possible, and indeed more likely than in other countries discussed in this paper, that Turkey could become the first consumer country to import Russian gas from independent producers. One thing is certain: the next several years will be at least as interesting as the last few have been in the gas sector so far.
Приказ Федеральной службы по тарифам от 4 декабря 2007 № 404-э/2
Приказ Федеральной службы по тарифам от 24 декабря 2008 № 414-э/12
Приказ Федеральной службы по тарифам от 18 декабря 2009 № 441-э/3
Приказ Федеральной службы по тарифам от 30 декабря 2010 № 497-э/2
Ведомости, «Не уложиться в инфляцию», 6 July 2011.
Ведомости, «Миллиарды с Газпрома». 6 July 2011.
Ведомости, «Альфа-банк: рост цен на газ – основной риск для генерирующих компаний», 13 June 2011.
Ведомости, «Газпром исключен», 24 August 2011.
Energy Charter, Gas-Transit Tariffs in Selected Energy Charter Treaty Countries, Energy Charter Secretariat, January 2006.
Henderson, James, Non-Gazprom Gas Producers in Russia, Oxford Institute for Energy Studies, Oxford, 2010.
Krasnov, Gregory V. and Josef C. Brada. ‘Implicit Subsidies in Russian-Ukrainian Energy Trade’, Europe-Asia Studies, Vol. 49 No. 5 (1997), 825-843.
Melling, Anthony J., Natural Gas Pricing and Its Future: Europe as the Battleground, Carnegie Endowment for International Peace, Washington, 2010.
Pirani, Simon. ‘Liberalisation Heralds Change in the Gas Market’, Russian Analytical Digest, No. 100 (26 July 2011), 10-14.
RBK Daily, “Gazprom Will Raise the Price of Gas by a Factor of 2.5” 1 July 2011.
Stern, Jonathan and Howard Rogers, The Transition to Hub-Based Gas Pricing in Continental Europe, Oxford NG 49, March 2011.
Tarr, David G. and Peter D. Thomson, ‘The Merits of Dual Pricing of Russian Natural Gas’, The World Bank, 2004.