Roughly ten years ago Russia began reconsidering its energy transit policy. The Commonwealth of Independent States (CIS) summit in Kazan, Russia, in 2005 was an important turning point. An important policy shift — known as the “strategy of transit avoidance” — was implemented in order to directly link Russian oil and gas resources to Moscow’s major clients in Europe, bypassing potentially unstable transit countries in the former Soviet space.

In this context, a reduction in the natural gas transit via Ukraine became an issue of strategic importance for both the Kremlin and Gazprom, which consider Ukraine’s gas transmission system the weakest link in Russia’s gas supply chain. Naftogaz’s recent decision to breach its transit contract with Gazprom and to impose a 50 percent increase in transit fees for exporting Russian gas across its territory to Europe seems to confirm Gazprom’s suspicions. It undoubtedly further increases Moscow’s desire to build the Nord Stream 2 gas pipeline in order to circumvent Ukraine.

The decision to put the Turkish Stream gas pipeline on hold announced in early December 2015 further increases the strategic importance of Nord Stream 2 as the only new natural gas route circumventing Ukraine and shifting the transit fees into construction of the Nord Stream 2.

Should a new transit fee ($4.5/1000 cubic metres (cm)/100 km) be implemented by Naftogaz, Gazprom will have to pay over $50 per 1000 cm for the transit of its gas via Ukraine. The re-direction of these volumes to the Nord Stream 2, will allow Gazprom to save up to $2.75 billion per year in transit fees. From the CAPEX point of view, the Nord Stream 2 pipeline is an expensive undertaking, but the project’s OPEX will not be so high: the main compressor station in Russia can be fueled by cheap gas supplied at domestic prices.

Quite expensive

Apart from saving on (excessively) high transit fees, there is an additional economic rationale justifying investment in this otherwise quite expensive transportation project. Most of domestic gas supplies in the EU originate from the rapidly depleting fields situated in the United Kingdom and the Netherlands. UK gas production declined from 96.4 billion cubic metres (bcm) in 2004 to 36.6 bcm in 2014. Despite an unprecedented increase in UK natural gas production in 2015 – to an estimated 44 bcm – UK output is likely to significantly decrease in the nearest future.

During the same period, Netherlands’ gas output fell from 68.5 bcm to 55.8 bcm, mostly due to an earthquake–related production cap imposed on the Groningen gas field. Overall indigenous production in Europe (EU plus Norway) has decreased from 345.6 bcm in 2004 to estimated 258.8 bcm in 2015.

Natural gas from Nord Stream 2 could close the gap between gas supply and demand in the Northwest of Europe. Currency devaluation also had a positive impact on Gazprom’s lifting costs, thus increasing the competitiveness of Russian gas in Europe. Gazprom’s lifting cost (excluding MET) went down  from $17.7 per 1000 cm in 2014 to (estimated) $14.1 per 1000 cm in 2015.

These numbers allow Gazprom to easily compete with US Liquefied Natural Gas (LNG) supplies (expected in 2016) even with high transportation/taxation cost and at current pricing conditions in the U.S. (NYMEX at around $70–75/1000 cm and average LNG transportation costs at $35/1000 cm).

Bureaucratic hurdles

However, it must be noted that all is not so rosy for this trans-Baltic undersea pipeline. Economic crisis and low energy prices affect Gazprom and other consortium members’ ability to finance the construction of Nord Stream 2. Furthermore, economic sanctions imposed by the EU and the US on Moscow – although not directly aimed at Nord Stream 2 – affect the pipeline’s ability to raise long-term financing through debt capital markets, while funds are also becoming scarce in Russia.

In addition, the project might face a number of bureaucratic hurdles linked with its (in)compatibility with the EU 3rd Energy Package, while a number of new EU Member States have called upon Brussels to take action to ban the pipeline altogether.

In his article “Why Nordstream 2 risks failure”, published on Energy Post in December, Alan Riley mentions the fact that EU energy law might be also applied to the Baltic’s seabed. Professor Riley mentions the fact that the “European Court of Justice in Commission v. United Kingdom (case)  in discussing the application of the EU Habitats Directive, was clear that EU law applied with respect to territorial seas.”

Gazprom already faces similar problems with the full unrestricted access to the OPAL gas pipeline in Germany and the company is likely to face similar difficulties with both onshore and offshore segments of Nord Stream 2. Should this option become reality, Nord Stream 2 will be forced to keep 50% of its capacity reserved for non-Gazprom suppliers both in submarine offshore and onshore pipelines. Needless to say this will seriously undermine the commercial viability of the new pipeline.

Elegant solution

An elegant solution to this problem is one that requires less time and work than trying to get an exemption from the existing EU energy rules. Russia has already liberalized its LNG exports and no one prevents Moscow from allowing Russian independent gas producers to book 50% of the Nord Stream-2 transportation capacity.

Such a decision might become a win-win situation to all parties concerned: the project will be fully compatible with the EU Law; Gazprom will have its guaranteed share of gas supplies (minimum 27.5 bcm) and could also share the pipeline construction bill with Russian independent gas suppliers; the participation of non-Gazprom suppliers will allow Russia to export more Russian gas to Europe and consequently increase the Government’s revenues.

Last but not least: export liberalisation for Nord Stream 2 may also allow foreign buyers to purchase some volumes on Russia’s largest commodity exchange SPIMEX (St. Petersburg International Mercantile Exchange).  SPIMEX launched its first trading in natural gas in October 2014. Despite relatively small volumes – 8.2 bcm between Oct. 2014 and Dec. 2015 – SPIMEX already offers month- and day-ahead physical trading and plans to launch forward (for 2-6 month period) and futures (2-72 month period) trading in 2017-18. Thus by 2020, SPIMEX will transform itself into an important trading hub offering a fair price-setting mechanism for natural gas both in Europe and Russia.

Could this usher in the end of the endless discussion on the pricing of Russian gas?

To read this article on Energy Post, click here.