Russian gas and European politics: I want to break free…

And this time I know it’s for real. Or is it for real? Significantly reducing European gas imports from Russia is possible. But the EU should give up the notion that gas in its domestic market will be much cheaper than it is now

Written by Istvan Zsoldos, Csaba Pogonyi and Péter Simon Vargha

Imagine the typical European government meeting about how to respond to Russian actions. The foreign ministry types start to talk about all kinds of sanctions, but the economy minister types quickly cool them down, pointing out that the EU is dependent on Russian gas imports, so it cannot get too radical, unless it wants to risk disruptions to its gas supplies or serious price hikes. Sure, Russia needs the gas revenues, but Europe could not punish it without damaging itself as well.

Source: Zerohedge

This short-term reality means that the EU needs more forceful triggers from the Russian side to go for an all-out economic war with Russia – but it of course does not rule it out. What is more interesting is what Russian military actions will lead to in the longer run. It is likely that European voters will want to reduce the dependency of Russian energy supplies, for two reasons. One is to increase their future room for maneuver – now future confrontations with Russia must seem more likely to them than just a month ago. The other reason is that they do not want to “reward” and strengthen a potential enemy state with gas revenues. On the contrary, given a choice, European politicians would like a less well-funded Russian state (especially if Putin is at its head), with fewer resources to bully others (but a stronger civil society and non-state business sector, that can act as a check on that menace).

All this of course assumes a long time horizon for policy-making in Europe, which is not always evident, to be polite, at the level of top politicians and policy-makers. But these issues will percolate through the political establishment, the experts and the committees and the think-tanks and the press and interested voters and so on. Democracy, where it works well, is not just about the qualities of the top leadership (though that helps, too). Ideas can gain their own momentum.

Checks and ballances? Source: blogs.voanews.com

But is it possible, and how much would it cost, to reduce European gas imports from Russia? The FT’s Nick Butler suggests five ways to reduce dependence.  We will be more specific and will show that on a 10 year time horizon, it is possible to largely eliminate gas import dependence on Russia, and probably would not cost that much.

The EU imports about a quarter of its gas consumption (or a bit more than 100 billion cubic meters, bcm) from Russia. For this, it pays roughly 40 billion dollars. Let’s assume the EU wants to drive both numbers down to zero by 2025. It could do this by reducing gas consumption, increasing LNG imports, and boosting unconventional production.

1. Saving on gas consumption

EU gas consumption in electricity generation is already declining, because of cheaper coal (which is partly due to cheap US gas driving down the price of US coal). This is not a welcome development in terms of CO2 emissions, and coal is not a long-term solution, but provides some flexibility in the short run. It would be better to operate German nuclear reactors in the short run, as Nick Butler suggested, and on a 10 year horizon, increased solar and wind production. This latter is likely to happen anyway as solar energy is getting cheaper. Let’s assume that the EU can eliminate 30% of gas use that currently goes into electricity generation, and 10% of what goes into industrial and residential use by better insulation and more efficient boilers, power plants and renewables.

2. Increasing LNG imports

The EU imported about 60 bcm gas in LNG form in 2012, but has an LNG import infrastructure with a capacity of about 180 bcm/year. Thus LNG imports could be increased to 100 bcm by 2025. The increment could be about half of the LNG that the US is likely to be exporting by that time (currently it is not exporting). US exports to Europe would be profitable at around current spot prices (even if domestic prices go up somewhat in the meantime), but may fetch a higher price in Asia, so this may push up marginal prices somewhat. But not that much, especially as Russia would probably also turn to selling gas to Asia, pushing prices down there. And it is probably not just the US which could have much more LNG to sell by 2025 than currently. Eastern Africa and the Eastern Mediterranean Levant basin have also seen big finds recently. AS we wrote earlier, there is a global abundance of natural gas.

Note that we are talking of buying US LNG from the market, at market prices. Some of those pushing the ‘let’s have US LNG exports to help Ukraine and Europe’ meme might have thought differently. So again, for those who need to be reminded: the US government doesn’t decide where exports go – as the Wall Street Journal’s blog and others have also highlighted.

3. Boosting domestic production

There has been political and public resistance to shale gas production in the EU. This is likely to change now that Russian supplies are seen as more problematic. But it takes time to boost production, so let’s conservatively assume that European shale gas (and, say, more favorable taxation on other domestic production) will only be enough to maintain current European production levels. This gas in the long run should be cheaper than the current import price, and pay taxes in Europe instead of abroad. Also, beyond the 10 year horizon it could provide serious quantities.

The following chart summarizes the hypothetical situation in 2025. Based on presumably conservative assumptions, it seems possible to eliminate European gas imports from Russia (in fact the net import number goes slightly negative in our scenario – room to export gas to Ukraine?). And there is no need for a complete elimination to greatly reduce political leverage…

Source: BP and our calculations

Let’s further assume that the EU wants to maintain a market in gas. How would it achieve this shift? Russia can always price its gas just below LNG import prices in a market setup, and thus hinder building up alternative supply routes. But the EU has the power to change relative prices. It can offer cheap loans to builders of US LNG export projects, provided that they do not sell the gas in advance to specific consumers in long-term contracts (and thus it is potentially available for European import).

Also, the EU could levy a tariff on Russian pipeline gas imports. This could start from a low level, so it is not an immediate large burden on energy users, but would gradually increase. If this increase is pre-announced, market players would incorporate future high taxes in their investment decisions.

Who is next on Putin’s list?

The “Who is next on Putin’s list?” game is very popular nowadays. In order to be able to see clearly among the candidate countries, we listed all the attributes that make the intervention more likely.

We know that Putin considers the fall of the Soviet Union the greatest failure of Russia in the 20^th century. Therefore, on the first place, we are looking for former Soviet states. Second, Russia’s intervention can be easily underpinned, if there is a significant Russian minority in the region. A third attribute is that the country is poor and there is no foreign power that could credibly save it.  There is a higher chance of intervention if the region is located between the “two empires of the World”, aka somewhere in Eastern Europe. Bonus points are for the target country trying to become like a Western one. And finally, why should Putin invade a country, if it is already under his control? And of course outright invasion would probably just the last act, creeping increase of economic and political influence and pressure likely to come before…

If we take into consideration all of these attributes, “Putin’s list” looks like this:

1. Transnistria: Already a de facto autonomous entity with significant Russian population (and military personnel), moreover, in a 2006 referendum they already expressed their will in joining the Russian Federation. Seems to be an easy catch (even without a link to mainland Russia or a seaport), and a cozy stronghold between the EU-oriented Moldova and Ukraine. Kaliningrad with a slightly better climate?
2. Eastern and Southern Ukraine: the situation is still shaky, and the present Kiev government still seems to run after the events. Regional identity seems to be strong; however, the Russian minority is only around 1/3 of the population, but this may be sufficient to be the “legal ground” for intervention. Moreover, as we know from Aleksandr Dugin’s 1998 book (Putin’s famed theoretician), “Ukraine should not be allowed to remain independent, unless it is cordon sanitaire, which would be inadmissible.” Trying to control this area would probably mean shooting war.
3. Western Ukraine: See above for justification, plus google Kievan Rus and the foundation of the Russian State. This is would be an outlier from the “ethnic Russian” principle – unless of course you believe that Ukrainians are basically Russians just some of them don’t know it…Even with large forces, Russian may not be able to fully control this part.
4. Georgia: Putin has sweet memories from Abkhazia and South-Ossetia, and this country is still outside of the safety net of NATO or the EU. There is some Russian minority in the country, but clearly local resistance would be strong.
5. Baltic states: A long diplomatic fight has been going on about the state of minority laws within the three former Soviet states.  In Estonia and Latvia more than ¼ of the population is Russian speaking.  These states are part of the European Union and the NATO; therefore, intervention seems to be unlikely. It would imply a war with NATO (or otherwise NATO could disband itself), and NATO would win that war.

All the other former Soviet countries are most likely not on Putin’s list, as all of them are either under indirect control of the Russian state, or have brotherly relationships with President Putin. But of course we cannot exclude opportunistic moves, should circumstances make them attractive…

Could such a unilateral tariff be economically justifiable? Probably yes, because buying Russian gas seems to carry larger risks and undesirable political side effects than buying gas from elsewhere, which is not reflected in its price and still requires policy involvement and public costs. Would this hurt countries currently dependent on Russian gas? No. It would only make their currently hidden costs more explicit and the proceeds could be used to enhance their access to alternative gas sources. Would this go through politicians and WTO? Well, we are not that sure. But the idea is at least worth a thought experiment or debate. The outcome clearly depends on the future relations with Russia. We would assume for example that in the case of a shooting war between Russia and Ukraine (another WTO member), the niceties of trade rules would be suspended….

There is plenty of gas around the world, and in the long run it is likely to be very cheap. But for a while the EU should give up the notion that gas in its domestic market will be much cheaper than it is now. But roughly current market price levels seem to be within reach…

If Europe (and Russia) are lucky, all this will remain largely theoretical. There could be a transition in Russia towards a less belligerent and more reliable and democratic country. But to presuppose that outcome is not prudent. Even in a happy scenario, Europe may prefer some switching towards LNG supplies, which is a more flexible supply option, but would probably keep a significant Russian import element in its energy mix. If Russia remains as (or more) threatening as it is now, or becomes more chaotic domestically, Europe will likely move to disengage from its gas exports. That would probably have serious implications in Russia domestically. Putin may get more pushback in the long run than he bargained for…

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