America’s Gas Shale Market Forces Gazprom To Rethink Strategy

April 2010 Vol. 237 No. 4

Russian gas giant Gazprom is expecting European gas demand to rebound this year, but is rethinking its ambitious gas export plans to the United States amid the ongoing shale gas “revolution” in that country.

After a year in which Gazprom lost market share in Europe and saw its export revenues shrink on weaker demand and lower prices, the Russian gas giant held its first board of directors meeting in 2010 recently and focused on a review of the company’s near-term export strategy.

Gazprom is expecting a rebound in European gas demand this year — or at least an increase its own gas exports to that market — but is warily eyeing the impact of the surge in U.S. gas production on gas markets in both North America and Europe.

Rising shale gas production in the United States is rapidly changing the export outlook for Gazprom, forcing it to review and perhaps revise its plans for major production and export projects such as the Shtokman LNG project.

It also coming off a year in which Gazprom not only saw its gas exports to Europe fall but lost market share in the continent to competitors. Last year was not kind to Gazprom, beginning with a commercial price dispute with Naftogaz Ukrainy that mushroomed into a two-week gas supply halt to 18 countries, and ending with the Russian company negotiating with its major European import partners on the delicate matter of “take-or-pay” penalties for their reduced offtakes below minimum annual levels. In between, Gazprom saw the bubble burst on rising European gas prices (although a recovery is under way) and was forced to shut in some gas production, as well as push back timetables for several major new fields, including the Bovanenkovskoye field in the Yamal Peninsula.

This year is off to a better start, if only because the company managed to avoid a New Year’s gas dispute with Ukraine. A political deal reached in November by Russian and Ukrainian politicians to reduce Ukraine’s gas import obligations in 2009 and 2010 (in the context of that country’s sharp economic contraction and subsequent weaker gas demand) helped reduce the risks of a new confrontation.

Gazprom is confident Naftogaz will pay its gas bill by the deadline, avoiding triggering a potential politically tinged dispute between the two firms. In an effort to put the past behind it, Gazprom has reportedly written off the 4.5 Bcm of gas (worth US$1 billion) that it was not able to deliver to Europe via Ukraine last year as a result of the January dispute.

Gazprom said its declaration of force majeure during the January 2009 dispute with Ukraine absolved it of having to deliver this gas to Europe, which — in the overall context of Europe’s weaker total gas demand last year—actually allowed the Russian firm’s import partners to reduce the size of their fines under take-or-pay principles. Preliminary operational results for Gazprom showed it supplied Europe with 140.2 Bcm of gas in aggregate, down 12.3% year-on-year, with European importers together taking 8 Bcm of Russian gas below minimum required levels under take-or-pay. Germany’s E.ON has agreed to pay Gazprom US$140 million for its own unused gas last year.

For the past few months, Gazprom has touted the signs of a recovery in European gas demand, and its own production has picked up. A cold winter heating season in Europe has provided Gazprom with a needed shot in the arm in terms of increased demand for its gas, but forecasts still point to the overall weakness of European consumption for the next few years as economic growth remains largely flat.

Gazprom remains optimistic the demand situation in Europe is not that bad in revealing its 2010–12 European export plan. It expects gas exports to Europe will rise to 160.8 Bcm this year, followed by additional increases to 163.5 Bcm in 2011 and to 170.9 Bcm in 2012.

Gazprom’s optimism on the recovery in European gas demand is tempered by the sobering realization that the U.S. gas market may no longer be in play. Even as it launched a gas-trading subsidiary in the Houston and set about securing regasification capacity in North America in order to deliver LNG supplies, Gazprom is learning that its ambitious plans to secure 10% of the U.S. gas market are no longer feasible in the context of the ongoing shale gas “revolution” in the United States. The boom in shale gas and unconventional gas production in the U.S. has caught most of the industry, including Gazprom, off-guard, as what only recently appeared to be a golden opportunity for it has all but evaporated.

Indeed, as the U.S. has quickly gone from being a potential major market for LNG imports to self-sufficiency, those LNG supplies are increasingly finding their way to Europe. Thus, the shale gas boom in the U.S. has the effect of a double whammy on Gazprom, not only curtailing its marketing options in the U.S. but also affecting its business in Europe.

Weaker demand in Europe and increased LNG supplies in the Atlantic basin translated to a gas glut and a major arbitrage last year between spot gas prices in Europe and Gazprom’s oil-indexed gas prices in its long-term contracts with its import partners. European firms took advantage of this arbitrage, reducing their offtakes of Russian gas and causing Gazprom to lose market share.

Gazprom’s solace in losing market share in Europe last year was in insisting on penalties under take-or-pay principles, but its board of directors is well aware that this money is merely a sticking plaster on a wound that may require a tourniquet. Already, Gazprom is being forced to the negotiating table by its import partners seeking lower overall gas prices in their long-term contracts, and the its cherished oil-indexation pricing formula is under attack as a result. Gazprom deputy CEO Alexander Medvedev acknowledges that the firm has made several “modifications” to long-term contracts in consultation with its European partners, but it seems unlikely that those will be the last.

The continued march of the unconventional gas revolution is forcing Gazprom to rethink its marketing strategy. The redirection of LNG supplies from North America to Europe is creating havoc with Gazprom’s pricing formula as well as its investment timetables for key production and infrastructure projects, not to mention costing the company important market share. Gazprom may be reconsidering plans to invest heavily in the Shtokman gas field, a project originally focused on delivering LNG supplies to the U.S., but even the pipeline component to Europe may now be in jeopardy. Similarly, the shale gas revolution is altering the equation for Gazprom in terms of its strategy for developing fields such as Bovanenkovskoye on the Yamal Peninsula.

The potential spread of the shale gas production revolution to Europe, which is believed to have significant untapped reserves of its own, would clearly have a profound impact on Gazprom’s production and marketing strategy as well.

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