It starts with flows to Ukraine…

Last year, Russia supplied half of Ukraine’s gas but Gasprom cut supplies on June 16 after the annexation of the Crimea in a disagreement over pricing. Ukraine has been seeking assistance from her neighbours to meet the short fall with deals with Slovakia, Poland and Hungary being proposed.

Attempts to flow gas from Hungary are reported to have been restricted by Russian measures to raise the price in that market to over $400 which make it too costly for Ukraine to import.

To the south, Slovakia recently opened an upgraded pipeline from the EU to Ukraine that could eventually supply 20% of Kiev’s annual consumption. The Slovak pipeline improves an older link between the Vojany power station and Western Ukraine and can supply up to 10 billion cubic metres (bcm). This increased capacity has seen Ukraine been buying gas from Slovakia for $320-300 per 1000 cubic metres.

Finally from the north, PGNiG, Poland’s state gas company, recently reported that flows from Poland to Ukraine have also increased to compensate. However, last week saw gas flows from Russia to Poland dropping by 45 percent, which some commentators say represents an attempt to try to punish Poland for selling gas to Ukraine as well as strong lobbying of the EU to impose tougher sanctions on Moscow and the hosting of a new NATO rapid reaction force.

In 2013, Poland bought 8.9 bcm of Russian gas which covered around 60 percent of its needs, another 30 percent is met with domestically produced gas and the remainder comes from Germany and the Czech Republic. Germany’s biggest utility, EON, is also facing slightly reduced gas supplies from Russia but issued a statement saying that its reserves were well stocked and that there was ample hub supply.

Sabre rattling

The disruption comes as the European Union imposed a new round of sanctions on Russia, a step that Russian officials warned would bring consequences for the continent.

The first round of sanctions, following the annexation of Crimea in March, saw measures including a ban on investments into new equity or debt with maturities longer than 90 days for a number of Russia’s biggest companies, as well as exports of equipment for new oil projects. The second round, announced this week, EU nationals and companies may no longer provide loans to five major Russian state owned banks, there has been a tightening the terms of loans to 30 days and deepened sanctions on the energy sector.

In the short term, sanctions have not yet hit oil production whose output is flat month on month, but Rosneft, Russia’s largest oil producer, has warned that it will seek state support in its latest debt issuance. The Russian budget assumes a $110 barrel oil price and as oil softens below this level, the state will continue to find its reserves tapped just as inflationary pressures increase and the economy begins to slow.

The EU is due to report on its plans on protecting itself from possible Russian cuts next week and comes as Guenther Oettinger, European Energy Commissioner, stressed that the EU needed to be prepared for attempts by Russia to use gas as a political weapon. As he said:

“What would happen if Ukraine was unable or unwilling to ship gas? Or what if Putin used the lever of gas as a weapon in the conflict after all?”

Russia meets around a third of EU demand for oil, coal and natural gas. In return it receives around $250 billion a year, or two-thirds of government revenue.

Three times in the past decade – 2006, 2009 and this year – Moscow responded to natural gas price disputes with Ukraine by cutting off supplies, affecting its European clients further down the pipelines. But a cut-off this time around would hurt Gazprom hard. With revenues cut, Gazprom’s finances would be affected and it cannot compensate through recourse to the financial markets this time around because sanctions bar Western financial services from lending to the firm.

Gazprom insists that it has been a reliable supplier and that flows to Europe were in the past disrupted only after Ukraine took some gas intended for the EU to meet its own demand. It should also be noted that switching off the pipelines is also technically difficult. The gas has nowhere else to flow apart from to customers and it is impossible to severely scale back extraction volumes or to flare of that amount of gas safely.

Are European winter gas shortages likely?

The recent reduced volumes are unlikely to have a knock-on effect for consumers in Europe unless they drag on for weeks. Mild temperatures mean that continental demand is relatively low and reserves have been built in anticipation of possible disruptions. Gas storage levels across Europe are around 16 bcm higher than this time last year and 5 bcm above levels recorded at the start of winter 2013.

While Western Europe needs relatively little Russian gas, the dependency rises steadily towards the East, with some EU countries such as Bulgaria and the Baltic states relying entirely on Gazprom. Furthermore, southeast Europe will struggle to find enough gas to meet demand – should there be cuts – as non-Russian gas infrastructure is not developed enough.

European reliance on Russian Gas
European reliance on Russian Gas

The EU has stated that it is prepared to take action should disruptions deepen. These measures could include making use of existing powers to ban companies from selling LNG cargoes outside Europe, keeping more gas in reserve, and even ordering industry to stop using gas. Tankers from Qatar and Algeria bring LNG to Europe via Atlantic and Mediterranean ports but European buyers often re-sell those cargoes abroad for higher prices rather than supplying the domestic market.

Conclusion

Whilst short-term gas prices have increased by 40 percent in the last month, the winter contracts have proven more resilient; though a risk premium has been factored in, the markets believe that large-scale disruption to European gas this winter is unlikely.

Both the EU and Russia know that disruptions to gas flows would be in neither parties short nor long-term interests. Eastern Europe would be hard hit by a gas cut and disruptions would be sure to accelerate EU moves to break the reliance upon a single importer and to seek diversification of routes for continental gas. On the Russian side, whilst moves to strengthen alternative markets are underway – most notably towards China – the EU will continue to be the primary market and principle source of revenue for Gazprom and the State.

It is the view of this blog that large scale continental gas restrictions are unlikely in the short-term. Putin’s interests are not served by turning off the lights across Europe but reducing flows this week have shown a willingness to respond with physical restrictions to western financial sanctions. Europe is far more reliant upon Russian gas than America is on Russian commodities or cash flows and thus the EU will not seek the most rigorous of possible sanctions. Both parties need to be shown to be taking action but hot heads need to be cool this winter to avoid further escalation.

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