Russia's natural gas dilemma

  

Russian home and industrial consumers have traditionally enjoyed generous subsidies for natural gas. Today, the Kremlin finds itself in a tough spot - satisfying domestic constituents or authorising dramatic rises in gas prices to fund major projects planned the Gazprom monopoly, Stratfor analysts say.

Stratfor is an Austin, Texas-based global intelligence company providing geopolitical analysis and commentary.

​"Russia produced approximately 510 billion cubic meters (bcm) of natural gas in 2011, and approximately 60% of it was sold on the domestic Russian market. Russia has one of the highest domestic consumption rates per capita of natural gas - understandably so, since Russia is one of the world's coldest countries, and heating and electricity use is high. Russian industry also depends heavily on natural gas.

Russia uses a four-tier pricing system for natural gas: two tiers for domestic prices, one for the former Soviet states and one for its European customers. Russia has long capped domestic natural gas prices, a practise left over from the Soviet era. Currently, Russia charges between $75 and $97 per thousand cubic metres (tcm) on the domestic market, with households and municipal entities, such as schools and hospitals, paying the lower price and industrial entities paying more. Most of the former Soviet states pay in the mid-$200s and Europe pays $350 to $450 per tcm.

Russia's natural gas firms - primarily Gazprom - are suffering financially because of measures that let domestic users pay a fraction of the price Russia's foreign customers pay. In the past decade, the Kremlin has permitted Gazprom to increase its price by 14 to 25% a year. This gradual increase has prevented a massive backlash from natural gas consumers in Russia because it has been accompanied by improving economic standards in the country. However, Gazprom says this increase is insufficient.

Gazprom sees four primary problems with Russia's current natural gas prices. First, Gazprom is losing money on its domestic sales. According to current Gazprom data, it costs Gazprom approximately $132 to produce or acquire and then distribute 1 tcm of natural gas, but its revenue from the domestic market is only $80 per tcm, which means Gazprom loses more than $50 per tcm sold domestically. Considering that the domestic market makes up 60% of sales, the loss is monumental.

Gazprom has continued to stay afloat and remain strong because of its sales abroad, where its revenue is approximately $279 per tcm (double the cost of production). However, Russia's domestic natural gas consumption has grown more than 15% in the past decade (but declined during the economic crisis of 2008-2009). Gazprom is thus producing more natural gas at a loss than it would if it charged its domestic customers what it charged its foreign customers.

Second, Gazprom is concerned that its revenues from sales to Europe will decrease amid negotiations over new natural gas prices with many of its European customers. Coupled with Europe's diversification of natural gas supplies away from Russia, this means Gazprom could soon be unable to continue offsetting its domestic losses with high profit margins from sales on the European market.

Third, when winters are particularly cold, Russia curbs what it exports (mainly to Europe) to keep more supplies at home. This happened this past winter and shortages of up to 30% were seen in Austria, Romania, Germany, Poland, Hungary, Bulgaria, Greece and Italy, all of which also experienced an extraordinarily cold winter. Although this practice might keep the population at home warm, it meant that Gazprom lost a great deal of money it could have made if more supplies had gone to Europe.

Finally, Gazprom is trying to offset a recent 61% increase in mineral extraction taxes, which cost Gazprom $2.2 billion more in 2011 and could cost an estimated $5.2 billion more in 2012. The tax issue is highly controversial and interwoven with the ongoing internal political struggle in the Kremlin. The idea of restructuring the country's energy tax system has drawn both robust opposition and staunch support within the Kremlin. The increased tax came from a faction in the Kremlin that believes the government needs more funds to offset its budget deficit and that the government needed to stop coddling Russia's energy firms with low taxes.

Citing these concerns, Gazprom is arguing that it cannot continue funding future projects without more revenue from domestic natural gas consumers. It is not that Gazprom would be unable to continue the de facto subsidisation overall; the company generates a great deal of revenue. Gazprom has some large and expensive projects planned that it does not believe it can fund without making more money. These projects include the Shtokman Arctic project, estimated to cost $15 billion to $20 billion; the South Stream pipeline, with an estimated cost of $24 billion to $31 billion; the Yamal fields project, which will cost tens of billions of dollars; and an expansion of Sakhalin, which will also cost tens of billions of dollars.

The Kremlin knows there are issues with continuing the price cap for domestic natural gas - hence its steady price increases over the past 10 years. The Kremlin plans to raise domestic natural gas prices by 15% for industrial consumers starting in July. Gazprom does not believe this will be enough and has offered three alternative plans to raise prices sharply before eliminating the price ceiling altogether over the next two years. The proposals Gazprom has put forth are a 26.3% increase in natural gas prices by the end of 2012, a 45% increase in natural gas prices by the end of 2013, and the end of all price restrictions by 2014.

These proposals are currently mainly for industrial users, though there is no guarantee that Russia will not increase domestic prices for households and municipal institutions at some point as well. Typically, when industrial prices rise, household and municipal consumers see a smaller increase. The problem is that the Kremlin has maintained the natural gas price ceiling for a reason: to keep the population happy and the industrial sector healthy. If prices skyrocket, the population and the industrial sector would destabilise.

Russian household consumers have not had to adapt to sharply higher natural gas prices since the fall of the Soviet Union. It is in the Russian psyche that, as the world's second-largest natural gas producer, its people have a right to a lower price. Should the Kremlin drastically raise natural gas prices for households, there would be a backlash. The Kremlin is fresh off a wave of anti-government protests sparked by the parliamentary and presidential elections and has no appetite for more social unrest, particularly demonstrations that likely would bring out more people than the political protests did.

Russia's energy-intensive industries, such as the metals industry, have long enjoyed a globally competitive advantage because their natural gas prices have been low. Cheap energy is one of the foundations of a successful metals industry. The cost of producing metals has increased steadily over the past decade as energy and labour costs have risen.

Because of its vast and domestically cheap natural gas supply, Russia has the lowest-cost metal producers in the world. Russia is one of the top five steel producers and exporters and has the world's largest nickel and aluminium companies: Norilsk Nickel and RUSAL. The 2008 financial crisis affected Russia's metals companies, but they have recovered in the last three years.

Should Russia dramatically increase the cost of natural gas for industrial consumers, it would be a huge economic detriment to the metals industry and could kill the industry altogether. Moreover, it would spark a conflict with Russia's metals oligarchs, some of the most powerful men in the country.

Unlike most of Russia's large and strategic industries, metals businesses are not state-run or run by Kremlin-picked business chiefs. Russia's metals industry is the country's one main sector still run by oligarchs because the sector is spread around the world, not mainly concentrated in Russia such as other sectors. Also, the metals oligarchs had an extraordinarily vicious series of battles in the 1990s and early 2000s known as the "metals wars." Though the Kremlin has been through some fiery conflicts, taking on the metals oligarchs is a monumental and possibly dangerous task.

Because a dramatic rise in domestic natural gas prices would create turmoil, the Kremlin is in a tough position and is divided on what to do. Gazprom will not go broke anytime soon because of domestic price caps, but selling 60% of Russia's natural gas at a loss is untenable in the long term. Moreover, Gazprom is planning numerous ambitious and expensive projects that are not only critical to Gazprom's ability to replace its declining natural gas fields but are a strategic part of Russia's foreign policy because of connections abroad or the involvement of foreign companies.

However, the Kremlin simply cannot afford to make such a controversial move right now. Moscow will have to develop another strategy to help its most important company move forward. The Kremlin is already attempting to restructure Gazprom to make it work more efficiently by laying off 100 of the company's top managers. But there is little discussion of what to do after that to assist Russia's natural gas giant."

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