Almost a decade on from the first Ukraine-Russia natural gas crisis of January 2006, Europe faces another winter with the threat of disrupted supplies through Ukraine hanging over it. The region’s  security of gas supply has improved significantly, but it remains vulnerable, not least where dependence on Russian gas

has grown as a result of lower import volumes from North Africa. The stubborn facts are that Europe has a structural gas deficit and the only new source of supply is LNG.

From Russia’s perspective, its markets have evolved into three distinct zones. First, captive markets. These are the former Soviet Union  and to a large extent south Eastern Europe, but increasingly excluding the Baltic states and Ukraine. In this zone, Russia can dictate pricing terms, has a high degree of control over transmission capacity and a high level of demand security. Nonetheless, prospects for market growth are limited.

Second are hostile markets. In Eastern Europe, including the Baltic states and Ukraine, growing interconnectivity with Western Europe and the ability to import LNG threatens Russia’s market share. Increasingly, buyers in Eastern Europe have options to use alternative supply routes and different pricing mechanisms. This is an area of potential demand growth, but one in which Russia faces increasing competition and political hostility.

And third are competitive markets in Western Europe. Acrimonious European Union-Russian energy relations represent a serious threat to further Russian penetration of Western European gas markets, but this is counter-balanced by national self-interest and the confidence engendered by the construction of the NordStream pipeline that takes Russian gas directly to Germany. The hostility of Eastern European states means Russia is now more dependent on Western Europe than before the Ukraine crisis.

According to data from EU gas regulator ENTSOG, between 2010 and 2015, 42 Bcm of new interconnection capacity was added within Eastern Europe and between Central and Western Europe. There has also been significant investment in bi-directional flow; capacity labelled as bi-directional amounts to 146.6 Bcm, up 49.8 Bcm from 2010, with about another 71 Bcm having some reverse flow capability and/or virtual backhaul capacity.  A lot of pipelines with virtual backhaul capacity have been upgraded to have physical reverse flow capability.

The extent of change is quite dramatic in some countries. In 2010, Poland had 1.1 Bcm/year gas import capacity from Germany. Now it has 7.6 Bcm/year of non-Russian or Ukrainian import capacity and in October expects to commission its first LNG terminal on the Baltic Coast. Lithuania’s first LNG terminal was commissioned in December. By 2020, Poland should have 22 Bcm/year of non-Russian or Ukrainian import capacity with new and expanded gas links to the Czech Republic, Slovakia, Lithuania and Ukraine.

The new infrastructure creates options that limit the price differentials between countries. These differentials are in effect a function of each country’s relative captivity with regard to Russian gas imports in terms of infrastructure, and the relative state of their political relations with Moscow.

But whether those options are fully exercised will ultimately be determined by price. There are three elements of competition: European hub prices; pipeline imports from outside the EU, where oil indexation is being eroded but remains a significant element; and LNG, where again oil indexation continues to play a significant role.

Platts data shows that there has been a remarkable convergence in gas prices in Northwest Europe over the past year and it is likely that both European hub prices and the price of LNG in the Atlantic basin will increasingly represent a ceiling for the price of Russian gas imports into Eastern Europe. As the LNG market is expected to remain soft, buyers should have the leverage to force contractual change on Gazprom.

Likely developments are the extension of hub pricing, shorter contracts and greater flexibility on volume. Ironically, Russia’s rerouting of its gas exports through NordStream creates a commercial rationale for the use of west to east and north to south gas supply infrastructure in Eastern Europe – the same infrastructure that is being built to reduce dependence on Russian gas imports.

The long-term nature of pipeline supply contracts, slow progress in gas market liberalization, and, in particular, the dominant position of incumbents means that change will be gradual, but conditions are ripe for the extension of gas-to-gas competition into Eastern Europe, even if much of the new flows are re-routed gas of Russian origin. Permanent change has and is taking pace that is more fundamental than the temporary effects of a soft market.
Source: Platts