In the face of multiple challenges in the European gas market Gazprom has attempted a “pivot to Asia” in order to diversify its gas sales. However, it is clear from the slow progress on the Power of Siberia pipeline and the lack of a second sales agreement with China, as well as the delay in Gazprom’s LNG projects, that Europe will remain the company’s most important market for many years to come.
As a result, the company will have to respond to the increasing pressure on its business model that is emerging not only due to the rise of renewables and the pressure of low coal prices, but also from the emergence of new sources of gas in the form of LNG from the US and Australia, which will likely see Europe as a market of last resort should Asian gas demand growth continue to disappoint.
The good news for Gazprom is that it is in a position to compete because of the low cost of its gas supply, which has especially benefitted over the past 12 months from the dramatic devaluation of the rouble versus the dollar. As a result, domestic expenses have fallen sharply, meaning that the delivered cost of Russian gas to the European border is as low as $3.50/mmbtu on a short-run marginal cost (SRMC) basis, including a 30% export tax. At this level, Gazprom could certainly fulfil its stated ambition to compete with US LNG, as at the current level of US gas prices this would land in Europe at a cost of around $4/mmbtu.
Although competing down to the SRMC of US LNG would effectively see Gazprom engaging in a price war in Europe, this strategy is not as nonsensical as it would have been when oil prices were over $100 per barrel and the consequent gas price in Gazprom’s oil-linked contracts was above $11/mmbtu. The fall in the oil price has already brought Gazprom’s average price to Europe down to $5/mmbtu, and by the third quarter of 2016 it will have fallen even further, to around $3.50/mmbtu as the 6-9 month lag in indexation sees prices reflecting the oil price in early 2016. In effect a price war is going to happen anyway.
A key question for Gazprom is therefore not whether its price will come down to very competitive levels but how it responds to this fact. If it maintains its reactive marketing strategy, then prices may rise again if oil price rebound, making way for LNG to arrive in Europe and potentially capture some of Gazprom’s market share. If, on the other hand, the company becomes more proactive and commits to a strategy of participating on European hubs more actively and pricing its gas in relation to hub prices, then it can essentially adopt a Saudi-style strategy of pricing its gas to maintain market share in the short-term and disincentivise higher cost gas (mainly in the form of LNG) in the longer term. Furthermore, this strategy could reap a number of other benefits. It could provide a strong commercial argument to support the policy drive to displace coal in the European power sector; it could undermine European arguments for diversification away from Russian gas; and it could demonstrate a willingness to comply with EU rules that might also smooth political relations ahead of a discussion about the removal of sanctions in the summer of 2016. Indeed, a key indicator of Gazprom’s plans will be the outcome of its negotiations with the European Commission concerning the DG COMP investigation into Gazprom’s activities in eight Central and Eastern European countries.
At present talk of a price war is premature, and Gazprom itself has denied any thoughts in this direction. However, the fall in prices has made contemplation of such a strategy almost inevitable and has reduced the cost to Gazprom because the benefits of maintaining, or even increasing, sales now outweigh the downside of a lower gas price. To fully benefit from the competitive advantage of its low cost base the company might decide to change its marketing strategy and perhaps concede to EU demands for a change in its business practices. This might be politically sensitive, but the history of Russian gas strategy has been one of commercial logic ultimately prevailing. As a result, it may now be time to contemplate a more proactive Gazprom sales strategy in Europe, with interesting consequences for consumers and suppliers of gas on the continent.
Time to contemplate a change of Gazprom marketing strategy in Europe? Tell us what you think.
To know more about Gazprom's role in the European gas market and discuss the dynamics of new natural gas sources to supply Europe, attend the European Autumn Gas Conference (EAGC) in The Hague 15-17 November 2016.
More on Gazprom and Russia's gas:
Sed do eiusmod tempor incididunt ut labore et dolore magna aliqua.