By Pierre Noël
[Editors’ note: This post is an extract from an article that will appear in the upcoming issue of Survival. See Samuel Charap, John Drennan and Pierre Noël, ‘Russia and China: A New Model of Great-Power Relations’, Survival, vol. 59, no. 1, February–March 2017]
During a presidential summit in Shanghai in May 2014, Russia and China signed a 30-year gas purchase and sale agreement reportedly worth $400bn. CNPC (China National Petroleum Corporation) committed to buy 38 billion cubic metres (bcm) of gas annually from Gazprom. This volume amounts to 20% of China’s 2014 consumption and 60% of its 2014 gas imports. The 38-bcm annual volume should be attained around 2025 after a ramp-up period of several years. The first exports could happen in 2019 or 2020. On the Russian side, the project involves some $70bn of investment, including $20bn for field development, $35bn for the pipeline itself and $15bn for a gas-treatment plant at the Chinese–Russian border, in partnership with Russian chemical company Sibur. Field-development and pipeline-construction work are now proceeding apace. In September 2016, Gazprom and CNPC finalised an agreement to build the cross-border section of the pipeline under the Amur River.
The official view in Russia is that Power of Siberia, as the project is known, is only the first step toward building a strategic gas relationship with China, akin to the one it has with Western Europe. Russian reserves would certainly support a long-term gas trade of 100bcm per year. Power of Siberia will create a physical link between the two countries, worth tens of billions of dollars, supporting a flow of energy worth many times that over three decades.
While this gas relationship between Russia and China necessarily has strategic implications, its significance to the two sides is fundamentally different. The Russian government would like it to be understood as a key strategic bond between the two countries. Energy has been the defining factor of Russia’s post-Soviet international economic policy and diplomatic influence. Establishing a gas relationship with China in the aftermath of the Ukraine crisis is perceived as a major success by Moscow. According to the narrative presented by Russia’s authorities, Power of Siberia signals the natural complementarity between the two countries and demonstrates Russia’s ability to develop new export markets outside of Europe.
For China, the gas relationship with Russia is much more mundane. China does not ‘need’ Russian gas (though some Chinese analysts see the energy relationship with Russia as an opportunity to reduce, in relative terms, the country’s dependence on imports by sea) and is under no pressure to compromise on its interests, economic or political, in order to get it. Some Chinese economic and environmental objectives will be easier to achieve with ample gas supply, but none are dependent on the gas relationship with Russia specifically. Chinese state-owned energy companies have demonstrated their ability to bring energy to China, including natural gas, from a fast-growing number of countries and regions, at prices consistent with (or lower than) international market conditions. Resource holders all over the world are competing to access the Chinese market; Russia is just one of them.
Therefore, the gas relationship does not provide balance to an otherwise asymmetrical relationship; it is an element of the broader asymmetry. Russia needs to export the gas much more than China needs to import it. For Beijing, this asymmetry is a factor to be carefully managed. One key aspect of this management effort was to agree to Power of Siberia in the first place.
Negotiations on the pipeline had lasted for more than ten years amidst a changing geopolitical and international-energy landscape. The Ukraine crisis made the deal a strategic priority for Moscow, which wanted to signal to the US and EU countries that its energy complementarity with China offered it a real alternative to European export markets and could be a building block for a broader strategic economic partnership with Beijing. However, just as the deal became a top priority for Russia, its importance for China was diminishing. The rate of gas-demand growth in China had declined sharply; prospects for Chinese shale-gas production had improved; Turkmenistan was eager to increase its exports to the east; a gas-supply deal with Myanmar had come on line; and, finally, US LNG exports were just over the horizon, contributing to a much brighter outlook for the global LNG market, at least from a consumer’s perspective.
The terms offered by CNPC, the Chinese contracting party, were not acceptable to Gazprom. The project is simply too costly to make Russian gas competitive in China in the current energy market. Eventually, both governments twisted the arms of their national energy companies to sign a deal that makes little commercial sense but is a powerful symbol of the countries’ structural complementarity. Gazprom was forced by the Kremlin into a project with extremely low return on capital, if any. The Chinese government, for its part, decided that the cost of offering Moscow such a symbolic achievement was less than the potential blowback from rebuffing Russia. So it forced CNPC to accept a less-than-optimal gas-import contract.
Figure 1: Net Present Value of Power of Siberia as a Function of the Oil Price
Two months later, the price of oil began to fall from its highs of $110 per barrel and stabilised at less than half that level. For Gazprom, such a fall, if it lasts after 2020, will transform Power of Siberia from a project providing a small but positive net present value (NPV) into one incurring a loss of up to $17bn (Figure 1). However, such heavy losses could be significantly mitigated if the Russian government were to waive all or part of the 30% natural-gas export duty and, crucially, if Gazprom lowered its discount rate. (The discount rate is a key financial variable that determines the relative value of a dollar today, compared to a dollar in the future. The higher the discount rate, the greater the preference for the present. A low discount rate makes a capital-intensive, long-lived project such as Power of Siberia look better financially, but minority investors in Gazprom would object that there are much better uses for their capital, at comparable risk levels, elsewhere in the market. Typically, governments use lower discount rates for infrastructure investment than for-profit corporations because they can borrow at cheaper rates, reflecting lower risks, and take into account the social benefits that accrue to the wider economy.)
If the discount rate were brought down from 10% – typical of commercial energy projects – to 3.5%, Power of Siberia would break even with an oil price of between $40 to $60 dollars per barrel, depending on the level of the export duty (Figure 2). This compares to $110 per barrel required to break even at a 10% discount rate and the current 30% export duty levied on pipeline gas exports.
Figure 2: Net Present Value of Power of Siberia vs Oil Price and Gas Export Duty, Using a Discount Rate of 3.5%
For the purpose of cementing its relationship with China, the Russian government is essentially using Gazprom as a non-commercial entity, akin to its Soviet-era incarnation: the Ministry of the Natural Gas Industry. At a recent event with foreign investors, Russian President Vladimir Putin, while acknowledging that government-controlled joint-stock companies such as Gazprom had ‘a significant share of private capital, including foreign capital’, admitted that projects such as Power of Siberia are long-term bets that do not reflect short-term market realities. A more accurate description is that the government is directing Gazprom to undertake a project with a very low expected rate of return on capital, which only makes sense because Moscow values its expected geopolitical benefits.
While this de-commercialisation of Gazprom may have created the conditions for the Power of Siberia deal to be signed, it does not provide a guarantee that the long-term gas relationship will be stable. CNPC will be operating in an ever more competitive domestic market, in which the price of gas could be lower than the price it pays under the Russian contract. It would then incur huge losses that the Chinese government would have to absorb, or else the contract with Gazprom would come under severe pressure. Therefore, Beijing’s political decision to accommodate Moscow on Power of Siberia might not be just a one-off concession; it might have to be sustained for years and potentially decades, depending on the evolution of natural-gas markets in Asia.