Will Putin sign up China?

Graham Stack for Russia Profile (www.russiaprofile.org)

 

Russian Prime Minister Vladimir Putin’s last visit to China, when he attended the opening of the Beijing Olympics in August of 2008, went badly wrong when Georgia opportunistically attacked South Ossetia, and the resulting war damaged relations between Russia and the West. Putin could now continue Russia’s eastward shift on his upcoming visit to China, by signing long-term gas supply agreements between Gazprom and the China National Petroleum Corporation.

Speculation is mounting that a long-term gas supply agreement might finally be signed between the Russian gas giant Gazprom and China National Petroleum Corporation (CNPC). The plan, outlined in a number of memorandums signed by the Russian and Chinese sides, but since bogged down in negotiations over price, envisages new gas pipelines from Western and Eastern Siberia to China and the development of virgin East Siberian gas fields.

As president, Putin was closely involved in the negotiation process during his previous visits to China, and may feel that it’s now time to go the final mile. The last Memorandum of Understanding on the issue was signed in 2006: it specifies a pipeline running from West Siberia with a 30 billion cubic meters capacity, and another from East Siberia with a capacity of 38 billion cubic meters, with work due to start in 2011. That date is now clearly unrealistic, but still, for most analysts, it is just a question of time.

“We have long taken for granted that Gazprom will sell significant amounts of gas to China,” said Alfa Bank energy analyst and Head of Research Ron Smith. “The resource base of East Siberia and Russia’s Far East is very large, including two untapped world-class gas fields in Chayanda and Kovykta that are very well situated for pipeline exports to China, not to mention the Sakhalin reserves that are already being tapped.” So analysts perceive Putin’s hastily arranged visit to China as indicative of the fact that a long-term deal has been finalized for signing.

Negotiations to date have been shrouded in secrecy, but the main problem holding up implementation of the project has been arguing over the price mechanism. Russia is rooting for the same price mechanism applied to Gazprom’s European Union customers. China has pushed for a discount price previously paid by former Soviet countries, such as Ukraine. “Since then, however, the discounted deal with Ukraine ended in a very high-profile manner, and Russia is also paying full price for gas purchases from Central Asia,” said Chris Weafer, an analyst at UralSib brokerage. “Hence the rationale for China’s discounted price demand is eliminated.”

But the Chinese may instead want a gas price linked to coal prices and not to oil prices, as is the case for European customers. Since there is no global market price for gas, gas prices are linked to the cost of the fuel gas substitutes for, which in Europe is crude oil and heating oil. In China, however, gas will substitute mainly coal used in power generation. “We are not sure whether the Chinese prefer a coal-linked price, as that fuel generates the bulk of the country’s power, or whether it is a matter of a simpler argument about the absolute level of prices,” said Smith.

“Linking the price of gas to the one of oil is an anachronism,” argued Mikhail Korchemkin of East European Gas Analysis. “There is an oversupply of inexpensive gas in the world, and the market prices of oil and of gas often move in opposite directions.”

Coal prices are currently very low following the economic crash, while oil prices have soared back up to 2007 levels, making it harder to reach a compromise. However, according to a source quoted by the Russian business daily RBK, in the absence of final agreement on a long-term price mechanism, Gazprom and CPNC could still provisionally agree on fixed prices for short-term delivery volumes.

But the Chinese have some trumps that could induce Gazprom to bring the prices down from the European levels. Firstly, China is flirting not only with Russia, but also with Central Asian countries. The 7,000-kilometer-long Central Asia-China pipeline is set to take Central Asian gas to China, particularly from Turkmenistan, which has contracted to supply 40 billion cubic meters of gas annually for 30 years. Korchemkin believes that Turkmenistan probably agreed to prices around 50 percent lower than Gazprom’s European price. “Moscow will be keen not to lose the opportunity to be a direct gas supplier to China, especially with a lot more uncertainty over future gas export volumes to Europe,” said Weafer.

Secondly and most importantly, with the economic crisis having raised the cost of borrowing even for Russian giants such as Gazprom, Chinese state companies can offer cheap credits unavailable elsewhere. The summer has seen a slew of Chinese credits granted to Russian companies in telecommunications, cement and energy. According to Kingsmill Bond of Troika Dialog brokerage, “China provides cheap financing and equipment for the development of Russian infrastructure. As the head of the Russian cement association poignantly said, ‘we can’t borrow from Russian banks at less than 20 percent, but from China we can borrow at under ten percent.’”

In June of 2009, China provided Turkmenistan with a $4 billion loan to develop its massive South Yolotan field. But the mother of all such deals was signed between Russia and China in February of 2009, with CNPC and the China Development Bank offering a $25 billion loan to Russian oil pipeline operator Transneft and state-owned oil company Rosneft, as part of an agreement for Russia to supply 15 million tons of oil annually for 20 years. The credit, at an unbeatable estimated interest rate of 5.7 percent, will finance oilfield development and pipeline construction from East Siberia to China.

“If that deal were to be replicated in the gas sector, we could see a timeline agreed not only for the pipelines, but also for the development of the giant Kovykta gas deposit, as that is the logical source of gas sales to China,” said Weafer.

Germany’s elections and Russia’s gas

Graham Stack for Russia Profile (www.russiaprofile.org)

 

Despite the rhetoric, Germany’s likely new coalition may slowdown nuclear power phase-out, but will not cut back on Russian gas.

 

If, as is likely, Germany’s September 27 national elections result in a new governing coalition between incumbent chancellor Angela Merkel’s Christian Democratic Union (CDU) and the small liberal Free Democratic Party (FDP), the planned phase-out of nuclear power in Germany will be slowed indefinitely, ostensibly to reduce dependency on Russian gas. However, analysts say the shift will make no significant longterm impact on German demand for Russian gas. Moreover, FDP head Guido Westerwelle as probable foreign minister is likely to be as Russia-friendly as his social democrat predecessor Frank-Walter Steinmeier, the loser of the election.

 

The man almost certain to be Germany’s new foreign minister did not mince his words when drawing conclusions from the Russian-Ukrainian ‘gas war’ January 2009, which saw supplies to Europe halted for a number of days.  “We Europeans have to do everything to free ourselves from dependency on a single supplier of energy,” Guido Westerwelle told Poland’s Gazeta Wyborcza in March, referring to Russia. “In Germany the government has made the mistake of phasing out nuclear power for ideological reasons. That makes us vulnerable to foreign energy suppliers. Germany should do what most of our European neighbors are already doing: achieve a reasonable energy mix, with renewable energy such as solar and wind power, fossil fuels such as oil, coal and gas, but also nuclear power.”

 

Westerwelle’s call to postpone nuclear power phase-out to reduce dependency on Russian gas found an echo in one of the minor scandals that livened up an otherwise lethargic election campaign in September: a detailed election-campaign PR strategy apparently commissioned by Germany’s large energy concern E.ON, subsequently leaked to the press, advised lobbyists to actively harp on the population’s “historically rooted fears of Russia.” “E.ON can draw on these fears for its own benefit,” read the leaked PR plan.

 

With Chancellor Angela Merkel’s CDU also in favour of slowing nuclear power phase-out, this coming shift in German energy policy might seem to be one of the immediate implications for Russia to come out of yesterday’s elections.

 

Russia currently supplies 37% of German gas imports. Germany relies on gas for 12% of electricity production and around 25% of total energy needs. Nuclear power, originally to be phased out by 2022 and replaced by renewable sources, counts for around 25% of power generation and 12% of total energy requirements. These figures give rise to fears that renewables will not be able to fill the space left by decommissioned nuclear plants, leading to even greater reliance on Russian gas.

 

However, analysts claim that much of the anti-Russian rhetoric is merely a political strategy to make slowing the phase-out more acceptable to voters, while it will in fact hardly impact on projected Russian gas deliveries to Germany.

 

“I do not think that a possible postponement of the envisaged nuclear phase-out is related to fears of increasing dependency on Russian gas,” argues Marcel Viëtor, Head of Foreign Energy Policy Program at the German Council on Foreign Relations. “Rather this fear is being developed by the atomic lobby to argue for the postponement. Fear of dependency on Russian gas imports is rhetoric but not factual since the Russian companies are mutually dependent on European gas markets,” says Viëtor.

 

Pierre Noel of the European Council on Foreign Relations also argues that the real reasons behind the coming policy shift is lobbying from German energy companies, who earn good money with nuclear power, together with growing electricity demand in Germany and carbon emissions reduction goals.

 

Furthermore, Russian analysts doubt that the move will even impact significantly on the projected volume of gas supplied to Germany from Russia.

 

According to VTB Capital’s gas analyst Lev Snykov, “such a move would not impact my long-term forecasts for Gazprom’s exports to Germany. Long-term Russian gas exports to Germany will grow at a low single-digit rate, although the market share may deteriorate due to a strong push towards LNG.” Similarly, energy analyst at Renaissance Capital, Alexander Burgansky, believes that, “German demand for gas may not now grow as fast as some people had expected, but Gazprom’s supplies are anyway protected by the minimum off-take commitments under the long-term contracts.”

 

Analysts also point out that Germany’s largest energy companies such as E.ON, although lobbying domestically for a suspension of nuclear power phase-out, are also heavily involved in Russia’s gas sector. EON’s CEO Wulf Bernotat is in fact a member of the Gazprom’s Board of Directors, as the company holds a 6.5% in the gas giant. E.ON and German chemicals giant BASF are also taking stakes in the major Siberian Yuzhnoe-Russkoe gas field.

 

Thus it was logical that Thursday September 24 EON was among a group of the world’s largest energy companies addressed by Russia’s ex-president, now prime minister, Vladimir Putin, in the town of Salekhard on Russia’s Yamal peninsula. Putin called on the international companies to invest in gas production in the region, destined to become Russia’s main production region in the long term, as older fields decline. Gazprom estimates total investment needed at $100bn.

 

Germany has particular interest in the massive Yamal development, according to UralSib energy analyst Viktor Mishnyakov. “Yamal is of strategic importance for the Russian government and for Gazprom as this gas will be the source for the Nord Stream pipeline project.”

Nordstream pipeline is a controversial Gazprom-led project to bring Russian gas directly to Germany via the Baltic Sea bypassing transit countries such as the Baltic countries and Poland.

 

There has been vociferous opposition from Poland and Baltic states to the pipeline. But, according to Marcel Viëtor, this is one energy policy that definitely won’t be changed under a CDU-FDP coalition.

 

“The CDU has shown different, more critical rhetoric on Russian domestic
issues than SPD did – but it has supported NordStream and German companies
cooperating with Russian companies, investing in Russia, just like SPD did,” says Viëtor. ”In a CDU-FDP-coalition this attitude is most likely to be continued.”

 

Russia – “Europe’s natural partner”

 

Apart from adjusting energy policy, the new German government’s Russia policy is likely to remain pragmatic and constructive, including disavowing Ukraine and Georgia’s bid to join NATO. With Westerwelle almost certain to become new foreign minister, the influence of SPD elder statesman Gerhard Schroeder in shaping Germany’s Russia policy will cede to the influence of FDP elder statesman Hans-Dieter Genscher, the Federal Republic of Germany’s legendary foreign minister from 1974 to 1992.

 

With 20 years marked since the fall of the Berlin Wall this autumn, events in which Genscher played a crucial role, an FDP-led foreign ministry will be especially minded to take a pragmatic and measured policy towards Russia, considering Moscow’s support for German reunification 1989-1990. Awareness of the Kremlin’s constructive role towards unification twenty years ago has even been heightened in recent weeks by archival revelations of how bitterly European leaders such as then British Prime Minister Margaret Thatcher and French President Francois Mitterand were initially opposed to the idea.

 

Outside of energy policy, the FDP regards Russia, in Genscher’s words, as “Europe’s natural ally, not natural enemy.” Added to this is the generational factor: 47-year old Westerwelle sees himself as one of a new generation of politicians that includes US president Barack Obama and Russian president Dmitry Medvedev. Westerwelle is thus an enthusiastic supporter of Obama’s “reset” policy of improving relations and cooperation with Russia. “If President Medvedev emphasizes he is a moderate politician and wants to reform his country and pursue disarmament, we should take him at his word,” he told Gazeta Wyborcza. “He is a young politician, and together with the US president, who is also young, he will have the chance to go down in history in a positive fashion.”

Post gas war, Ukraine’s gas market remains a can of worms

Graham Stack in Kyiv for business new europe (www.businessneweurope.eu)

Ukraine’s Prime Minister Yulia Tymoshenko touted January’s gas agreements between Russia’s Gazprom and Ukraine’s main energy company Naftogaz Ukraine as creating transparency in the sector by eliminating the gas trader Rosukrenergo. But while Rosukrenergo has definitely exited, the Ukrainian gas market is a far as ever from transparency – and Naftogaz Ukraine is far from being the only provider of gas to industry.

“Naftogaz has cut off our gas since May 5th, the plant has completely stopped working,” a source close to management of Rivneazot, West Ukraine’s largest nitrogen fertilizer producer, told bne. “And the reason is the Prime Minister [Yulia Tymoshenko]’s personal feud against Dmitry Firtash. We have no debts to Naftogaz.”

Dmitry Firtash was the man who until January 2008, as co-owner of Swiss-registered gas trade Rosukrenergo, appeared to hold all the strings in Ukraine’s notoriously opaque gas industry. For this reason he was the personal bete noir of firebrand Prime minister Yulia Tymoshenko.

In 2008, she declared it her mission to eliminate Rosukrenergo, and all intermediaries in general, from the gas trade. She claimed to have achieved this in the gas agreement finally signed between Ukraine’s domestic energy operator Naftogaz and Gazprom in January 2009, ending a stand-off between Russia and Ukraine that saw gas supplies to Europe interrupted. The agreement stipulated that Gazprom would in the future sell gas directly to Naftogaz, with Naftogaz granted the status of monopolist gas importer for Ukraine.

In May, the conflict then took another twist, when Naftogaz cut gas supplies to three chemical companies owned by Firtash – Rivneazot, Crimean Soda Plant, and Crimean Titan. Supplies to the Crimean plants, but not to Rivneazot, were later restored. Naftogaz claimed the companies had run up debts for gas supplies, while the companies argued they were consuming gas they has purchased earlier.

Demonstrating how politicized Ukraine’s gas market has become, Naftogaz’ decision to restore supplies to Firtash’ Crimean companies led to the dismissal from the company of deputy CEO Vladmir Trikolich on May 25, according to media reports that were confirmed by Rivneazot. “Tymoshenko demanded his head for the decision,” said bne’s source.

The episode with Firtash’ companies goes to show that the elimination of Rosukrenergo may have increased government control over the gas sector in Ukraine, but it has not created the hoped-for transparency.

In fact, the move may have done exactly the opposite, thanks to the ongoing collapse in Ukrainian industry. Supplying gas to industrial customers is the only profitable part of Ukraine’s gas sector, with gas supplies to households and utilities tightly regulated by the state. So when Tymoshenko vowed to remove intermediaries, part of the idea was to improve Naftogaz’s hitherto disastrous financial position by giving the company a dominant position on the market for industrial customers.

But in times of crisis, having a state-run and budget-subsidized company supply energy to cash-strapped industrial customers has one huge disadvantage: any decision to cut off gas to a major industrial plant, because of debts, becomes a political decision taken at highest level, opening the door to populism, cronyism and corruption and cronyism. Government officials ultimately decide the fate of tens of thousands of workers, and of their oligarch employers.

According to Ukraine’s Centre of Energy Studies, industrial companies’, excluding utilities, payment discipline is at 86.1%, with total debts of $2bn.

So while Firtash’ chemical companies had their gas switched off for (alleged) debts of less than $1m, other oligarchs can run up substantially larger debts with apparent impunity, as seems to be the case with metallurgical giant Industrial Union of the Donbass (IUD), owned by oligarch’s Sergei Taruta and Vitaly Gaiduk. A letter leaked to business daily Kommersant-Ukraine June 10 showed that Naftogas’s deputy head Igor Didenko had directly ordered supplies to be continued to IUD plants, despite IUD having run up nearly $51m in debts.

N.B: Vitaly Gaiduk also just happens to be head of Tymoshenko’s advisory service, and Naftogaz head Oleg Dubinin, until moving to Naftogaz Ukraine in December 2007, was CEO of IUD-owned Dzherzinsky Metallurgical Combine. IUD is one of the most heavily indebted industrial groups, with an estimated $3bn total debt, of which $500m is still due in 2009.

Privat Group’s private gas supply

Privat Group, co-owned by billionaire Ihor Kolomoyskiy, is another oligarch structure for which Tymoshenko is said to have a soft spot for. In 20005, since she backed Privat in its attempt to take Nikopol Ferroalloy Plant from Viktor Pinchuk in scandal that led to her first exit from government.

Privat is also, via Ukrnafta, Ukraine’s largest oil and gas producer, owner of a large stockpile of gas estimated at being from 3bn to 10bn cubic meteres held in underground storage. Ukrnafta. While the state in fact holds a 51% stake in Ukrnafta, Privat group, with a 42% stake exercises operational control over the company via management appointments.

Ukrnafta, as a state-owned company, is by law allowed only to sell its gas to households at prices around 11 timed lower than those charged to industrial customers. Privat has for this reason since 2007 blocked any sale of Ukrnafta’s gas, which is where the stockpile comes from.

But when in late February 2009, deputy chairman of Ukrnafta, Valentin Franchuk, linked to Privat Group, moved to become deputy chairman of state-controlled Naftogaz, analysts held it only a question of time before Ukrnafta’a gas seeped through to industrial consumers. Sure enough, at the end of May, the first sketchy reports provided by trading structure insiders surfaced of Ukrnafta gas finding its way to industry, unhindered by the government.

Analysts agree that Ukrnafta has been selling its oil for artificially low prices to Privat-affiliated companies. Since the Privat group comprises gas-guzzling metallurgical and chemical plants, it would not be far-fetched to think that the same scheme is going on with its gas, although this has not been confirmed.

Gazprom Sbyt of the action

The biggest winner from Tymoshenko’s elimination of Rosukrenergo as intermediary is, potentially however, Gazprom itself, in the form of its fully-owned Ukrainian subsidiary, Gazprom-Sbyt Ukraine, as well as a possible direct supplier of Ukraine’s chemical sector itself.

According to the gas agreements signed between Naftogaz Ukraine and Gazprom, Gazprom Sbyt gained the right to purchase up to 25% of gas imports, reselling a maximum of 7.5bn cubic meters to industrial customers. According to Gazprom Sbyt’s CEO Anatoly Podmishalk’skii, the company aims to sell 4-5bn cubic meters in 2009,

“It’s a myth that Tymoshenko got rid of intermediaries,” Bogad Sokolovsky, adviser to President Yushchenko on energy issues, told bne. “What is Gazprom Sbyt, if not an intermediary and indeed one that surpasses all that went before. And explain to me how it is that Gazprom Sbyt Ukraine is managing to conclude contracts with the most solvent companies in the country?”

Gazprom Sbyt cannot undercut Naftogaz in price, since it buys its gas back from Naftogaz at the import price, and has to earn a margin on this. However, in crisis times, it crucially has the resources to offer considerable more flexible payment conditions and also more supply security than cash-strapped Naftogaz. This means it is likely to attract the more solvent companies that can afford to pay the mark-up to get the added payment flexibility, where Naftogaz demands prepayment from industrial customers. This will then leave Naftogaz with the dross who are struggling to pay their bills.

It is however not just Gazprom Sbyt that is filling the void left by Firtash. Big brother Gazprom itself is starting to loom as a potential direct supplier of Ukrainian industry – with the Ukraine’s crisis-stricken chemicals plants serving as a bridgehead.

Ukraine’s industry minister Volodymyr Novitsky announced June 3 that six nitrogen fertilizer producers would be allowed to purchase gas directly from foreign companies. “Nitrogen fertilizer producers are in a very special position,” a source in Ukraine’s Union of Chemical Producers, which was involved in lobbying the resolution, told bne. “Gas for them is not just a source of energy, but their key raw material, comprising around 70% of costs”.

“The suppliers could be famous Russian companies,” the source explained. “This would be a step towards demonopolisation of the gas market. After all, what is Naftogaz Ukraine if not a giant intermediary itself?”

But the move has prompted apprehensions that any company supplying cheaper gas directly to these companies would then be in a prime position to acquire or privatize them. President Yushchenko has been bitterly resisting the government’s attempts hitherto to privatize Odesa Portside Plant, Ukraine’s most strategic chemical asset, and one of the companies on the list. Russia’s largest petrochemicals holding, Sibur, is a Gazprom affiliate.

“The whole thing seems unclean,” Bogdan Sokolovsky says, referring to the government announcement. “It in fact directly contradicts the gas agreement between Gazprom and Naftogaz that stipulates Naftogas as monopoly importer. How will it then be possible?”

Hungary and Russia sign off on cheaper South Stream

Gazprom chief Alexei Miller and Janos Eros, president of the Hungarian Development Bank, yesterday March 11 signed a deal to create a joint venture to build Hungary’s section of the South Stream gas pipeline by 2015. According to the Russians, the estimated cost of the project has fallen over half to 10bn euros, and the pipelines projected capacity has increased.

South Stream is a joint project of Gazprom with Italy’s Eni to pipe Russian gas to Italy and Austria through countries including Hungary, Serbia and Greece.

The Russians reported improved parameters for the pipeline. Russian Prime Minister Vladimir Putin, attending the signing ceremony, stated that due to lower materials and services prices, the cost of building the South Stream pipeline is expected to fall to about 10bn euros compared to the previous estimates of 25bn euros, according to Interfax.

Gazprom CEO Alexei Miller also announced that total transportation capacities of the pipeline could be higher than previously estimated, with the Hungarian section alone could pump up to 10 bcmpa.

Hungary’s Prime Minister Ferenc Gyurcsany was also present. Gyurcsany said the deal would help his country improve its energy security. Hungary currently receives all its gas through Ukraine, and was directly affected by January’s cutoff of supplies in connection with the Russia-Ukraine gas dispute.

“Hungary is not interested in there being one gas pipeline or one oil pipeline,” he said. “Hungary is interested in having as many pipelines as possible.”

Gyurcsany also said the South Stream project should not be considered a rival to the US-sponsored Nabucco pipeline, intended to pipe gas from Azerbaijan and the Caspian basin to Europe. He argued Budapest would benefit from transit fees from both pipelines.

The deal also includes Gazprom and Hungary’s oil and gas giant MOL building a large underground gas storage facility in Hungary for 1bn cubic meters of gas. Gyurcsany said existing such facilities helped Hungary cope with the gas shortages resulting from January’s dispute between Russia and Ukraine, according to Itar Tass.

The South Stream pipeline will bypass Ukraine and directly link Russia and Central and Western Europe. The pipeline will run beneath the Black Sea to the Bulgarian coast and then split into two branches – one heading South to Italy and one going North to Austria with a total combined capacity of 31-47 bcmpa.

Gazprom has already signed intergovernmental agreements with Bulgaria, Greece, Serbia and Hungary and negotiations with Slovenia and Austria are on schedule.

According to UralSib’s Victor Mishnyakov , “questions remain. We welcome Gazprom’s intention to diversify gas routes and increase its presence in the key European market. We regard this news as positive from a strategic perspective but neutral at the moment, as many questions remains unanswered.”

“In particular,” says Mishnyakov, “the Southern regions of Russia do not have sufficient gas deposits to supply the South Stream and the high-sulfur Central Asian gas would need to be treated before being transported. We also doubt that the current macroeconomic environment makes the project economically viable and do not believe that it will be built by 2015, as originally planned.”

Alfa’s Ron Smith is also downbeat about South Stream prospect: “We are still less-than-certain that South Stream will ever be completed. It is not clear that there will be enough European demand for Russian gas to justify the additional route, especially if Russia’s relations with Ukraine eventually quiet down.”

However, Russia’s PM Vladimir Putin had a quick response to doubters yesterday, according to Moscow Times. “If we aren’t able to build South Stream, which I doubt,” said Putin, “we’ll liquefy our gas and sell it to you for more.”

Russia forms ‘Gas Opec’ with Iran and Qatar

Graham Stack for business new europe (www.businessneweurope.eu)

Russia, Iran and Qatar, the world’s top three countries by gas reserves, who together control 60% of global gas resources, yesterday agreed to start forming a “Gas OPEC” or “Gas Troika” in Moscow.

The three countries agreed to set up a ‘technical committee’ as a prelude to creating a natural gas equivalent to oil cartel OPEC. The committee will be responsible for drafting the organisation’s charter to be presented at the next meeting of the Gas Exporters Countries’ Forum (GECF), to date a largely informal structure.

The goals of the new organisation are not  clear yet, with cooperation expected in the areas of gas production, processing and marketing, according to Rencap analysts. The new body will hold regular meetings three to four times a year, with the first meeting to take place within weeks.

According to UralSib analyst Victor Mishnyakov, Russia views the gas OPEC as a platform to discuss logistic and pricing mechanisms, not as a political instrument.

Mishnyakov says forming a price cartel similar to the oil OPEC would mean “that Gazprom would have to shift away from signing long-term “take-or-pay” gas contracts, which provide for less volatile export prices and guaranteed gas deliveries.” Gazprom is thus highly unlikely to support such a move.

When then President, now Prime Minister Vladimir  Putin first backed the idea of a Gas Opec at a press conference in January 2007,  he also emphasised it would not be a price cartel like oil Opec, but a forum for cooperation.

Indeed, according to analysts, an effective unified pricing mechanism is unfeasible because Gazprom exports natural gas via pipeline and there is no tradable exchange instrument for natural gas (like Brent for crude oil). The Persian Gulf countries export LNG, for which prices are volatile and set differently than under Gazprom’s natural gas contract prices.

There is currently therefore no such thing as a world gas market such as there is for oil. Shortages in one part of the globe have little or no impact on the supply/demand balance in another part of it.

This will change over time, believe analysts from Alfa bank, as liquefied natural gas (LNG) becomes a larger part of the gas supply chain. However, LNG will not have a material effect on international pricing for at least a decade.

Centrifugal forces

There is also considerable scepticism about whether the three countries have enough shared interests for the new organisation to be coherent.

Russia usually competes with OPEC gas producers such as Qatar and Iran for the European market. A topical example is the current rivalry between the planned  Nabucco and South Stream gas pipelines. The Nabucco project is intended to supply gas from Iran as an alternative to Russian gas due to be supplied through South Stream.

Consequently, Alfa’s Ronald Smith believes that “while this story captures headlines, in reality it should have little impact on the fundamentals of Gazprom for at least a decade, even should the proposed cartel hold together.”

UralSib’s Mishnyakov argues that the powerful centrifugal forces in the cartel will be exacerbated by Russia’s close cooperation with non-cartel members in Central Asia. “The creation of a gas OPEC must not neglect the interests of the CIS gas producers – Turkmenistan, Uzbekistan and Kazakhstan – or of Belarus, the main transit country for European deliveries. In our view the gas OPEC may create additional difficulties for Russia as it will now have to balance the interests of the Persian Gulf producers and its historical partners in the CIS,” says Mishnyakov.

Thermal coal producers are sure-fire winners of Russia’s electricity reform

Graham Stack for business new europe

The jury is still out on the radical reform of Russia’s power generation sector, but with the sale of the state’s last remaining stake in OGK-1 currently being negotiated, one thing is clear: Russia’s thermal coal producers are going to be the winners.

This year has already seen a vital watershed passed: as of January 1, steaming coal is now cheaper than gas following a 25% hike in domestic gas prices. Gas prices for industrial customers are now set to rise sharply to achieve netback parity by 2011, making coal for the first time a considerably cheaper fuel for Russia’s enormous, and rapidly growing, power generation sector.

So it’s no coincidence that 2008 has seen power generators start a scramble for coal: OGK-3 announced April 18 it was acquiring a licence for a nearby coalfield to cover 19% of its fuel needs; in March, Oleg Deripaska’s energy holding En+ said it’s looking to acquire thermal coal assets for around $750m; and OGK-4 has been making similar noises.

Gazprom is coal’s best friend

All this comes against the backdrop of Gazprom pushing from all sides to reduce the amount of gas used in power generation in order to free up volume for politically important exports. Gazprom is making plain it will obstruct the expansion of gas in power generation wherever possible. A new gas-fired power block at CHP Northwest was finally switched on in May one and a half years after commissioning due to Gazprom’s refusal to supply gas. And in Kaliningrad, the construction of a second gas-fired plant for Kaliningrad’s CHP-2 has been abandoned altogether for the same reason. The plants that have signed five-year gas supply agreements with Gazprom have complained bitterly that the terms are punitive, containing among other things up to 200% price penalties for any over-consumption of gas.

But this is overshadowed by the looming impact of Gazprom’s power generation joint venture with coal mining concern Suek, that finally got the go-ahead from the Federal Anti-monopoly Service (FAS) on February 28 after a year of wrangling. The FAS, the Ministry of Economic Development and Trade, and soon-to-disappear electricity monopoly UES itself had all opposed the merger of Gazprom’s extensive power generation assets with Suek’s. The effort was doomed, since the FAS was part of first deputy prime minister Dmitry Medvedev’s remit – who, apart from being president elect, is also chairman of the Gazprom board. The Gazprom-Suek venture now unites 41% of fossil-fuel generation capacity, and its owners control 40% of the power sector’s coal supplies and 85% of gas supplies – constituting market dominance that puts the very emergence of a competitive market in question.

However, Gazprom’s strategic goal in power generation is not to extract monopoly rents, but paradoxically to repress demand for gas by shifting from gas to coal wherever possible. “Gazprom’s OGK-2 and OGK-6 currently use 60-70% gas, but can also take coal,” says Renaissance Capital’s Vladimir Sklyar. “Gazprom will switch them. They are also building new coal-fired capacity for TKG-11 and -12.”

An exception is Gazprom-owned Mosenergo, the power giant that serves Moscow. It is gas-fuelled, and for environmental and logistics reasons, coal is not an option. Gazprom has obligations to invest $5.4bn in an additional 4,500 megawatts (MW), increasing output by 40% through 2011 – and is openly refusing to fulfil these, despite spiralling demand in Moscow. UES publicly lambasted Gazprom in a statement on April 24 for “the failure of the company’s board of directors to approve a range of projects, which must be realized in the next two to four years,”

The shift to coal has been blessed on the highest political level. A year ago, President Vladimir Putin declared in his last parliamentary address that the reduction of gas in the power generation fuel balance was a strategic priority. This priority was subsequently fixed in the $30bn investment programme for generation capacities spun-off in the course of restructuring: 30% of 57 gigawatts worth of new generation capacity to come on stream 2008-2014 will be coal-fired. This despite the fact that coal-fired facilities cost 30-40% more than gas-fired, meaning the total new capacity built with the money will be less.

So Gazprom effectively hijacked the initial aim of the great electricity reform – to introduce competition and increase generation capacity – with its own agenda of freeing up gas for export. And the winner is coal. Coal use would have risen anyway due to price liberalization causing gas prices to overtake coal, but now demand for thermal coal is set to soar. The share of coal in Russian power generation is set to grow from 23% in 2007 to 29% in 2010 and 37% by 2015 – at the same time that Russian power consumption is expected to grow at 5% per year. This means that demand for thermal coal will almost double from 2007 to 2015, from approx 130m tonnes to 250m tonnes, predicts Deutsche Bank.

Steppes are paved with coal

“There is a vast amount of steaming coal in Russia and it’s not expensive to get at,” says UralSib’s mining expert Kirill Chuiko. According to Chuiko, Russian steaming coal production has increased at an average 3.3% per year over the last six years, but there is still massive under-utilisation of capacities after the collapse of the 1990s. In 2006, total coal production amounted to only 70% of its historical Soviet peak.

And even when capacity is reached, Russia has the second largest (after the US) coal reserves in the world. Mine life is often long, and many companies have options for adjacent fields, meaning that production expansion is inexpensive. High quality reserves and plenty room for modernization also mean costs will stay low.

So thermal coal looks set to roll – and all the more now that it has friends in high places. On March 13, reports indicated that a sharp cut in coal mining taxes was on the cards, which would be “positive for all coal mining companies in Russia, including Mechel, Raspadskaya, Belon, Kuzbassrazrezugol, and Yuzhny Kuzbass,” said UniCredit analysts.

“At the same time,” Unicredit added, “the news is somewhat strange, as coal mining companies do not appear to need support during a period of high prices.” Unicredit concluded dryly: “We believe that Gazprom is lobbying for the change.”

Russian shipping and shipbuilding: The league of national champions

Graham Stack, for Radio Free Europe / Radio Liberty

In the 1990s, as the Soviet economy collapsed, the shipping sector was one of the few to bob to the surface, buoyed by international demand for its tonnage. It migrated to offshore tax havens and operated under flags of convenience.

As a consequence, less than 10% of Russian fleets’ business was done in Russia, and a decade of surviving in international waters forced Russian shipping companies to become lean and mean.

Now the ‘Kremlin-garchs’ want to change things: they want Russian shipping home again – to increase added value in the energy sector by serving national oil and gas giants. And with the prospect of demand for ships mushrooming due to giant offshore energy projects and Arctic shipping lanes opening, they also want Russian shipping companies to buy Russian-built ships.

Actors in the Sovcomflot-Novoship merger

The vehicle for state policy in maritime shipping a new ‘national champion’, created by merging the state’s 50.3% share in Novorossisk-based Novoship, the world’s twentieth largest carrier, into 100% state-owned Sovcomflot, the world’s sixteenth largest. The result is the world’s fifth largest shipping company.

The driving force behind this policy, of which implementation started in 2007, is the former Minister of Transport Sergei Frank, himself originally from the shipping industry in Vladivistok, moving to the Ministry of Transport in 1995, and becoming minister in 2000. Frank had advocated such a merger while in office. In 2004 he left the ministry to become CEO of Sovcomflot, evidently tasked with implementing the merger and effectively renationalizing Novoship.

2004 can be considered the birthyear of the new era of industrial restructuring of state-owned assets and related private assets in Russia, including renationalisation of the latter through ‘market methods’ – a term that however in Russia traditionally has a very broad meaning, including use of legal and extralegal coercion. In the first Putin term, further privatization of state assets was formally on the agenda, but a lack of political will meant that state-owned assets remained in limbo.

In 2004, as a result of Putin’s administrative reshaping of government, a powerful Federal Agency for Industry under Boris Aleshin, an industrialist, emerged with a remit to restructure state assets to create large merged companies or sectoral holdings that could compete internationally. Instead of being privatized, these were to remain under state control, but take on (foreign) strategic investors or conduct IPOs and enter international alliances to attract funds and technology.

Moreover, the Yukos case and the post-Beslan transition to appointed governors in 2004-5 strengthened the Kremlin against big business and regional lobbies.

Alongside the appointment of Aleshin and Frank, 2004 also saw Sergei Chemezov, often regarded as the mastermind behind this plan, and an old friend of Vladimir Putin, take over as head of state arms intermediary Rosoboronexport, and launch a programme of restructuring the defence sector through renationalizing privatised companies. The reshaping of government 2004 also led to the corporatisation and connected restructuring of industrial giants Ministry of Railways and Ministry of Atomic Power, pushing industrial policy firmly to the fore, for the first time since the collapse of the Soviet Union.

Despite this ‘sea change’ in 2004, the Sovcomflot-Novoship merger has been a work of compromise, in particular regarding the regional component: Sovcomflot is registered in St. Petersburg, of which the governor Valentina Matvienko has influence in the Kremlin. Novoship, in its turn, is the largest tax payer in the southern region of Krasnodar territory, the governor of which, Alexander Tkachev, is an influential pro-Putin nationalist whom pundits occasionally tipped as a Putin successor. In addition, Sochi, successful Winter Olympic candidate, is located in Krasnodar. Tkachev was particularly active in lobbying against any reregistration of Novoship away from Krasnodar as a result of a merger, and partly as a result, Novoship will remain an independent affiliate of Sovcomflot registered in Novorossisk.

Frank himself is not overtly aligned with any Kremlin groups. As CEO of Sovcomflot he replaced Dmitry Scarga, appointed to Sovcomflot in 2000 at the age of 30. Scarga was linked to the Petersburg group around the Baltic Pipeline System that includes Alexei Miller, who in the same year became head of Gazprom. In 2005, Sovcomflot filed a lawsuit in Britain against Scarga, by then a ‘senator’in the Federation Council, due to financial manipulations uncovered at Sovcomflot’s British subsidiary causing damages of $200m. Scarga moved to London ostensibly to defend himself. Criminal charges in Russia were subsequently opened against him, and an extradition request filed in early 2008. Scarga is now claiming political asylum in Britain – alongside former Novoship CEO Tagir Izmailov (see below). Both these cases indicate at the very least that Frank can count on support from law enforcement and justice organs.

During Putin’s first term, the supervisory board of Sovcomflot was chaired by Dmitry Kozak, a close Putin aide and reformist liberal with a law background. After the Beslan hostage-taking, Kozak moved to become presidential representative to the Southern Federal District, and was replaced by Igor Shuvalov, also a Putin aide on economic matters and a liberal. Neither of them, nor Frank, are closely associated with the silovik faction of former and current KGB / FSB members – showing that the ‘national champion’ industrial policy launched 2004 currently enjoys consensus support among government groups, and can rely on the backing of law-enforcement agencies irrespective of whether siloviki are directly involved in running the business or not.

Implementing the merger

Such backing from law enforcement and legal organs soon proved necessary, since Novoship management resisted the merger from the start. Despite the state’s 50.3% stake retained, Novoship management exercised de facto control over the company through cross-ownership with subsidiaries and influence over financial flows. The company was growing strongly and expanding its fleet rapidly. But state officials and Sergei Frank argued it was doing nothing to reduce exposure to the volatile spot market, and was suspected of shifting assets offshore.

As in many other cases, the complex financial structures set up by insider management in order to control their companies ultimately proved to be their Achilles’ heel: When company president Tagir Izmailov openly expressed opposition to the proposed merger in 2005, he found himself charged with abuse of position and money laundering, and fled to London. In December 2006, ex-chairman of subsidiary Novoship-Invest, holder of 6.5% of Novoship, shot himself after being summoned for questioning. Days before the merger was finalised, management tried to offload a 14.41% stake held by Novoship’s Liberian-registered subsidiary to Gazprombank – to retain some independence from the new bosses – but Moscow blocked this at the last minute.

Kremlin mistrust of management or ‘insider’ ownership for important companies – such as titanium producer Avisma, car giant Avtovaz, plane manufacturer Irkut or Novoship – appears to be one of the driving forces behind current restructuring. Kremlin officials suspect management ownership – often through cross-ownership of companies by their subsidiaries – of restricting companies’ growth prospects, because insider owners risk losing control of the company, and thus their position, if they take on badly-needed strategic investors. The state then proves its point about vulnerability by coercing management into selling up.

Nevertheless, for all the charges brought against former Novoship management, analysts regarded Novoship as – at least formally – more transparent than Sovcomflot. Novoship disclosed its results on a quarterly basis. Sovcomflot disclosed very little and there is an ongoing criminal case against former manager Dmitry Scarga and other management members, who are accused of defrauding the company.

The league of national champions

What does the Kremlin want of its new national champion? Now that state companies Gazprom and Rosneft have secured control of development of offshore gas and oil reserves (specifically the massive Shtokman and Sakhalin projects), the idea is to create linkage to other domestic sectors to increase added value generated in Russia. Shipping services are the obvious next step. Next in line are the shipyards. Ideally tripartite alliances of Russian oil and gas giants, Russian shipping companies, and Russian shipyards should emerge. Sovcomflot management talk of the merged company acting as a catalyst for the development of maritime clusters similar to the role played by Maersk in Denmark, NYK in Japan, Stena Bulk in Sweden or COSCO in China.

Sovcomflot is moving rapidly in this direction, specializing in energy and ice-class shipping, placing orders home and abroad, and rapidly expanding its fleet of LNG carriers, with large orders placed at Korean and Japanese yards – no Russian shipyard currently produces LNG ships, although Baltic shipyards plans to start in 2011.

Supporting offshore projects is however seen to be only the first step. With the Arctic ice melting due to climate change, the Arctic is opening up both for more energy exploration – the US Geological Survey estimates that 25% of the world’s undiscovered oil and gas reserves are located in the Arctic – and also for shipping route: the North-East passage, if sailed from Hamburg to Yokohoma – is almost 40% shorter than passing through the Suez canal.

The offshore developments are expected to put in place a lot of the shipping infrastructure needed for the Arctic to become a main shipping lane, if present climate change trends continue. Sovcomflot estimates that over the next ten years, Arctic shipping will quadruple in connection with Shtokman alone. Currently there is almost no shipping in this area at the moment, and so there is little current competition.

Sovcomflot is not the only Russian shipping company to be thinking along these lines. The smaller, private Vladivostok-based Primor’e Shipping Company (PRISCO) is also an oil carrier currently increasing deadweight at 18% pa and looking to expand into the LNG market. Prisco is well placed for Sakhalin oil shipping and the company has won contracts to ship oil even against bigger players such as Sovcomflot, with a $150mn contract to ship oil for Exxon in Sakhalin. As the relationship with Sakhalin develops, Prisco expects half of its business to be domestic.

The question for PRISCO is whether Sovcomflot’s status as national champion will not jeapardise its ability to win contracts for Sakhalin, after national champions Gazprom and Rosneft having taken leading roles in these projects. Furthermore, if shipping sector consolidation were to continue, PRISCO, or other private shipping companies, might find itself under pressure to sell out to the state-owned shipping giant.

Meanwhile, having merged into a national champion, rich pickings also loom for Novoship in connection with the planned Burgas-Alexandropolis oil pipeline, in which the Kremlin is involved. According to Renaissance Capital, the company is set to become a preferred partner for shipping Russian oil to Burgas.

In early 2008, the advantages of the merger for Novoship became more evident.
Sovcomflot management outlined significant synergies in both revenue generation and on the cost side, including attracting new clients with, for instance, right of first refusal contracts, and savings potential through joint purchasing, cheaper debt financing and the reduction of administrative expenses.
Despite the fierce resistance from Novoship management, minorities and investment banks were mildly positive about the merger – pointing to the chances to increase liquidity and create economies of scale. The merger should produce both synergies and diversification: Novoship is a classic tank oil carrier working the Black Sea routes, while Sovcomflot concentrates on the ice-bound Arctic and hi-tech transport of liquid natural gas.

Analysts argue that size does matter when it comes to international competitiveness, and that the new company will enjoy considerably more pricing power. One of the tenets of the state shipping doctrine has been to move away from the spot market and time charters – where everything is short term and subject to oil price fluctuations – towards establishing long term contracts with direct customers.

Most importantly, in January 2008, Sovcomflot signed a cooperation agreement with state-owned oil pipeline monopolist Transneft for oil shipping to the Burgas-Alexandrupolis pipeline. The January 2008 agreement envisages Novoship becoming the seaborne carrier linking the Transneft pipeline ending in Novorossiysk with the new Burgas-Alexandrupolis pipeline in Bulgaria and Greece that bypasses the Turkey-controlled Bosphorus.

The agreement is very positive for Novoship, since it will support the targeted shift from the volatile spot market towards more sustainable pipeline-like utilisation. However, this deal also showed that the Sovcomflot merger was by no means purely a case of industrial restructuring. It was also a key component in the Kremlin’s pipeline policy looking to expand and diversify its oil and gas pipelines to Europe, while crowding out other competitor pipelines bypassing Russia. This means that the company is of strategic interest to the Kremlin, which could in the future run counter to commercial considerations.

The merged company is correspondingly emitting contradictory signals in terms of its interest in boosting shareholder value and internationalisation.

The new Novoship board appointed in January 2008 is positive sign in this regard, including three independent directors, a rarity in Russia, with two of them non-Russian: Marlen Manasov, managing director of UBS Securities and Robert Sasson, an investment banker, former Head of EBRD Mission in St. Petersburg. Analysts agreed this indicated Sovcomflot was intent on boosting Novoship capitalisation in preparation for an IPO of the entire group.

However, in February 2008, this policy experienced a significant set back, as state interests prevailed over commercial. Inside sources reported that Sergei Frank had been lobbying for independent directors to join the Sovcomflotboard, specifically Morgan Stanley’s Elena Titova and Deutsche Bank’s Charles Ryan. But instead, state officials supported Andrei Kostin, CEO of state bank VTB – and most significantly the new CEO of Transneft, Nikolai Tokarev, a probable former KGB man. Tokarev’s inclusion instead of an independent director indicated that strategic state interests would prevail over commercial considerations in running the company as a member of the league of ‘national champions’.

Uniting Russia’s struggling shipbuilders

The Novoship merger was the prelude to a sweeping overhaul of the shipbuilding sector, the cornerstone of which was the presidential decree of March 9th, 2007, “On the Establishment of the United Shipbuilding Corporation” (USC). This decree provided for consolidating all state-owned assets in the shipbuilding branch, totalling around 40 companies, into a holding with 100% state ownership.

The Sovcomflot-Novoship merger was child’s play in comparison to setting up the USC. The template for the USC was the United Aircraft-builders Corporation (UAC) established in 2006. However, here there are also substantial differences: the aircraft industry consolidation came initially ‘from below’, with considerable consolidation between Irkut, Sukhoi and MiG already underway. Moreover, the Russian aerospace industry includes some very internationally competitive production, such as the MiG and Sukhoi fighter jets, around which a successful company might be built.

Government officials seem, in contrast, to have made decisions about the USC at speed and without consultations. The USC bundles all existing state shareholdings in maritime shipbuilders. There was a strong political flavour to its launch, with much telegenic championing of ‘national shipbuilding’ by at that time potential presidential sucessor Sergei Ivanov. At the same time, relatively efficient fully privatised outfits, such as Petersburg’s Baltiskie Zavody and Northern shipyards, both owned by oligarch Sergei Pugachev’s United Industrial Corporation group, were not invited to join.

The formation of the new holding is not to be completed until 2009, and is already well behind schedule. In its final form, the USC will unite 40 odd companies from Kaliningrad to Konsomolsk-on-Amur, ranging from federal state unitary enterprises (FGUPs) to joint stock companies where the state is only a minority shareholder. Alone the process of inventorying FGUP’s assets and converting them into joint stock companies is, Sergei Ivanov has himself admitted, extraordinarily laborious. The need to facilitate integration influenced the decision to structure the company along regional lines, instead of functional roles; there are to be regional centres in Petersburg, Severodinsk and Vladivostock.

In fact the operation has already run into considerable difficulties, reflected in personnel turnover in top positions. There was initial confusion over who would head the supervisory board. Originally it was expected that Sergei Ivanov would do so, then defence minister Valery Serdyukov was tipped, and finally deputy prime minister Sergei Naryshkin got the job in July 2007.

The difficulties in putting together the corporation were even more apparent regarding the crucial position of CEO. Alexander Burutin, first head of the USC and charged with swift implementation of the presidential decree, resigned in September 2007 after three months of fruitless negotiations with shipyard managements about the terms of their integration. It took over a month to find a replacement for Burutin, with the first choice candidate for the job, Andrei Dutov moving instead to head the State Industry Agency. The next best candidate, retirement age Yury Yarov, a former cabinet minister, in the 1980s boss of current prime minister Viktor Zubkov, was finally appointed October 23, with six months having lapsed since the presidential decree.

What does the Kremlin expect from USC?

The declared goal of the USC is to strengthen commercial, not military, shipbuilding in Russia. To cite Vladimir Putin’s annual address to parliament 2007, the modest goal of USC is ‘for Russian shipbuilding to occupy a decent niche on the world market’.

Currently, Russia basically has zero market share in the global commercial shipbuilding industry. Whereas Japan and South Korea each produce 70m tonnes deadweight per year, Russia turns out only 1m, lagging behind Vietnam, Iran and Turkey. But Russian companies place orders worth $1bn for ships each year, 80% of which go abroad. In fact, 80% of Russian ship-building output is for naval procurement. The imbalance is a legacy of the Soviet era, where naval shipyards were concentrated on Russian territory, with merchant fleet ships being built in Poland, Finland and East Germany, and Ukraine.

As a result, even now that state defence procurement is soaring, Russian yards are on average only working to one third of their capacity. This makes the idea of Russian commercial shipping companies placing a higher proportion of orders with Russian shipyards so alluring.

However, Russian shipyards largely fail to compete even on the domestic market. They suffer from productivity levels far lower than South-east Asian countries. They are also unable to achieve turnaround times anything like the Asian countries, on average half as fast, which is critical, or reliable. Furthermore, Russian shipyards lack the capacity to build the ships with over 80,000 tonnes deadweight that enjoy wide global demand. One major problem here is the location of major shipyards, such as the Admiralty and Baltic shipyards in the historical heart of Petersburg, where there is simply no room to expand

The call of the Arctic

Despite this seemingly hopeless position, Russian planners have identified a market niche they believe Russian shipyards could fill. The grand plan for the ship-building sector is to build vessels to service the Shtokmann gas field and the Pacific shelf projects, as well as for the Arctic shipping routes expected to increase fourfold over the next 10 years.

Government estimates put the number of platforms needed for offshore oil and gas production by 2030 at 40, the number of 85 specialized ships at 80 with more than 140 support ships needed. Demand is set to boom for atomic icebreakers, hydrographic craft for exploration, ice-class oil tankers and LNG carriers, as well as platforms for oil and gas drilling, and pipeline-laying and transport ships

The policy is realistic in looking for Russian shipping to occupy a specialist niche – ships specially suited for Arctic operations. Thus the USC does have a vision going beyond the next elections: an alluring vision of Russia’s twin evils – dependency on budget money and dependency on the resource sector – cancelling each other out – with military shipbuilding diversifying into commercial, and the economy as a whole beginning to put added-value on its resource base.

However international competition still has a head start in tackling these new challenges. Japanese and Korean yards dominate global production of LNG carriers. Even in ice-class shipping, the pioneering role is held by Norwegian Aker-Kvaerner producing double-acting icebreakers (with a stern that can be deployed as an icebreaking bow). Aker-Kvaerner is already supplying freight ships to Norilsk Nickel for year-round shipping between Dudinka and Murmansk. Russian shipbuilding is going to need the sort of hidden protectionism the national champion policy implies, but the costs will be borne by the projects they supply.

In November 2007, the Ministry of Energy and Industry authored a federal target programme to support this technological transition, called “Development of civil marine technology 2009-2016”, which envisages R140 investment for this time period, of which around R100bn will come from the federal budget. The programme focuses on financing R&D and modernising testing and design bureaus. The funding is also sufficient to purchase foreign licences especially for LNG tankers. However, the programme does not foresee direct budget investment in upgrading the shipyards themselves.
The Kremlin’s grand plan thus hinges on creating a chain of ‘national champions’ to increase added-value generated in Russia from the resource sector, comprising Russian energy giants, Russian shipping giants, and a Russian shipbuilding giant. This chain can be extended into supplier sectors. For instance, ice-class shipping requires high-grade steels, of which steel giant Severstal is planning to increase production, launching an investment programme for this purpose worth R850m through 2009, in time for the start of construction of LNG and modern ice-class tankers in 2011.
What use is USC?

An additional question mark over USC is that market forces were already pushing the most efficient shipyards in this direction. Such shipyards are currently either ignoring the intervention of state officials, or regard them and USC as a threat to their efficiency. The most capable shipyards picked up on the new source of demand long before government officials. In recent years, for example, Admiralty shipyards has built five ice-class tankers for Sovcomflot and five for Lukoil. But it is precisely Admiralty shipyard management that has expressed deep misgiving about the corporation – and having to undergo a complex metamorphosis from unitary enterprise to joint stock company, entailing loss of decision making freedom.

Management is particularly troubled about how much freedom the company would retain to conclude contracts independently. In particular, since the USC is to have a two level structure, with separate shipping centres for the West (St. Petersburg and Kaliningrad), the North (Severodinsk and Murmansk) and the East (Vladivostok), united under the umbrella organisation USC, constituent companies are afraid of excessive bureaucracy and loss of the flexibility that is crucial to making effective business decisions.

Two of the most advanced shipyards in terms of producing for offshore projects are Petersburg’s Baltiiskie Zavody and Northern shipyard, both of which are affiliates of oligarch Sergei Pugachev’s United Industrial Group. There has been no attempt to strong-arm these companies into joining, which is in some ways a positive sign, but also questions the rationale behind the project.

Analysts argue that both these shipyards should comprise the core of any Petersburg-based shipbuilding holding. They have also been trailblazers in terms of restructuring, proving that private capital is more effective than government ministers in turning industry around: Baltiiskie Zavody is embarked on a complete relocation from constricted premises in Petersburg’s historical heart to the expanded facilities at out-of-town Northern Shipyards.

Baltiiskie Zavody is Russia’s main producer of nuclear and diesel powered icebreakers, and The UIG shipyards are active in moving into the Arctic shipping business, including preparation to build LNG tankers that are currently not built in Russia at all. Production is slated to commence in 2011, in time for start of operations at the Shtokman offshore gas field in the Barents Sea. In contrast, the state is dragging its heels on holding tenders for constructing shipyard facilities large enough to build ships over 80,000 tonnes, especially large LNG tankers.

Confirming this trend of efficient companies responding swiftly to energy sector demand, the to date largest shipbuilding contract resulting from the Shtokman field development – for two marine drilling platforms worth $2.5bn – went to the privately-owned Vyborg ship-building yard. Vyborg shipbuilding yard that hopes to secure four further such contracts, will also not be part of USC. Vyborg shipyard was recently acquired by influential Petersburg financial group ‘Bank Rossiya’, reputed, as is also Sergei Pugachyov, to enjoy some access to Vladimir Putin.

Further questions were then asked of the efficiency of state-owned yards when in February 2008 the Norwegian shipping concern Odfjell terminated a $500m contract with the Sevmash shipyard, based in Severodinsk, the Russian producer of nuclear submarines. Sevmash called the contract for twelve 45,000 tonne tankers the ‘deal of the century’ when it was signed in 2004.

Odfjell claims that the first tanker was slated for delivery in September 2007, but will not be ready until May 2009, and that the cost of the order has risen from $500 million to $544 million. Following termination of the contract, Sevmash will also be liable for damage claims.

Sevmash for its part argues that the soaring price of steel is to blame for the rise in costs, but in fact this is not Sevmash’s first failure of this kind. The yard also mismanaged a large Indian order to reequip the Russian aircraft carrier Admiral Gorshkov for sale to India. Originally planned for 2008, the handover has now been postponed to 2011, a delay that cost the previous Sevmash management their jobs.

The Sevmash case points again to weak management as a major problem for many state-owned shipyards, and it is unclear how the USC intends to improve this situation.

Conclusions

- The basic goal of boosting commercial production by former naval shipyards is positive, since, if successful, it will increase international economic integration of the sector and hinder the emergence of any ‘military-industrial complex’ lobbying for arms spending increases. The Arctic shipping / offshore niche has some real potential.

- The increase in state involvement should not be exaggerated. In shipping, there remain three major and expanding private shipping companies. In shipbuilding, the state has not yet tried to persuade or pressure private companies into joining the holding – even major ship-building companies with considerable defence significance such as Baltic and Northern shipyards remain in private hands.

- The selective use of criminal charges apparently to pressure former Novoship management into consenting to the merger is extremely disquietening.

- The new focus propagated for shipping and ship-building on offshore projects and the energy sector will add to Russia’s assertiveness in this area, in terms of ‘resource nationalism’. Multinationals are often regarded as reluctant to contract out to Russian suppliers, and the Kremlin is intent on maximising added value in the energy sector as part of its diversification strategy. Moreover, the increasing, and increasingly politicised, focus on the Arctic waters as being of strategic significance for Russia will lessen readiness to compromise on questions of demarcation of territorial waters.

- The developing system of ‘national champions’ is potentially detrimental to competition and the market mechanism, since it is likely that national champions, such as Gazprom and Rosneft, in the energy sector will prefer other (state-owned) national champions in shipping and ship-building, even where private companies are more competitive. Furthermore, state-owned companies that have proved themselves efficient outside of national corporations, such as Admiralty shipyards, or the Sukhoi holding in aircraft construction, risk being shackled to inefficient loss-making companies.

Green as camouflage for Kremlin’s energy agenda

Graham Stack for business new europe

Far from flooding the carbon trading market with hot air, Russia is posing as an environmental purist and using the green issue to push the Kremlin’s energy agenda.

After vacillating for months, Russia’s decision to sign off on the Kyoto Protocol in January made the international agreement that is supposed to regulate international emissions of gases harmful to the environment a real document.

One of the quirks of the document was the chance it gave Russia to sell lots of “hot air:” because the 5% reduction target for 2008-2012 took 1990 as its baseline, before Russia’s post-Soviet industrial collapse, it handed Russia 300m tonnes of carbon emission indulgences to dispose of. Environmentalists and traders were waiting anxiously to see what Russia intended to do with the Kyoto lottery win. Would Russia swamp the nascent carbon trading market with cheap hot air, allowing European companies to ramp up emissions with impunity and turning Kyoto on its head?

They needn’t have worried – the opposite seems to be true. After years of bureaucratic foot-dragging, Russia’s paper-pushers have finally drawn up the regulatory framework for joint implementation – the system whereby companies from signatory countries can harvest carbon credits for own consumption or for trading by investing in carbon-reduction “joint implementation” projects in other signatory states.

And the big surprise: far from letting the lottery win go to their heads, Russian officials have outed themselves as environmental purists.

Vsevolod Gavrilov, head of the natural resources department in the economy ministry, announced at a press conference on March 13 that his department will process joint implementation projects – of which 60 have already been drawn up by investors – according to a rejection-based approach. “The most correct approach is forbidding everything, but allowing certain things to go forward. The worst approach is to approve everything, but say certain things are forbidden,” Gavrilov said. “We are working according to a principle of rejection – we have no interest in creating the largest carbon emissions market. Our goal is to promote norms of ecological responsibility.”

Many potential foreign investors hoping for a slice of carbon credit action in Russia were dismayed at his words, although Gavrilov’s statement was consistent with earlier assertions in January that, “the key goal is to attain ecological benefits both globally and locally here in Russia,” rather than for Russia to earn big bucks.

Considering that the Russian government originally hemmed and hawed over signing up to Kyoto, leveraging a very strong bargaining position to secure EU consent to its WTO bid, is it really the case that Russian officials are now “greener than green” and intent on implementing the agreement for the sole good of the global environment? Or is Russian bureaucracy simply displaying its usual regulatory zeal? Or is there a more sophisticated Kremlin agenda for joint implementation, as for most everything else these days?

Trailing Ukraine in carbon readiness

The proposed stringency regarding project approval follows a long period of foot-dragging by government over establishing the procedures for joint implementation – meaning that for potential investors, time is running out. “The window of opportunity is closing now that with 2008 the commitment phase of the Kyoto protocol has already started,” says Maria Kovalenko, carbon trading analyst at pointcarbon. “Projects have to be completed before 2012, the emissions reduction target date. Newcomers should consider carefully whether there is sufficient time left.”

“Ukraine established its procedures in 2006, and they already have one project up and running,” she says. Not surprisingly, pointcarbon’s CIS office is located in Kyiv and not Moscow. The Ukraine project, the Podolsky cement factory, consists of a €140m investment to replace wet cement production with dry technology. Ireland-based CRH Finance is providing the investment and will acquire the resulting carbon credits.

Konvalenko explains the Russian time lag with the detailed work that the government has performed in establishing procedures for project approval – a testimony to Gavrilov’s professed purism. The very real complexity of the process is all down to the concept of “additionality:” joint implementation projects have to prove that the emissions reduction would not take place without the incentive of carbon credits, to cut down on freeloaders’ distorting the carbon credit market. Needless to say, the bureaucratic effort in ascertaining this additionality is immense. Joint implementation projects are both subject to approval at the national and UN level to guard against any softening of criteria leading to carbon credit inflation. Thus there is ample justification both for delays in establishing procedures and for future delays in approving projects. “Joint implementation is in itself a very slow process,” says Kovalenko.

In Russia, the situation is made even more complex by the currently distorted incentives set by state-controlled prices for power and gas – controls that are about to be phased out. This means that rising domestic energy prices will anyway force companies to invest in improving energy efficiency, without any need for the additional incentive of selling carbon credits.

So the ministry, argues Astrid Moe of Norway’s Fridtjof Nansen Institute, has a powerful argument for handling joint implementation strictly: to fence off “real” carbon reduction emissions from simple energy efficiency improvement stimulated by price rises. “I believe the Ministry of Economy wants to steer [joint implementation] into projects where new technology is needed and let the bulk of easy reductions be taken care of by price reforms, as well as emissions trading further on.”

This is view is shared by Ingo Ramming, executive director of Carbon Trading and Finance, a joint venture established by Gazprombank and Dresdner Kleinwort. “This is a very important statement,” argues Ramming, referring to Gavrilov, “coming against the background of controversies last year about projects in India and China where the additionality of projects was disputable. It seems the Russian authorities wanted to make quite sure about additionality. I would even say it was an important statement upholding the credibility of joint implementation in Russia.

This seems to back up eco-purist Gavrilov when he says, “unfortunately not all the investors are taking this opportunity the right way, some see it as a way to get a freebie without doing any work. We want to avoid these speculative projects.”

Green as camouflage for energy agenda

However, Gavrilov not only surprised potential investors by the stringency of his department’s approach and his green purism, he also surprised them by naming Russian oil major Surgutneftegaz as a shining example of how to implement carbon emission reductions – by capturing the associated gas for power generation instead of simply flaring it.

This relativises Gavrilov’s ecological credentials: since 2007 it has been established Kremlin policy to clamp down on flaring. President Vladimir Putin even mentioned the issue in his last state of the nation speech in April of 2007. Government ministries have started drawing up regulatory measures to encourage a shift towards utilizing associated gas. The Kremlin’s motivation is for cutting flaring is, however, not ecological, but to maximise Russia’s energy clout. This raises the question of whether the tight bureaucratic supervision, combined with the small remaining window of opportunity for joint implementation projects, is not intended to channel Russia’s carbon credit wealth towards strategic projects backed by the Kremlin.

The case of associated gas is one where Kremlin strategic goals and carbon emission goals coincide. However, a carbon-reducing classic – switching power generation from coal to gas – fundamentally contradicts Gazprom’s ideas about how the Russian power sector should develop, and is thus likely to be a non-starter.

Gazprom is lobbying for exactly the opposite to happen: for an increase in the use of coal in Russia, to free up gas for more profitable exports. A planned rise in gas prices should stimulate this process. Gazprom has also just been given the go ahead to merge its considerable power generation assets with those of the SUEK coalmining concern, paving the way for increased use of coal domestically. According to Moe, this means that joint implementation projects envisaging a coal-to-gas switch for Russia are unlikely to win approval, however impeccable their environmental credentials. Russian regulatory authorities have the power to simply delay project approval until time runs out for implementation. So Gazprom’s preferences are likely to shape policy regarding carbon credits as it does in most other policy spheres as well. And all the more so for that Gazprom is hatching big carbon plans itself.

Phillip Dewhurst, head of PR at Gazprom’s London subsidiary Gazprom Marketing and Trading, a vehicle for global carbon credit trading, calls Russia “the Saudi Arabia of carbon.” Gazprom M&T has already made its debut on the world’s carbon trading market, acquiring carbon credits by investing in a Brazilian bioethanol plant and selling to Japanese company Marubeni. According to Gazprom M&T, however, these deals were just testing the water. Gazprom’s ultimate aim is to set up a scheme systematically bundling carbon credits with its own natural gas sales, marketing the package as “carbon-neutral gas.” In this way, Gazprom can leverage Kyoto to expand market share in Europe, in particular facilitating direct access to industrial customers, one of its long-term strategic goals.

And Gazprom is not going to be short of carbon credits. According to Anna Korppoo also of the Fridtjof Nansen Institute, 52% of proposed joint implementation projects and 60% of proposed emission reductions in Russia involve refurbishing gas pipelines to reduce leakage. This means that Gazprom, monopoly owner of Russia’s gas pipelines, will be the driving force behind joint implementation in Russia. Korppoo notes that gas pipeline projects involve a minimum of foreign actors, some of which are anyway Russian companies registered overseas.

In general, Korppoo notes revealing details about proposed joint implementation projects in Russia compared to Ukraine: an extreme concentration of the Russian projects in few hands, with only 17 foreign actors spread between 38 projects, compared to 15 foreign partners for a total of 15 projects in Ukraine.

These figures also point to joint implementation in Russia being nationalized to further the Kremlin’s strategic goals – with restrictive bureaucratic means being used to channel credits to national champions, while maximizing their value by restricting supply to the market as a whole.

Green fields for biofuel, blue skies for Sukhoi

It’s hardly by chance that the same week Gavrilov outlined government policy on joint implementation, a trio of political heavyweights called on biofuel to become an important new string in Russia’s energy bow. Russia currently has no bioethanol production, but the agriculture ministry estimates there are 20m hectares of idle arable land that could be brought back into use for biofuel production – supported by carbon credits.

No less than Vladimir Putin got the biofuel ball rolling. “Considering that the significance of biological fuel in the global energy sector is steadily growing, special attention will now be paid to countries that have enough arable land to ensure the necessary amounts. Certainly, Russia will occupy a special place among these countries. This is becoming no less important for us than the use of common national resources in the hydrocarbon sector,” Putin said at a meeting with top officials of the State Duma on March 11, according to Interfax.

Duma speaker Boris Gryzlov was even more direct, saying: “we should capture this market, and then we will dictate our terms not only on the sale of gas and oil, but also of biofuel. This is a realistic opportunity for us.”

The day after Putin’s call for action, Prime Minister Viktor Zubkov, attending a timber industry conference, announced a state programme to be launched with the goal of achieving 2m tonnes of biofuel production per year, including construction of some 30 biofuel plants. The timing of his announcement in front of timber industry representatives might indicate future utilization of timber waste for bioethanol production, something done in Soviet times – and also chiming with Kremlin plans to increase added-value in the forestry industry,.

The Kremlin carbon agenda is not limited to energy. At least one of the Kremlin’s pet high-tech projects is also lining up to gain from the carbon credit bonanza: Russia’s flagship civil aviation project, the Sukhoi Superjet, a state of the art medium-range passenger plane yet to go to serial production, boasts significantly lower carbon emission values than its competitors – making it eligible for carbon credits under Kyoto. As Maria Konvalenko of pointcarbon points out, “in Russia a lot of business is very close to politics, and sometimes it is simply the same.”

Gazprom’s Sochi: The Shtokman Field gas project moves towards implementation

On Feb. 21, the CEOs of Russia’s Gazprom, France’s Total and Norway’s StatoilHydro signed a deal establishing the Shtokman Development Company, a joint venture that will develop (but not own) the eponymous gas field in the Barents Sea. The timing was highly symbolic, ten days before the election of Gazprom’s Chairman Dmitry Medvedev as Russian president and ten days after lavish celebrations of Gazprom’s 15th birthday starring outgoing president Vladimir Putin.

The Shtokman project epitomizes Putin’s policy of combining state control over oil and gas with accelerated development. The deal marks a new frontier for the pivotal Russian gas industry firmly under Russian state control. The energy giant threesome formally established what had been agreed months ago. It is a special purpose vehicle that will develop the field while leaving the license in the hands of Sevmoreneftegaz, Gazprom’s 100 percent subsidiary. In contrast, Gazprom holds a 51 percent stake in the SPV. Total has 25 percent and StatoilHydro – 24 percent.

Gazprom comes up trumps

The creation of the Shtokman Development Company puts an end to a number of intrigues that developed over the past two years. In 2005, initial intense jockeying among foreign energy companies to join the Shtokman consortium resulted in a short list, comprising the Norwegian companies Statoil and Hydro, the U.S. majors Chevron and ConocoPhillips, and France’s Total.

Jaws dropped at Gazprom’s hubris in October 2006, when its CEO Alexei Miller declared that the company did not need any foreign partners to develop Shtokman, but would go at it alone.

Then, in July 2007, Gazprom relented and closed a deal with Total, which the Financial Times termed possibly “the worst a foreign oil company has ever accepted in Russia.” Gazprom retained full ownership of the field and the production license while gaining access to Total’s liquefied natural gas (LNG) expertise.Later the same year Norway’s merging Statoil and Hydro agreed to similar terms.

From the Russian point of view, there was poetic justice in avenging the humiliatingly one-sided Sakhalin PSA deals of the early 1990s. These had just undergone a major revision, and Gazprom been cut in on the deal following foreign company harassment by Russian state watchdogs.

In this case, the boot was on the other foot. The deal, which reduced Western oil and gas majors to the role of mere contractors, was seen as catalyzing the era where multinationals would only be able to access reserves in junior partnership to state-owned companies.

Gazprom’s subsequent announcement that all Shtokman gas would go to Europe (without the liquid natural gas supplies previously envisaged for North America) combined with the exclusion of US companies from the project, pointed to geopolitical considerations and caused further irritation.

But this year, the emotional reactions have given way to a calmer approach. Observers were pleasantly surprised to learn that the foreign partners will be able to book the field’s reserves – boosting a key market indicator of long-term economic health of the companies and raising their status.

“They were originally hoping for ownership rights, but it was pretty clear that they weren’t going to get these. They were allowed to book reserves, which surprised analysts. That makes them much more than just contractors,” USB Moscow analyst Dmitry Loukashov said.

“Basically, what the foreigners get from this project is booking reserves proportional to their stakes in the SPV, and secondly, they will be entitled to profits. They will have ownership rights only to infrastructure, not to the field itself or the gas produced,” said Constantine Batunin, an oil and gas industry analyst at Alfa-Bank.

According to French energy expert Pierre Noel, the same results could have been attained through a conventional contract with shared ownership of the field. He argues that the difference is symbolic, but the issue itself, he believes, is all about symbolism of who has the upper hand.

However, one crucial aspect for Gazprom will be far from symbolic. The deal means Gazprom owns the gas, and thus dictates the markets where it will be sold. This secures Russia the extra-economic leverage, the “soft power” it is demanding from its resource base.

The tip of the iceberg

Having decided who will own the gas when it comes on stream, the only outstanding issue is drilling 4,000 meters below an uneven seabed, 350 meters below an iceberg-ridden ocean 550 kilometers from the mainland.

“They simply do not know exactly how they are going to do this,” Batunin said. “Gazprom admits this openly. It doesn’t pretend to hide the fact. But they believe they can do it, and the deadlines are tight, with gas to go on stream in 2010.”

In 1988, when the Soviet Union discovered the sprawling gas field 550 kilometers northeast of Murmansk (on the Kola Peninsula), the super-giant field was estimated to harbor some 3.2 trillion cubic meters, in addition to around 31 million tons of condensate.

The unique features of the field meant that assistance from foreign partners was inevitable. It is technological expertise, and not financial resources or market access that determined Gazprom’s choice of partners.

“It would have been impossible to pursue a project like Shtokman alone both financially and technologically. Total has expertise in LNG and deep sea projects, and the Norwegian companies have expertise in the area, so for Gazprom it is about risk reduction and sourcing technology,” Batunin said.

“Frankly, it’s yet to be decided which technologies should be used for this project. It might not even be the Norwegian technologies. This is going to be an incredibly sophisticated project. All similar Norwegian projects are significantly less ambitious than this one, because the field is located very far offshore, and new technologies have to be created. These will be created on the basis of expertise that Statoil has, but they will be new.”

The project is mind-boggling. There are 565 kilometers of open sea between the Shtokman field and the onshore production facilities at the Barents port of Teriberka. A sea populated by icebergs and drift ice with sub-zero temperatures, polar nights, mega-waves and an uneven seabed. A total of 156 wells will be drilled to a depth of 1,900 to 2,300 meters below the sea floor. Four platforms will be built, and forty wells drilled directly from the seabed.

“Gazprom realized nobody would do this sort of job on a contractual basis,” says Loukashov. “The foreign partners will have more responsibility because of the technological demands.” Pierre Noel agrees that it was the technological difficulties that drove Gazprom to share risks.

But the main technological dilemma concerns the pipeline link to the mainland. Statoil managed to cover 160 kilometers from the pioneering Snovhit gas field to their liquid natural gas plant on Melkoya Island. Anything over that has never been attempted.

Is Gazprom up to the challenge? Politicized, bureaucratic and opaque, it would seem that the company is the weakest link in the Shtokman troika.

However, precisely by relegating foreign partners and taking most of the risk upon itself, Gazprom and the Russian government have turned the development of the Shtokman field into a prestige project – Gazprom’s very own Winter Olympics, substituting Shtokman for Sochi and symbolizing national revival. With the Russian penchant for gigantism and Gazprom’s chairman becoming president, this could mean there is too much hinging on the project for it to be allowed to fail.