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Fri 21 Nov 2008 04:00 AM

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Looking further a field

Richard Baillie explores Europe's gas supply options in the face of an ever more belligerent Russian bear.

Richard Baillie explores Europe's gas supply options in the face of an ever more belligerent Russian bear.

Since the turn of the century European Union energy policy has been constructed with three specific goals in mind: to meet environmental targets, boost energy market competition and increase supply security.

Until recently, the focus was very much on the first two but the credit crunch and high energy prices have slowed moves towards greater competition, while ambitious environmental targets now look harder to achieve.

Meanwhile Russia's growing self-confidence, belligerent foreign policy and desire to restrict foreign investment in energy projects have increased jitters and brought the issue of supply security to the top of the policy agenda.

The growing problem of European dependence on Russian energy first attracted widespread attention during the Ukrainian gas crisis in January 2006, but it has since been reconfirmed by Russian energy diplomacy against former Soviet states Belarus, Georgia, and Lithuania.

These developments highlighted both Russia's willingness to use its energy leverage as an active component of its foreign policy and the vulnerability of the EU to a reliance on Russia as its dominant gas supplier.

And Europe is increasingly vulnerable. Russia supplied 42% of Europe's gas in 2006 and with indigenous North Sea production falling and consumption rising fast, Europe's dependence on Russian gas imports will become more noticeable.

Looking for supply alternatives, the vast gas resources in the Caspian region, primarily in Azerbaijan, Kazakhstan, and Turkmenistan, remain the most accessible alternative energy supplies for Europe.

But although supply diversification is supposed to constitute a key component of European energy security, and despite the urgings of the United States, the EU has been slow at securing access routes to Caspian resources that are not under Russian influence.

To date, the Baku-Tbilisi-Ceyhan (BTC) oil pipeline and the South Caucasus (Baku-Tbilisi-Erzurum) gas pipeline (SCP), constitute the only infrastructure for bringing Caspian energy to the European market that is not under Russian control. Unfortunately for those worried about a growing over-reliance on Russian imports, both pipelines are now in trouble.

The recent conflict in South Ossetia highlighted the risk to the BTC pipeline, which had been earmarked to carry Kazakh oil from Kashagan. Its route runs across Georgian territory and as a result of the conflict its future is now in doubt, particularly as it now seems probable that Kazakhstan will transport its hydrocarbons via Russia instead, rendering a planned capacity increase from 1 bcm to 1.6 bcm unlikely.

Terrorism is a further concern. The newly resurgent Kurdish separatist PKK blew up part of the BTC in August, putting it out of action. Given the possibility of further disruption, Turkey now looks a lot less attractive as an energy bridge between Europe and the Middle East and Central Asia, and the SCP is also vulnerable to similar attacks.

The outlook for the Nabucco gas pipeline is equally bleak. The EU had high hopes that Nabucco would transport gas from the Caspian basin to European markets. But the future of the project is currently hanging in the balance, mainly because it doesn't have enough gas.

On the face of it this is rather surprising, given that Nabucco's capacity is 31 bcm/yr, while the IEA estimates the EU will need to import at least 500 bcm/yr by 2030. The bad news for Europe is that even with optimistic estimates, getting Nabucco to 31 bcm is going to be difficult.

Azerbaijan can supply at best probably 10 bcm, while official estimates of Turkmenistan's gas resources tend to be wildly over-optimistic. The regime's claims of vast reserves in the Dauletabad gas field also seem wide of the mark and recent production levels have been disappointing.

Nabucco's backers say that the shortfall could come from Egypt and Iraq, but these are longer-term solutions, and even then it is hard to see the pipeline being much more than half full.

The only way that Nabucco really becomes economically feasible is if it brings Iranian gas to Europe. On paper, Iran has the world's second largest gas reserves after Russia. But they have to yet to found and developed, and infrastructure has to be created.

And all of this will require massive investment. Again, this is unlikely, at least in the short-term.

Royal Dutch Shell recently pulled out of talks with Iran, as did France's Total with chief executive Christophe de Margerie claiming that the political risk was too great.

The reality for Nabucco is that getting a clear commitment on Iranian gas supplies will be difficult, if not impossible.Meanwhile, Russia's conflict with Georgia over South Ossetia and Abkhazia has changed the regional power balance and increased the risk attached to future oil and gas projects, further damaging Nabucco's viability. Worse, the initially estimated cost of constructing the pipeline has risen from €5 billion to around €8 billion.

Nabucco partners in central and Eastern Europe already appear to be voting with their feet in the face of sustained diplomatic pressure from Moscow. Several key transit states such as Hungary are now shying away from Nabucco in favour of Gazprom's rival South Stream project, which is also more attractive to suppliers now that Gazprom is offering to pay the market price for Caspian gas.

Meanwhile, the investment climate for energy projects in Russia has worsened with BP losing TNK-BP, a 50:50 US $7.6 billion joint venture with a grouping of Russian oligarchs.

For foreign investors in Russia, the TNK-BP case has worrying echoes of the fall of Mikhail Khodorkovsky's Yukos, once Russia's flagship oil company, and while TNK BP's foreign executives are unlikely to share Khodorkovsky's fate, the investment climate has been severely soured with the likely result that TNK-BP assets will end up in the hands of Kremlin-controlled Gazprom or Rosneft.

At first glance, the picture is not uniformly bleak. Following years of negotiations, Total and Norway's StatoilHydro are developing the massive Shtokman field in the Barent's Sea and Italy's Eni recently signed a number of deals that allow it access to the Russian downstream market through gas sales contracts, timed to take advantage of the gradual convergence with EU gas prices.

But suspicion remain. Gazprom appears to have joined forces with Eni at least partly in order to stifle criticism from Brussels over reciprocal access to the Russian market, and in any case the failure of TNK-BP is not exactly an isolated incident.

Companies including Total, Royal Dutch Shell, ExxonMobil and Amoco have all failed to make headway in Russia, and with inward investment flows drying up, development plans are at risk, given that Russian domestic investment in new energy projects and infrastructure is unlikely to make up the shortfall.

Taken together, the war with Georgia, TNK-BP and the Ukraine dispute appear to have persuaded the EU that its security of gas supply is under threat, and French Foreign Minister Bernard Kouchner, whose country currently holds the EU's rotating presidency, has spent the summer urging EU member states to club together to give them greater bargaining power in their negotiations with Russia.

But the fragmented nature of European energy policy means this is unlikely to happen. Europe remains divided over how to deal with Russia. France may want the EU to speak with a single voice in its dealings with Gazprom, but other states such as Germany and Italy have broken ranks and chosen to strike bilateral energy deals, rather than reach a common EU negotiating strategy, thereby allowing the Kremlin to divide and rule, fatally weakening the EU's hand in negotiations.

As a result, European states are looking elsewhere for their gas. In terms of pipelines, North Africa is the obvious alternative. Two pipelines from Algeria and one from Libya already supply Spain and Italy, but concerns of the potential price impact of a gas cartel lead by Gazprom and Algeria's Sonatrach are pushing Europe towards greater investment in LNG infrastructure.

There is certainly growth potential. Spain does not receive pipeline gas from Russia and is Europe's largest consumer of LNG. But overall, Europe has only 15 operational LNG regasification terminals with a further 13 under construction.

The credit crisis may impact on the financing of new infrastructure, as will onerous planning restrictions, particularly in Italy, but heightened security of supply concerns should mean that growth in the sector is likely to be robust.

In terms of supply, Qatar and the UAE are already exporting large quantities despite growing local demand for gas putting further pressure on supplies, leading to some delays in projects getting off the ground.

But elsewhere, Total's Yemen LNG project appears set to come on line in 2009 despite some delays, while in the medium-term, Egypt has the potential to boost its share of the LNG market by adding further trains at Idku and at Damietta.

That LNG is increasingly a sellers market will likely spur further LNG development in the region. Contracts are being loosened and the kind of long-term supply deals that were prevalent just a few years ago are no longer the norm.

This makes LNG an attractive proposition for suppliers who are able to divert LNG cargoes to destinations where market prices are highest. Currently, that means North East Asia, but European prices have been edging upwards and if relations with Russia remain poor then the demand for alternative suppliers will grow.

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