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LNG Versus Russian Gas In Central And Eastern Europe: Playing Poker On A Continental Scale

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By Nathalie Hinchey and Anna Mikulska

The recent U.S. sanctions leveled against Russia, and Europe’s split reaction to those sanctions, reflect the ongoing struggle concerning energy security on the continent. Western European governments generally oppose the sanctions, as they would target the contentious Nord Stream 2 (NS2) project championed by the Russian and German governments, multinationals and German corporations. Western European countries generally accept the NS2 project as a way to access relatively cheap gas backed by large reserves. Conversely, many Central and Eastern European (CEE) countries welcomed the U.S.A.’s action against Russia because the region has been fighting NS2 based on the conviction that the pipeline would increase Europe’s dependence on Russian natural gas and halt other diversification projects, most importantly developments in LNG that allow non-Russian gas to access the CEE. NS2 is often predicted to strengthen Russia’s monopoly and geopolitical power, particularly in the CEE.

The move towards diversification away from Russian gas in the CEE has been based on three factors: 1) the generally higher prices that the region has been charged for Russian natural gas in comparison to those paid by less dependent Western Europe (Figure 1); 2) the broad belief that Russia uses the CEE’s dependence on its gas to increase its geopolitical influence in the region; and (3) concerns that growing Western European reliance on Russian gas could weaken Western Europe’s willingness to stand up to Russian interference in the CEE countries.

Figure 1. Average Price Paid to Gazprom by Country in 2013

Data Source: Izvestia, Gazprom.

As a result, countries like Poland and Lithuania have invested in and are currently operating LNG import terminals. Both terminals have already accepted LNG imports from Qatar, Norway and, most recently, from the U.S. Other countries, including Estonia, Latvia and the Ukraine, have plans to invest in LNG or have undertaken other efforts that would help diversify their natural gas supply.

But all these efforts are accompanied by a serious doubt that the push for LNG cannot be sustained long-term and will die out organically given the competitiveness of Russian gas. Whether piped via NS2 or other routes, Russian gas can be priced more cheaply than LNG, which, in addition to the domestic price of gas, includes the cost of liquefaction, ocean transportation, and regasification.

There is a concern that the security premium that CEE countries might be willing to pay is not high enough to sustain the new investments in LNG.

However, a recent CES article by Nathalie Hinchey entitled “The Impact of Securing Alternative Energy Sources on Russian-European Natural Gas Pricing”* sheds new light on the impact of LNG investments in the CEE. As opposed to many current publications, the article does not dwell on the importance of geopolitics, an element that is difficult to quantify and measure. Instead, it calculates the direct pricing benefits that CEE countries can incur from securing non-Russian gas suppliers; a phenomenon that is becoming increasingly more feasible as a result of LNG imports through floating storage and regasification units (FSRU). FSRUs are especially appealing as they can be used as LNG import terminals and are cheaper and more flexible than land based LNG import terminals. Further, they encounter less regulatory and permitting burdens.

More specifically, the paper develops an economic model that demonstrates that the introduction of alternative natural gas suppliers into the CEE gas markets has altered the bargaining landscape between the CEE and Gazprom. The ability to procure non-Russian sourced gas from LNG cargoes has allowed the CEE to use LNG as a "credible threat" if Russian piped gas becomes too expensive. This essentially leads to lower prices for Russian gas and puts a ceiling on Russian piped gas with respect to internationally sourced LNG.

The model does a good job predicting the price that Lithuania paid for natural gas imports from Russia in 2016 (after the FSRU LNG Terminal in Klaipeda opened its doors to imports), deviating in its prediction by only 0.38 Euros off the actual price that Lithuania paid Gazprom (25.6 vs. the actual price of 25.98 Euros/100kg). This lends credibility to the underlying thesis that diversification of options can lead to lower, more competitive prices. In 2014, prior to securing Norwegian LNG, Lithuania paid 48 Euros/100kg for Russian natural gas. At the same time, the model suggests that if Latvia decided to purchase only 20% of its natural gas supply from the Lithuanian FSRU Independence, the average price that it would pay for all its gas would decrease by an additional 11% to 21.59 Euros/kg, which amounts to 17,732,485 Euros in annual savings.

Thus, there is a systemic relationship between a country’s ability to procure non-Russian gas and the price it pays for Russian gas: countries with a lesser dependence on Russian gas pay less for that gas.

The results are intuitive. They also explain the differences in Gazprom pricing between its Western European and CEE customers. Western Europe’s dependence on Russian gas is far smaller than that of the CEE, as other sources of supply are readily available: domestic supplies as well as LNG, storage solutions and the ability to use reverse flows if temporary shortages emerge. On the other hand, CEE countries have been historically highly dependent on Russia, some as much as 100 percent, thereby giving Gazprom significant market power. As this relationship changes, so does the bargaining position between the CEE and Russia with respect to natural gas delivery, becoming more similar to that of Western Europe.

This brings us back to the assessment of the viability of LNG imports into the CEE. Prices should not be taken at face value but assessed as part of the entire natural gas market within a country and possibly within the entire CEE region. There is a way to calculate directly how much diversification contributes to lower average prices and to what extent these lower prices justify investments in LNG, storage solutions or new pipeline interconnections, all of which would raise the level of competition thereby weakening Russia’s market power.

At the same time, it is hard to imagine that LNG producers, investors and utilities responsible for natural gas deliveries will fully engage in diversification efforts. Since importing utilities just pass the price of gas through to the customer, lower prices do not necessarily lead to higher profits. Meanwhile, LNG suppliers and investors are likely to turn to markets with the necessary infrastructure already in place and/or standing economic and political will to drive LNG market development. However, the existence of a large incumbent monopoly gas supplier to a region can compromise LNG entry. Indeed, the threat of LNG imports could lower Russian gas prices and encourage more imports of Russian piped gas resulting in any investment in LNG infrastructure being delayed or seriously underutilized.

And here is where governments can play a proactive role in streamlining the investment pathways to developing LNG offtake. After all, lower prices of natural gas are likely to benefit their populations and their economies. Also, a change in their bargaining position vis-à-vis Russia will limit any type of geopolitical influence (actual or perceived) the latter may have derived from natural gas exports. Hence, even if LNG terminals are underutilized, they should provide enough of a “credible threat” to incentivize Russia to cut prices long-term; should Russia increase its prices, importers can always increase their procurement of LNG to compete with piped gas.

So, how should CEE governments proceed?

Poland and Lithuania have already invested heavily to diversify their natural gas supply by building LNG import and regasification terminals in Swinoujscie and Klaipeda, respectively. As aforementioned, evidence indicates that they are already reaping benefits from these investments. Other governments could also follow this course but any action plan should not be considered in isolation. Each country is endowed in different ways and may be able to achieve elements of diversification through them, such as expanded LNG import capability, more storage capacity or development of greater pipeline interconnectivity.

Thus, the viability of LNG imports into Europe will not only depend on whether NS2 is built or how competitive Russian gas is in terms of price. It will also depend on governments’ understanding of what LNG imports (and other diversification solutions that reduce heavy dependence on Russian gas) mean for their natural gas markets and for the market of the entire CEE in terms of reducing Russian natural gas market power, prices, and geopolitical influence in the region. New CES research indicates those governments can tangibly benefit by pursuing diversification strategies and quantifying the potential large-scale economic benefits.

Nathalie Hinchey is a graduate fellow for the Center for Energy Studies at Rice University’s Baker Institute for Public Policy; @NathalieHinchey

Anna Mikulska is a nonresident fellow for the Center for Energy Studies at Rice University’s Baker Institute for Public Policy;  @anna_b_mikulska 

*The most recent version of this study will be published in The Energy Journal, Volume 39, Issue 2, in March 2018. The predicted prices examined in this blog are taken from an older version of the paper, which is freely accessible under provided link. Price predictions vary slightly in the newest version of the paper but do not change the findings.