Challenges ahead for Russian LNG

Russia looked at tapping into the lucrative LNG markets several years ago but times have changed. Lianna Brinded investigates if the country is still aiming to compete with other LNG players and how it is adapting to the changing gas market landscape

Russia - bearish on LNG

Unconventional gas sources have transformed the global gas markets and have left countries competing for a foothold in various gas plays such as liquefied natural gas (LNG). As the world's largest gas producer, Russia has invested a substantial amount of time and money in developing its own LNG plants and projects to cater for projected high US gas demand. But the global economic crisis and the unexpected success of shale gas in the US have radically changed the gas market. Russia now seems to be lagging behind in LNG production and supply to both the US and the fast-growing Chinese market compared with other LNG players such as Qatar and Australia.

"Delays to Russia's participation in the LNG markets have been caused by two major upsets, through no fault of their own," says Ross McCracken, editor of Platt's Energy Economist. "First, the sudden drop in demand for gas in Europe; recession in the Organisation for Economic Co-operation and Development (OECD) [countries] has squashed a lot of projected demand in the last two years. Second, the incredible success of US shale gas has upset the balance of global markets. This US phenomenon has meant that previous US LNG demand projections have proven to be completely wrong, as domestic supply has been so strong."

In addition to delays in Russia's earlier plight to become a major LNG supplier to the US, the country is looking to refocus its efforts in the gas markets with various LNG projects. Despite the short-term refocus, Russia is still looking to the LNG market for the longer term.

"The recent rapid development of unconventional gas resources in the US and Canada, particularly in the last three years, has transformed the gas-market outlook, both in North America and in other parts of the world", says the International Energy Agency (IEA) in its 2010 Gas Market Review. "The under-utilisation of pipeline capacity between the main regions and global LNG liquefaction capacity combined is expected to rise from around 60 billion cubic metres (bcm) in 2007 to close to 200 bcm in the period 2012-2015, as a number of new projects come on stream."

The LNG business is an integrated one, from production and liquefaction to shipping and regasification. The Paris-based agency also says that the 2009-2013 period will see liquefaction capacity increase from 373 bcm by the end of 2010 to 410 bcm by the end of 2013. Over a five year period, IEA figures show a 50% increase in capacity.

Existing global LNG liquefaction capacity currently stands at 351.9 billion cubic metres per year (bcm/yr), which is set to increase to at least 459.2 bcm/yr, according to Platts data (see table 1).

"Unconventional gas in the US has certainly caught everyone - including Russia - off guard," says David Hart, oil & gas analyst at independent brokerage and investment house Westhouse Securities.

Gazprom, which is responsible for 85% of Russia's gas output has said that it aims to capture 25% of the world LNG market by developing gas fields in three main region: Sakhalin in eastern Russia, Shtokman in the Barents Sea and those in the Yamal Peninsula.

Until the end of 2008, Gazprom developed its business based on three super-giant gas fields in Western Siberia, however production in these fields is declining at around 20 bcm/yr, says the IEA. The agency says that "significant new investment is needed upstream to ensure adequate and timely natural gas supplies."

Analysts say the Yamal Peninsula is critical to replace production in Western Siberia, while the Shtokman LNG project is meant to be the biggest offshore development for the Russian gas industry with an estimated 3.8 trillion cubic metres (tcm) worth of gas.

Russia made some strides in the LNG markets after exporting LNG for the first time last year, by launching a stand-alone LNG marketing project in the Asia-Pacific using gas supplied from the Sakhalin basin. The group then said it had "replenished its portfolio with a long-term supply of LNG volumes until 2028".Dealing with delays

However analysts are unconvinced that Russia will reach this target. "This looks overly ambitious in the current climate", says Craig Lowrey, consultant at financial risk consultants JC Rathbone Associates. "For example, the Shtokman field will now be delayed by three years until 2016 (for pipeline gas) and 2017 (for LNG). The Sakhalin II project has also experienced delays in terms of the potential for expanding production, although progress on the Yamal Peninsula has been more promising, with Gazprom signing a deal with Novatek in June to develop a pilot LNG project in the region."

Indeed, delays are largely due to two main factors that are out of Russia's control; the glut of unconventional gas supply and the global economic crisis, which have both stemmed US demand.

"The exponential growth of shale gas in the US has dented the growth potential in the global LNG market," says Lowrey. "This could well continue if shale extraction increases at the expected rate. As a result, not only has shale gas expansion affected Gazprom's plans for growth in the US through the supply of LNG, but it has also contributed to a drop in global gas prices that has contributed to the kind of investment delays."

While Gazprom has had some success with its Sakhalin II gas project, it has still failed to make a call on whether to expand the $22 billion project, Russia's first LNG plant, which started up last year, just north of Japan.

"Capital expenditures were cut by 30%," said Alexey Miller, deputy chairman of Gazprom's board of directors and chairman of Gazprom's management committee in his latest statement to shareholders. "But the reduction didn't affect the company's major projects."

However, analysts believe that Russia and other countries' LNG market plans have been scuppered by the unexpected success of unconventional gas sources.

"Investment in LNG terminals in the US did not take into account, or under-estimated, the development of unconventional gas sources, notably from shale," says Harry Tchilinguirian, head of commodity markets strategy at BNP Paribas. "As hydraulic fracking techniques and horizontal drilling were perfected, the US could exploit very large domestic reserves. The boost in reserves brought by the development of shale means that US domestic supply is sufficient to cover future consumption well into 2030 and beyond according to some estimates."

Hart adds: "The sheer amount of unconventional gas in the markets has shifted expectations of LNG producers because it wasn't too long ago that there was a potential shortage of natural gas in the states. However, with a growing number of shale gas plays, this is no longer the case any more and alternative markets are sought after. Thus far, Asia is doing a good job of mopping up the output."

And this is where Russia seems to be falling behind. Before the success of US shale gas, Russia ploughed its efforts into developing and producing LNG to export to the US. Meanwhile, major players in the LNG markets, such as Qatar and Australia diversified their sales and focused their efforts on the major demand for LNG from China.

"Gazprom's role in the LNG sector looks to have stalled," says Lowrey. "Or more accurately, it looks to be standing still relative to the progress that has been made in other markets, such as Qatar and Australia."

Australia, which has double the existing LNG liquefaction capacity compared to Russia, with 27.1 bcm/yr, has secured some of the largest LNG deals with China, securing its foothold in the lucrative market.

Australia's oil and gas exploration and production company Woodside Petroleum secured Australia's biggest ever single export deal with a preliminary agreement with Chinese energy producer PetroChina to sell up to $45 billion worth of liquefied natural gas from the as yet undeveloped Browse Basin two years ago.

China's growing energy demand continues to fuel a resources investment boom, with projects such as Chevron Corporation's $39 billion Gorgon LNG venture in Western Australia.

Change of strategy

Waning US gas demand due to the abundance of supply and the strained macro-economic picture has also led to a stalemate in gas prices, which has severely affected the need for Russia to pursue the US as a LNG buyer base.

"Russia's focus has changed from addressing US demand to Asian demand," says McCracken. "Countries like China are the new areas of demand growth."

China's LNG demand forecasts were boosted from earlier estimates by 48%, as unconventional supply looks to plug the supply and demand gap, says energy research firm Wood Mackenzie Consultants.

"China's demand for LNG is driving Asia-Pacific LNG market growth," says Gavin Thompson, China Gas Study director at Wood Mackenzie. "We now forecast China LNG demand in 2020 to be 46 million tons per annum (mtpa), up from our previous forecast of 31 mtpa. This will expand the opportunity for LNG suppliers seeking to secure markets, particularly those in Australasia. However, China's LNG import growth will be mitigated by the emergence of indigenous unconventional gas."

Analysts say that Russia's priorities may have shifted over the past two years but Gazprom still looks to embed itself in the market in different ways, whether through LNG gas swaps or direct LNG sales.

"The LNG markets offer Russia diversity in the markets they supply across the world, where pricing and demand can vary regionally," says Jon Clark, director of oil & gas at transaction and advisory services firm Ernst & Young. "Additionally, for more remote projects, LNG is potentially the only way to develop them as pipelines may be uneconomical."

Looking east

Gazprom changed tactics in the LNG markets over the last year to address China's demand. While its LNG projects and investment may be stalled, Gazprom looked at other ways to stay in the market and shift its focus to China, rather than the US.

"The commercial talks with China National Petroleum Corporation (CNPC) on Russian gas deliveries to China under long-term agreements have progressed significantly," said Miller in a shareholder statement in late June this year. "We are at a new level in the relationships with our Chinese counterparts. There is a clear understanding of the parties' interests and a constructive dialogue is underway that will bring tangible results before long, we hope."

Earlier this year, Alexander Medvedev, deputy chairman of Gazprom's management committee and director general of OOO Gazprom Export told Energy Risk that Gazprom shipped 1 million tonnes of LNG to China as the US gas market developed an unfavourable pricing environment.

"We have a terminal in California and two projects in the US and owned 1 million tonnes of LNG," Medvedev said. "We looked to market it in the US, but only with a favourable pricing environment. Because the environment was not favourable, we sold it in the Asia-Pacific, specifically China."

Gas prices have been depressed for a long period of time, and this has clearly made Gazprom re-think its strategy in terms of its LNG customer base.

"Investing in any type of infrastructure is a long-term play and you have to understand that markets can change significantly in the future," says Clark. "For Russia, they have to take a view on the long term of whether there will be more gas demand in Europe, China or in the US. While [Russia] already has a stronghold in domestic and European gas markets, with the gas price depressed in the US following the glut of shale gas, currently exporting LNG to the US doesn't seem like such a good idea."

Gazprom has opened new offices in Singapore in 2010, to cater for China's LNG demand.

After establishing LNG trading with China, analysts say Russia is looking to develop its participation in the LNG markets in different ways.

"There have been some indications in the market that Gazprom is looking to participate in existing LNG projects in addition to developing its own assets," says Lowrey. "This could be a better expansion route for them in the short term. For example, Qatar Petroleum has invited Gazprom to take part in developing new LNG assets in [Qatar] once the moratorium on expanding production at the North Field is lifted in 2014, but I don't know how far talks on this have got."

While Gazprom looks set to enter some existing projects, analysts say that Russia's energy behemoth could focus its investments in pipelines in the shorter term.

"To some extent, Russia has to weigh the advantages of building direct pipelines from regions like Eastern Siberia against the development of north European LNG projects," says McCracken.

However, as with all infrastructure developments, investments would need to be substantial and long term. Analysts say this may be a consideration for Gazprom, but it would not necessarily amount to a long-term plan to meet Chinese gas demand, as this would require a complete re-think of its project development and investment policy.

Despite the delays to existing projects and the lag Russia seems to have when compared to big LNG market players like Qatar and Australia, analysts stress that Russia will still have a strong foothold in the LNG market in the long term.

"I do think Gazprom will be a big LNG player in the longer term," says McCracken. "While it is still the largest player in the gas pipeline market, having a foothold in the LNG market too means that will be more competitive and will give Russia better control and perspective of the markets."

Moreover, market players say that the very factors that have delayed Russian LNG production projects, may help once favourable market conditions for LNG development return.

"Shale gas production comes at a price," says Moorfield. "Horizontal wells and multi-stage fracking are expensive and the current gas price of around $4-4.50 per million metric British thermal units (mmBtu) is approaching break-even. While gas inventories have continued to grow at fairly high rates this year - offset somewhat by the unusually hot summer in the US - companies are turning more toward development in the oil sector."

Russia may have fallen behind on it's a major ventures in the LNG markets, analysts say, but it still intends to become a key player in these markets and in the longer term will be able to compete with big LNG players such as Qatar once projects are completed.

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