The Deal That Wasn't

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Vladimir Putin went to Shanghai to sign an energy pact worth billions of dollars. Too bad China wasn't ready to play ball.

BY KEITH JOHNSON

MAY 20, 2014

Everybody from financial analysts to the Russian government expected Moscow and Beijing to finally ink a massive, $400 billion energy pact Tuesday that's been in the works for nearly two decades. But it didn't happen, with the first day of Russian President Vladimir Putin's much-touted trip to China ending not with a bang but a whimper.

After weeks of Russian insistence that the landmark energy deal was virtually in hand, including Putin's own comments just before jetting off to Shanghai, the two sides failed to clinch the deal Tuesday. That was a shock, a blow to Putin's objectives, and a reminder of how much China has the upper hand when it comes to gas deals with Europe's biggest gas supplier.

Indeed, the failure of Russian and Chinese negotiators to strike the deal on the first day of a two-day trip stems from the issue that has bedeviled them for years: price.

Russia still wants to charge roughly the same, high rates it charges customers in Europe, which average about $12 per million British Thermal Units, a standard measurement of gas volumes. But China only wants to pay what it already pays for gas piped in from Central Asia, which costs about $10 per million Btus. Over the expected, 30-year life of the contract, such a difference translates into at least a $60 billion difference between what the seller wants and what the buyer is willing to pay.

Gazprom executives said just before Putin's trip that the two sides were just "one digit" away from an agreement -- and apparently still are. Russian spokesmen told reporters in Shanghai that disagreements over the price kept the two sides from finalizing the big gas deal on the first day of the summit.

"There really was an expectation that things were going to be different this time. There was a widespread sense that the Ukraine crisis would change the political calculation" for Putin and make a deal more likely, said Erica Downs, an expert on Chinese energy at the Brookings Institution.

That doesn't mean the long-awaited deal is dead, of course. There are still opportunities to finally close the gap still separating both sides, starting as soon as Wednesday in Shanghai. Later this week, global business leaders will descend on St. Petersburg for a big international economic forum that offers another chance to cement an agreement.

But the surprising delay during Putin's high-profile visit makes clear that China can afford to keep playing hardball on the energy deal. There are a host of reasons for that. The European blowback in the wake of the Ukraine crisis has made Russia more eager to tap into a big new market in Asia. Russia's still-undeveloped Siberian gas fields don't have many potential big customers other than China. And global gas supplies are set to spike in years to come, giving China even more options than it has today.

"The Chinese have many alternatives while Russia has none," said Mikhail Korchemkin, the director of energy consultancy East European Gas Analysis.

"The Chinese have many alternatives while Russia has none," said Mikhail Korchemkin, the director of energy consultancy East European Gas Analysis. "Putin needs the contract with China to show the European Union he has a choice" about where to ship Russian energy, he said.

The Ukraine imbroglio has given Russia added reason to sign a deal with China, but it is not the driving force behind Russia's own pivot to Asia. Russia has been looking to the east for new markets since at least 1997, when Gazprom first started talks with prospective Chinese customers. And in 2010, when Moscow laid out its energy strategy for the next two decades, it stressed the role that the Asian shift would play in Russia's energy-export strategy.

More broadly, years of delay in signing the deal with China have coincided with a revolution in global gas markets. The boom in U.S. domestic production of natural gas means the United States doesn't need to import natural gas, which has freed up global supplies, giving Europe and Asia more options right now. Further, the United States will itself likely be a significant gas exporter by the end of the decade, further adding to growing global supplies.

At the same time, traditional gas sellers such as Australia and Qatar are ramping up export plans. New entrants, such as east African countries like Mozambique and perhaps even countries in the eastern Mediterranean, including Israel, Lebanon, and Cyprus, also have big plans to become natural gas exporters in years to come.

All that adds up to a potential glut of natural gas on the market starting as soon as the end of the decade that makes China less willing to make any concessions to sign a 30-year contract for Russian supplies.

Today, importing liquefied natural gas, or LNG, is much more expensive than getting it by pipeline. But all that future gas-export capacity could help push down LNG prices. That's especially true in Asia, where prices have been sky high in recent years due to Japan's reliance on imported natural gas in the wake of the shutdown of all its nuclear plants after the 2011 Fukushima accident.

What's more, on paper, China is sitting on top of the world's most abundant reserves of shale gas. While Chinese development of its shale resources so far has been very slow, that could give Beijing a way to greatly boost domestic energy production and help meet a good part of its expected surge in demand for natural gas. As big as the potential deal with Russia is, it would provide in a first phase only 30 billion cubic meters of gas per year starting in about 2020, or roughly 10% of forecast Chinese gas demand at that time.

So what's next? Moscow has apparently made some concessions in the hopes of securing the contract with China: Putin reportedly floated the idea Tuesday of a tax break for gas fields producing for the Chinese market, which would effectively lower the sales price for China.

But two other areas will be key barometers of Russian willingness to meet Chinese demands: whether Russia allows Chinese energy firms a stake in gas production, and whether Russia lets China build the necessary pipelines. Both would make it easier to solve the impasse over pricing -- but both would require a fundamental shift in Moscow's approach to energy development.

For years, when looking at potential suppliers, China has sought to get a piece of the action in energy production, rather than just buying up gas and oil. Such equity stakes give Chinese firms both experience in developing new gas and oil fields, but also a financial bulwark that helps offset domestically-controlled natural gas prices. Gas deals between China and Central Asia, for example, weren't signed at bargain basement prices. But by having a stake in production operations, such as inTurkmenistan, Chinese energy firms like China National Petroleum Corporation can still make money despite domestic market headaches.

Russia hasn't been willing to go that far yet with Siberian fields earmarked for the Chinese market. But the Ukraine crisis and the need to lock up Chinese contracts for the long term could push Putin to make exactly that kind of concession, said Keun Wook-Paik, an expert on Sino-Russian energy cooperation.

Another way to give Gazprom more negotiating room when it comes to the final price with China -- and to ensure that the China contract is actually profitable for the company -- would be to use Chinese builders for the pipeline itself from eastern Siberia to northeastern China. Russian pipeline projects cost more than comparable projects built elsewhere, not unlike Russian Olympics, and for many of the same reasons, notes Korchemkin, the gas analyst.

Gazprom's main pipeline contractor, Arkady Rotenberg, also reportedly landed billions of dollars worth of government contracts related to Sochi. He was recently placed on a U.S. sanctions list in the wake of Moscow's annexation of Crimea.

Korchemkin estimates that Gazprom's pipeline construction costs could be cut by about 60% by using Chinese firms. That, in turn, would make it more profitable for Gazprom to ship gas to China. But such a move would require Putin to jettison longtime business allies. Whether Moscow's desire to secure the China contract outweighs traditional, political considerations remains to be seen.