DOMESTIC SALES OF NATURAL GAS IN THE RUSSIAN FEDERATION

The Russian federation lacks true market mechanisms. The government controlled
monopoly Gazprom dominates the market. The domestic Russian market is structured in
a way to give this monopoly the leverage to determine directly or indirectly, the
independents’ production level and rates of growth. Gazprom is the dominant player in
the domestic natural gas market in Russia. It controls about 70% share of Russia natural
gas reserves (Gazprom, 2009). The rest is controlled by the independent companies who
have access to the Unified Gas Supply system. Unlike Gazprom, Independents sell their
gas at deregulated prices, but they only meet around 1/4 of Russia’s “blue fuel” needs
between them. (Gazprom, 2009) Thus, it is the responsibility of Gazprom to supply the
rest of the natural gas requirement of Russia.

In spite of its size and influence and significance, Gazprom is subject to domestic
regulations. By law, the company must supply the local market with all the natural gas
need for heating and power generation. This is done, not in line with free market
economics; rather the price of natural gas is regulated by the government. And this is
fixed regardless of whether it is profitable for the company or not. The regulation of
prices of natural gas in the local market in Russia has caused some significant problems.

There is obvious disparity in the price of natural gas in Russia and in other parts of
Europe. Domestic gas prices in Russia are only about 15- 20 percent of the market rate at
which Russia’s gas is sold to Germany. Gazprom lost around 420 million dollars in 2006
on its domestic natural gas sales because it had to sell its natural gas at the government
regulated price. (EIA, 2008) The low price of natural gas in Russia has impacted
negatively on the level of efficiency of the company. It has reduced drastically the gas
industry ability to finance heavy capital spending necessary to boost its natural gas
production. Raising domestic prices towards parity with market rates in Europe is now a
major component of the country’s energy strategy that will play a significant role in
avoiding supply shortfalls in the future.

As mentioned earlier the price of the gas Gazprom sells domestically is set by the
Government. On the other hand, the Government stopped regulating the prices of
alternative fuels, notably coal and fuel oil, in the early 1990s. With, the regulation of its
price, gas became relatively cheaper than other energy source. The Low gas prices forced
other fuels out of the power generation and industrial sectors. As a result, the share of
natural gas in Russia’s energy demand pattern grew from 42.1% in 1990 to 48.1% in
2007. (Gazprom, 2008)

Cheap gas made the introduction of energy conservation technologies and new eco-
friendly fuels noncompetitive. The Russian economy is nowadays the most gas-
consuming economy in the world. Unlike in many industrial countries where gas is
mostly consumed by households, in Russia gas is primarily supplied to power-generating
companies and metallurgical and chemical enterprises.
Artificial restriction of regulated wholesale prices of “blue fuel” supplied by Gazprom to
Russian customers leads to losses and leaves the Company with insufficient funds for its
expansion. In 2005, Gazprom lost eight billion Rubles due to gas supply in the domestic
market. That situation remained has unchanged till now.

Not only does this price aberration hobble growth in the gas industry, which finds itself
short of cash to invest; it carries adverse macroeconomic implications for the entire
economy of the federation. For instance supply of cheap gas to Russian export-oriented
manufacturers is viewed as export subsidizing.

Russia’s top-heavy fuel balance threatens national energy security; with gas being as
cheap as it is, the demand and consumption of other fuel alternatives such as black oil,
peat and coal tend to stagnate. Cheap gas calls for careful utilization. According to
Gazprom, Russia’s gas industry should develop as a free market where prices result from
fair competition, which will become possible once the Government stops mandating gas
prices for industrial consumers.

In recent years, Russia’s economy has developed whole new industries capable of paying
market rates for the gas they consume, rather than the depressed, state-regulated rates. In
this environment, market pricing in the gas industry will not cause the prices to spin out
of control, bumping up inflation. In fact, market pricing will help more accurately
identify industry’s real gas needs; it will also encourage consumers to conserve and
rationally use the “blue fuel” in stead of taking it for granted, while motivating producers
to cut gas extraction, transit and sales costs. Further “Gazprom urged the Government to
abandon its practice of regulating gas prices for industrial consumers. It also suggests that
the prices for gas deliverable to industrial consumers be shaped by stock exchange
practices, while regulated prices should remain only for housing and utilities, the public
sector and households. The interests of natural gas consumers and producers will be
balanced during the expansion of the area, where market pricing for natural gas is
applied, under state regulation of gas transmission tariffs.

DOMESTIC CONSUMPTION OF NATURAL GAS IN THE RUSSIAN FEDERATION

Russia is second only to the United States of America in total natural gas consumption,
with demand totaling 16.6 trillion feet in 2006 and representing 55 percent of Russia total
energy consumption. (Energy Information Administration, 2009) As a result of several
factors, the consumption of natural gas in Russia has been on the increase, and several
projections shows that the increase will continue for a long time to come.

Russia gets over half of its domestic energy needs from natural gas, up from around 49
percent in 1992 (EIA, 2008). Since then the share of energy use from coal and nuclear
has stayed constant, while energy use from oil has decreased from 27 percent to around
19 percent (EIA, 2008).
INTERNATIONAL (EXPORT) MARKET OF NATURAL GAS IN RUSSIA

Exportation of natural gas from Russia started in the mid-1940s, with the export of
natural gas to Poland (Gazprom, 2009). Before 1967, Poland had received about 5.3 bcm
of Russian gas. Exports to Western Europe started in 1968 with the first customers being
Austria OMV

Russia is the world’s largest exporter of natural gas, exporting about 6.6 Tcf of natural
gas in 2006 (EIA, 2008) It derives most of her export earning from the sale of natural gas
to other countries. In 2007, Russia real gross domestic product grew by approximately
8.1 percent surpassing growth rates in all other G8 countries (EIA, 2008). This marked
the seventh consecutive year of economic expansion in this nation. This economic growth
has been driven primarily by energy exports, given the increase in Russia oil production
and relatively high world oil prices during the period. The exportation of natural gas is
vested solely on Gazprom.

Gazprom is now the main foreign exchange earner in Russia, accounting for about
forty billion dollars to the country coffers in 2008 alone. (Krammer, 2009)
In 2007, Gazprom’s earnings from gas export to outside the FSU (excluding excise and
customs duties) increased 3.3% to RUB 873.4 billion. In the CIS and Baltic region sales
grew by 28.6 % to RUB 269.6 billion. (Gazprom, 2008)

The export of natural gas is very crucial to the survival of the natural gas industry in
Russia. This is because although Russia is the second largest natural gas consuming
nation of earth. However, because of the low price of natural gas caused by price
regulation by the government the domestic market is less profitable. Through the export
market Gazprom receives over 60% of its revenues which it uses to offset the losses
incurred on the local market and builds on the company investment resources.

Nature of agreement

Gazprom exports gas to central and Western Europe mainly under the long term
agreement of up to 25 years that typically derive from governmental framework treaties.
Long term agreements with vital customers normally contain a “ take or pay” provision
meaning that the customers agrees to pay for a certain minimum amount of gas even
when a lesser amount is physically used.

The advantage of long term agreement is that it assures steady, ready and a reliable
market. Only long term deals can guarantee the producer and exporter returns on its huge
investments in major gas export projects; besides, also assuring steady and reliable gas
flow for the importer in the long term.

European importers are committed to their long-term agreements with Gazprom. Gaz de
France has renewed its gas import contract until 2030. E.ON Ruhrgas (Germany) – until
2035, Wintershall (Germany) – until 2030, Gasum (Finland) – until 2025, RWE Transgas
(Czech Republic) – until 2035, ENI (Italy) – until 2035. Contract extensions and new
arrangements were agreed on with Austria’s EconGas, GWH and Centrex. Contracts
were concluded with Romania’s Conef Energy SRL for 2010—2030, Switzerland’s
WIEE for 2013—2030, Germany’s WIEH up to 2027, and Czech Republic’s Vemex for
the period till 2013 (Gazprom, 2008).

Destination

Russia is the largest supplier of natural gas in Europe. Most of the western European gets
their natural gas from Russia. In addition, the Baltic and eastern European countries also
gets most of their natural gas from Russia. In fact some of these countries depend wholly
on Russia for supply of its natural gas. Western Europe is the major external market for
Russian gas. Gazprom supplies around 1/3 of Western Europe’s aggregate gas imports.
The largest importers of Russian gas are Germany, Italy, Turkey and France.

Gazprom Group supplies natural gas to the following countries: Germany, Italy, France,
Turkey, Hungary, Czech Republic, Slovakia, Poland, Austria, Finland, Belgium,
Bulgaria, Romania, Serbia, Montenegro, Slovenia, Croatia, Greece, Switzerland,
Netherlands, Bosnia and Herzegovina, Macedonia, Great Britain, Ukraine, Belarus,
Moldova, Kazakhstan, Lithuania, Latvia, Estonia, Armenia, and Georgia.
 Gas sales to Europe in 2007 in bcm; Source: Gazprom, 2008

Source: http://upload.wikimedia.org/wikipedia/commons/c/c4/Russian_natural_gas_as_
%25_of_domestic_consumption_chart.PNG
In the last decade, Russia has reformed its natural gas export policies in a bid to optimize
gas transit costs to Western Europe and gain access to end users. In order to reduce its
operation cost and improve efficiency, Gazprom has gone into joint ventures with some
energy companies in other countries. For instance, Gazprom established the joint venture-
WINGAS owning about 2000 kilometers of pipelines in Germany and Europe’s largest
underground gas storage facility. Gazprom currently owns about 49 % share of the joint
venture. With an interest in WINGAS, Gazprom effectively owns a stake in Germany’s
gas mains. (Gazprom, 2008)

Gazprom also holds an equity stake in Estonia’s Eesti Gaas, Latvia’s Latvijas Gaze and
Lithuania’s Lietuvos Dujos. Due to Gazprom’s participation in the management of gas
companies in the Baltic States, its presence in these gas markets has become more solid.

INDEPENDENT NATURAL GAS PRODUCERS IN THE RUSSIAN FEDERATION

Three major types of natural gas producers can be distinguished in Russia. First,
Gazprom, along with its production subsidiaries; second, independent gas producers, i.e.
smaller gas production companies not controlled by Gazprom; and lastly oil companies
selling their non-flared associated gas or producing gas from their own natural gas
reserves. Nevertheless, Gazprom still dominates the Russian gas business because it owns
the largest part of Russia’s huge natural gas reserve base and it completely controls the
pipeline network through which nearly all gas in Russia has to be shipped. Furthermore,
Gazprom controls the marketing of natural gas on the domestic market.

Despite the fact that gazprom a very large percentage of the Russian gas reserves,
independent producers such as vertically integrated oil companies and specialized gas
companies accounted for 24% of the explored reserves. The remaining reserves belong to
the undistributed fund of Russia gas reserves. Independent producers hold licenses for
gas fields containing an estimated 11.7 tcm of the total gas reserves, of which about 60%
belongs to oil companies (Heinrich & Kusznir, 2005). Most of the reserve of independent
producers is at depths of 4000 meters and more. Most of the deposit belonging to the
independent producers is generally located in remote regions requiring infrastructural
development and special technologies.

The most significant issue for the independent gas producers is access to Russia pipeline
grid control by Gazprom. The principle of third party access to pipelines is established in
law. The principle advocates that third party independent gas producers in Russia should
have access of up to 15% to the usage of the gazprom network of pipelines. However, the
reality on ground is that the independent gas producers still finds it very difficult to gain
access to the UGS mostly based on technical grounds. Gazprom has always opposed
attempts by independent gas producers to access its infrastructure by introducing
extremely strict access requirements and claiming lack of free capacity mainly because
the pipelines are clogged with transit gas exports from Kazakhstan and Turkmenistan.
This limits independent producers from having unfiltered access to the UGS.
The argument of lack of free capacity in the gazprom network appears rather weak
because no independent observer is able to ascertain gazprom figures. Gazprom refutes
the allegation that it denies independent gas producers’ access to it network of pipelines.

In the last few years, the Russian government has repeatedly pushed back reform plans
for as well as liberalization of the Russian gas market which is what pipeline access for
the independent producers would connote. Due to several factors, gazprom is projected to
experience a shortfall in supply of natural gas. On the other hand, the demand for natural
gas by its major customers is expected to rise. Thus unless there is a significant increase
in Russia production capacity, it will unable to meet the level of demand of natural gas by
it foreign customers. The independent producers could alleviate some of the pressure that
Gazprom will face. Remarkably, the contribution of independent producers to the
Russian gas industry has increased yearly since 2001 (Heinrich & Kusznir, 2005)

In recent times the most crucial and until now unsolved issues for independent gas
producers is the access to Russia’s pipeline grid control by Gazprom. The principle of
third-party access to pipelines is established in law, but it is virtually unenforceable
(OECD 2004: 147). Since 1997 the Russian government has repeatedly passed
resolutions on access for third-party organizations to Gazprom’s pipeline grid, under
which independent gas producers would have access to up to 15% of Gazprom’s
transportation facilities (Interfax Petroleum Report, 8–15 August 1997, pp. 17–18).
However, independent gas producers have found it hard to gain access, mostly on
technical grounds. Even if all gas producers were to be granted access to the Russian
market, there is still the matter of access to foreign markets to consider

FOREIGN INVESTMENT POTENTIAL IN RUSSIA NATURAL GAS INDUSTRY

No country generates as much interest nor as much worries amongst energy investors
worldwide today as much as Russia. Its role in the energy sector is very crucial not only
because it holds world’s largest gas reserves, second largest coal reserve and seventh
largest oil reserves, but because it is the worlds largest gas exporter, second largest
exporter and third largest energy consumer. Unlike many other energy supply-based
economies, it is not facing the problem of managing oil and gas production maturity, but
its major problem now is how best to establish positions in new markets and to develop
its enormous potential.

The International Energy Agency (IEA) estimates that the required levels of energy
sector investment in Russia over the next 25 years could amount to some $900 billion.
Whilst much of that investment will come from Russian domestic players keen to
consolidate their position, international investors will also have a part to play. There will
be stiff competition for investment into available upstream, midstream and downstream
opportunities in Russia not only from the full range of the international oil companies but
also from national oil companies (particularly from resource-hungry Countries such as
India, Japan and China) who are looking to secure interests in strategic reserves
Till date, the history of foreign investment into Russia’s energy sector has been
somewhat chequered. Some foreign investments have worked out well; on the other hand
numerous joint ventures have failed due to several factors. Examples of successful
foreign investment to date are BP’s participation in TNKBP and ConocoPhillips’
investment into Lukoil. On the negative side, Total withdrew its planned investment into
Novatek

Russia’s economic growth over the last 5 years has been driven primarily by energy
exports, particularly in consequence of the boom in Russian oil production and high
world oil prices during this period. Such growth has made the Russian economy
dangerously dependent on oil and gas exports however, and especially vulnerable to
fluctuations in world oil prices. Roughly two-thirds of Gazprom’s revenue comes from its
export sales to Europe. Russia’s domestic gas market presently benefits from low prices
which are effectively subsidized by export gas prices; although the Russian government
has more recently sought to increase prices to domestic industrial customers, domestic
prices are still significantly less than export prices. In the long term this could cause
foreign investors into Russia’s gas sector to be pre-occupied with projects having an
export element and this could impede the development of the domestic gas sector. The
Russian government has however to some extent recognized the problems with this
pricing disparity,

Looking eastwards there enormous potential for Russian natural gas, There are many
projects and plans to enter the Asian market. For instance there have been ambitious
plans for the export of Russian gas into north western China by pipeline. Russian
Petroleum (a TNK-BP-led consortium), South Korea’s state-owned Korea Gas
Corporation and the Chinese National Petroleum Company have been discussing plans to
construct a pipeline connecting the Kovykta field in east Siberia to China’s north-eastern
provinces and across the Yellow Sea to South Korea. Beyond pipeline exports, Russia
will be looking further afield for markets to export its gas into and this is where the
prospects for growth of the Russian LNG sector become of interest.

LIQUEFIED NATURAL GAS

To convert the natural gas to a liquid, it is cooled to approximately -160 °C. Liquefied
natural gas (LNG) is a colorless odorless liquid, less than half the density of water. The
process of liquefying natural gas reduces its volume by 600 times. It remains in a liquid
state under normal atmospheric conditions, and is transported by sea in specially
designed LNG carriers.
Natural gas has the least environmental impact of all the fossil fuels and the global
demand for it is steadily increasing. Transporting gas in the form of LNG provides the
flexibility of supply to accommodate any number of LNG buyers in different countries.

Russia was a net importer of liquefied natural gas until 2004 (Langer, 2006) however, at
present it is rapidly becoming one of the largest and net exporters of LNG in the world.
There are several factors responsible for this growth. These includes huge domestic
reserves of natural gas estimated to be about 30 % of global supply; secondly, increased
demand fueled by declining natural resources in gas-consuming countries; thirdly;
technological advancements in exploration, production, transportation and storage of
LNG and improved relations with western energy companies and capital sources
especially in the united states and Britain.

Like every other oil and natural gas related resources, the LNG industry in Russia is
controlled by the natural gas giant Gazprom. Until the recent time, gazprom could not
effectively and efficiently market or export its natural gas in liquefied form. But with the
advent of modern shipping and storage capabilities LNG is more cost effective.
Transported by specially designed cryogenic sea vessels and road tankers and stored in
specially designed tanks and with a relative volume of less than two tenths of one percent
of natural gas.

LNG has become much more cost effective to transport over long distances where
pipelines are shut down or do not exist or otherwise are curtailed by capacity. With this in
mind gazprom has mounted an assault on the global LNG market with the aim of
capturing a large chunk of the market.

LNG Plant

Russia’s first LNG plant on Sakhalin Island was inaugurated on 18th February 2009. It
features two production trains, each with an annual capacity of 4.8 million tonnes. Once
the plant has reached its design capacity of 9.6 million tonnes, expected in 2010, the
highly automated facility will continue to be operated by only 300 personnel. The newly
built Sakhalin II infrastructure includes three offshore platforms, an onshore processing
facility, 300 km of offshore pipelines and 1,600 kilometres of onshore pipelines, an oil
export facility and the LNG plant. (Shell, 2009)

Practically all of the 9.6 million tonnes of annual production capacity of the LNG trains 1
and 2 has already been committed in long-term contracts to supply customers in Japan,
Korea and other markets. Sakhalin LNG is the first Russian gas supplied to these regions
and the establishment of the new export route confirms the country’s status of a global
energy power.

The construction of this world-class facility commenced in August 2003, with around
10,000 people employed on site at the peak of construction activities. Construction
workers and specialists came from over 40 countries. The LNG plant on Sakhalin uses a
specially adapted technology of double mixed refrigerant, which enhances the plant’s
efficiency by taking advantage of Sakhalin’s cold climate. 
The LNG plant output was contracted under long-term contracts (some 20 and more
years) before the end of construction. Approximately 65% of all Sakhalin LNG will be
exported to nine buyers in Japan, the world’s largest LNG market. (Lebedev, 2009) The
remaining volume (in approximately an equal split) will go to South Korea and other
markets. This will establish Russia as a new player in Asian Pacific energy markets and
will serve to strengthen the bilateral economic and trade relations between Russia and the
Asia Pacific. It creates opportunities for countries in that region to diversify their gas
supplies and lower their dependency on exports from other sources. The share of
Sakhalin gas in the LNG consumption of Japan, in particular, will approach 8%. The
project which cost around US $ 2 billion, will supply about 50 cargoes of LNG during
2009, mostly to Japan. In addition, Russia will be able to supply 5% of world demand for
LNG in 2010 when the Sakhalin-2 project will be running at full capacity.
The Sakhalin II Project introduced the Russian Federation to a range of innovative
technologies, from LNG production to offshore development of hydrocarbon fields.  The
project, which brought together Russian and International expertise to overcome the
formidable challenges, provides a potential model for similar collaboration in unlocking
much needed reserves in Arctic regions (Shell, 2009)

Gazprom bought control of the US$ 22 billion project after a prolonged crisis that forced
Shell, the project's former leader, and its partners to reduce their holdings. The battle
became symbolic of resource nationalism in Russia and the state's desire and ability to
renege on previous deals. Sakhalin-2 is being implemented under a production sharing
agreement with the participation of Gazprom (50%), Shell (27.5%), Mitsui (12.5%) and
Mitsubishi (10%). It comprises two offshore fields, the Lunskoye gas field and Piltun-
Astokh, which started oil production during the ice-free summer months in July 1999.
Recoverable reserves were given by Shell in July 2005 as 17.3 Tcf gas and 1 billion
barrels liquids.

The new project promises to establish Russia as a new player in Asian Pacific energy
markets and will serve to strengthen the bilateral economic and trade relations between
Russia and the Asia Pacific. It creates opportunities for countries in that region to
diversify their gas supplies and lower their dependency on exports from other sources.

References

Global LNG Market: Russia takes 6% at once: Lebedev K, February, 2009.

http://www.ifs.ru/upload/190209-global.pdf

Energy Information Administration: 2009.

http://www.eia.doe.gov/cabs/Russia/NaturalGas.html

Management report OAO Gazprom: 2008

http://www.gazprom.com/f/posts/71/879403/2gmr.pdf

gazprom: 2009.
http://eng.gazpromquestions.ru/index.php?id=5

Independent Gas Producers in Russia: Heinrich A & Kusznir J, 2005

http://www.kices.org/downloads/KICES_WP_02.pdf
“LNG is HOT” Examining the Russian Liquefied Natural Gas Market: Langer R. 2006
http://www.haynesboone.com/files/Publication/6b936620-6ad3-401d-8184-
adb813a0cc46/Presentation/PublicationAttachment/9ac223a6-3ae3-4d85-87b8-
948be345d81a/Langer-Porter-Willding_LNG%20article_sept.%202006.pdf

First Russian LNG cargo starts its journey to Japan: Shell, 2009
http://www.shell.com/home/content/media/news_and_library/press_releases/2009/
first_russian_lng_to_japan_29032009.html