The EU-Russia Energy Relationship:
From Addiction to Rehab?

Russia is important to the EU as the supplier of about one-third of its oil, gas, coal and nuclear fuel. Russia itself is just as dependent on the EU: More than half of the federal budget comes from taxes and duties on hydrocarbons, and two-thirds of Gazprom’s revenue comes from sales to the EU and Turkey.

Back to main

The Impact of the Ukraine Crisis
The conflict in Ukraine has destroyed trust between the EU and Russia, calling into question Russia’s reliability as an energy supplier. In that respect, the trilateral talks on gas supplies between the EU, Russia and Ukraine might serve in some ways as a confidence measure, supporting the peace process. But so far it has been impossible to agree on a new package to guarantee stable supplies of affordable energy for the EU and Ukraine until March 2016. The EU’s role in the negotiations is to mediate between Russia and Ukraine - who remain very far apart.

In the longer term, Gazprom says that it wants to stop supplying gas via Ukraine to Europe by 2019, and supply it instead via the Turk Stream pipeline to the Turkish Greek border (Turk Stream’s capacity of
63 bcm would be slightly larger than the capacity of the pipelines across Ukraine, which currently supply about 15 per cent of the EU’s gas needs); and, supported by Shell and E.ON, it wants to double the capacity of the Nordstream pipeline under the Baltic Sea to 110 bcm. Any Gazprom investment would have to comply with EU regulations and meet the interests of the EU gas market.

The EU view is that modernisation of the transit route across Ukraine would be cheaper than either building Turk Stream or expanding Nordstream (both of which would simply add to Gazprom’s financial problems, already exacerbated by ‘political’ interruptions to gas sales to Ukraine), and would increase European energy security because it makes use of gas storage available in Ukraine (which is unavailable on the Baltic or Black Sea routes); and Ukraine would be eligible for EIB loans to modernise its gas transit system. Continued use of the Ukraine transit-route also benefits the embattled Ukrainian economy.

The publicly-stated Russian view is that the infrastructure in Ukraine is old, inefficient and time-expired. Given Russia’s disputes with Ukraine over gas supplies and prices, they would rather get away from being dependent on transit via Ukraine. Beside the commercial reasons for Russia to diversify supply routes, however, there is also the political angle: Putin wants to increase his leverage over the pro-Western government in Kyiv. But the fact that Gazprom has warned contractors that it plans to cut the planned capacity of Turk Stream by 50 per cent suggests that Russia is either worrying about the cost of the project or lacks confidence in future levels of European demand.

Ukraine does not have enough gas in storage to get through the next winter, even with reverse flows of gas from Central Europe – it needs 60 – 90 billion cubic meters (bcm), and has 12 bcm. It has raised gas prices sharply – which is cutting demand; but it also needs to remove disincentives for investment: the current royalty tax is reducing domestic production. It should privatise state-owned energy production companies. With a well-run oil and gas sector, Ukraine could become a net exporter of energy.

The EU’s ultimate goal (and the objective of the Energy Union concept) is to make the energy market like any other market, in which prices depend on supply and demand and not on political considerations. To achieve that goal, it needs to diversify supply routes, particularly from the Caspian via the Southern Gas Corridor; and it needs to improve energy security in South East Europe. It is unlikely that Turk Stream will affect the viability of the Southern Corridor. In the north, Lithuania’s new LNG terminal has already forced Gazprom (previously a monopoly supplier) to cut its prices.

Russia as a Supplier
Russia may have systemic problems as a hydrocarbons supplier, despite its huge reserves and its current level of production. Oil producer Rosneft and Gazprom between them have €150 billion of external debt that they must refinance this year. The strategy of creating state-owned or state-controlled “national champions” has decreased the efficiency of the sector (which grew in the early 2000s as a result of private investment e. g. by Yukos, but has now started to fall again). With the right technology and investments, more production can be squeezed out of old, depleted fields – but the state-owned companies in Russia are not achieving this. As a result of Western sanctions on finance and technology, Rosneft has had to cut its capital investment, and Q1 2015 figures show production declining by 3 - 5 per cent per year. It is possible that (as in the West) low prices will eventually drive innovation in Russia, as companies look for ways to increase production and reduce costs.

In the gas sector, by contrast, there is a glut of supply but falling demand: Russia needs to find new customers. European demand for Russian gas has fallen by 8 per cent in 2015. In the period 2010 - 2014, European gas consumption declined by 120bcm. Ukrainian gas consumption has decreased due to the difficult political situation. Increases in Russian domestic gas prices have (as intended) led to a fall in demand. This fall in demand from elsewhere explains Gazprom’s enthusiastic pursuit of markets in China. The question is whether its strategy is being executed in a way that makes sense.

The ‘Power of Siberia’ pipeline, currently under construction, will connect two new but isolated gas fields in Eastern Siberia to their only available market, in China’s north-eastern provinces. It is likely to be a buyer’s market. The Russians are talking up the possibility of taking gas from fields in Western Siberia (the area which supplies much of Europe’s gas) and diverting it to China; but 10 years of negotiation between Russia and China have not yet led to any contracts. There is some disagreement over whether China has so much gas from other sources (Turkmenistan, earlier contacts with Russia, LNG from the Middle East and elsewhere) that it can afford not to buy more Russian gas unless the price is very advantageous. It seems likely that over time it will get more gas from Russia - but it could be a long time.

Privatisation of the hydrocarbons sector in Russia would increase its efficiency; but that would conflict with the priority of the authorities, which appears to be to control the market and the cash flow. And in Russia, with the right connections it is still possible to extract cash from loss-making firms.

For Western investors in the Russian market, a long-term perspective is essential. There have been tumultuous times since they started to engage with the Soviet Union in the 1980s, but relationships have generally been reliable and productive, despite short term challenges. And despite current political tensions and sanctions, Russia is still keen to welcome in Western oil and gas companies.

There is an immense amount of Russian territory which has still to be explored, and plenty of potential for conventional oil and gas to be found and exploited, even before Russia needs to look at shale and other higher cost, more difficult sources.

From the perspective of Western oil majors, Russia is an important partner in a diverse portfolio of suppliers. The European market will work more efficiently if there is a multiplicity of sources of energy (including hydrocarbons from different areas and renewables) and improved connectivity throughout Europe. Equally, Western energy producers expect Russia to diversify its markets over time (notably, increasing supplies to Asia).

The EU’s energy relationship with Russia is fraught with legal complications – legacy issues from Russia’s signature of the Energy Charter Treaty and its subsequent withdrawal; Russia’s complaint against the EU at the WTO (which argues that some European companies have been granted derogations from the Third Energy Package in a way that discriminates against Russia); the EU’s competition case against Gazprom. Russia may be willing to explore legal avenues and negotiate with the EU on their various disputes, but it is far from clear that it is ready to do so. And the lack of rule of law and functioning courts within Russia are probably even more important brakes on Western investment than the various international legal disputes.

America’s Role in the EU’s Energy Market
The American view of the Energy Union is generally positive. It sees European dependence on Russian oil and gas supplies as a political weakness, which can inhibit EU policy-making (for example, diluting its response to Russia’s invasion of Georgia in 2008). The US is ready to contribute to the diversification of EU supplies through LNG. But there are still bottlenecks in Europe’s energy grid, preventing the efficient flow of gas and electricity to the places where it is needed. The EU needs to focus on ensuring that every country is well-supplied, rather than worrying as much as it does about the details of the routes used.

As a potential supplier to the EU, the US has continued to increase gas production despite low prices. A number of LNG terminals have been approved, enabling exports of up to 80 bcm per year to the EU when the US government issues permits. These permits are not dependent on TTIP; but even more LNG would be available, without further licensing, if the US and the EU reached agreement on TTIP. American LNG, however, is not the only solution to Europe’s energy needs – the EU needs to tackle barriers between neighbouring EU member-states, for example Hungary and Croatia, and across the Pyrenees; and entrenched energy companies with cosy links to Russia.

The EU - an Evolving Market
The EU is transitioning to a low carbon, renewables-based economy. But for the next 15 – 20 years, gas will be a key fuel to provide flexibility, and will have a big share of the energy market. LNG is likely to play a role, but only if innovation reduces the cost of liquefaction and regasification; otherwise it will struggle to compete with piped gas. Iran could become a significant supplier of piped gas to Europe if sanctions are lifted (presumably connecting to the Turkish pipeline system). Europe as a whole would benefit from neighbouring countries such as Turkey and Ukraine adopting the EU acquis in the energy field, including the Third Energy Package - the broader European market could be liberalised.

The Energy Union is about demand, not just supply. Energy security relies on competitive, interconnected gas and electricity markets (including aggregators, who can help customers to increase their buying power). Unfortunately, too many member-states (including the UK) continue to prefer to deal with their energy problems nationally or with limited interconnectivity, which increases costs and reduces efficiency. There is EU money available to build interconnectors, but a risk that it may not all be spent. Too many EU member-states, especially in Central Europe, still have local energy monopolies and unhealthily close ties to Gazprom; the EU needs to take on practices which obstruct market liberalisation.

Russia’s preferred model of long-term government backed gas contracts with fixed prices is at odds with the EU’s goal of a proper European energy market. But that does not mean that the EU should stop buying energy from Russia. If companies like Gazprom were properly run, they could be low cost, efficient suppliers. The key to transforming Gazprom behaviour is playing by the EU’s rules. But every time Russia seems to be threatening to use gas as a political weapon, or keeping prices for unfavoured countries artificially high, it damages its prospects as a supplier. The EU needs both strong regulations and strong enforcement to keep Gazprom (and other companies) honest.