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Streetwise Professor

May 21, 2014

Still as Clear as Mud

Filed under: China,Energy,Politics,Russia — The Professor @ 3:21 pm

We all know the real reason Putin did a last hour gas deal with China: he wanted to make me look bad.

For yes, mere hours after I declared my perspicacity in doubting that the widely expected deal would get done, the Russians and Chinese announced that they had reached an agreement. So my powers of prognostication were short-lived. Don’t gloat too much, Vova.

That said, I believe that there is less here than meets the eye. Or at least, there are many outstanding questions.

Although the deal supposedly agrees on pricing, the pricing structure is very opaque. Gazprom’s Miller said the pricing was set, but a “commercial secret.” In other words, he would tell us, but he’d have to kill us.

People are widely quoting a number for the price, based on Gazprom leaks and back of the envelope calculations based on announcements of the notional value of the deal ($400 billion over 30 years) and the quantity (38bcm/year). But as I noted in the post a couple of days ago, there is no way that the parties would set a fixed price for the 30 year term. Instead, they would agree to some indexing formula. Gazprom said that a “base price” had been established, and Putin said that the contract utilizes oil indexing. (In my original post I said this was an important thing to look for. On its own, this is a win for Gazprom, which has been a diehard advocate of oil indexing. But given the lack of any gas hubs in Asia, it’s hard to see what other alternative there is. Perhaps indexing off a European hub, but this would present real problems for Gazprom.)

But all that said, the devil is in the details. Since the price is indexed, any statements about a flat price (e.g., $350/mcm) are based on a huge number of assumptions on the indexing formula. Since nobody knows what that formula is, they have no clue on what the real price is. (And since the oil forward curve doesn’t really go out much beyond 10 years, there would still be incredible uncertainty about the revenues that Russia will realize or could lock in by hedging even if the formula was known: given that the gas will not flow for another 6-7 years, the forward prices that would be input into the formula for the last 20+ years of the 30 year term of the deal can’t be known with any precision.)

And the devil is indeed in the details of these assumptions. There are infinitely many ways to create an oil-indexed formula, and the economic outcomes vary crucially with the exact parameters that are chosen as inputs to the indexing formula. (Indeed, the weights can be made to vary over time.)

Moreover, there are some clues that things aren’t quite as final as the public crowing suggests. Putin says that the Chinese have agreed to front $20 billion towards the construction of new infrastructure, with Russia ponying up $50+ billion. But Gazprom’s Miller says that the “two sides were still in talks over any advance.”

Well wait one cotton picking minute. Upfront payments have to be offset by favorable prices over the life of the deal, to compensate the Chinese for the principal amount of the advance and the interest on it. If the upfront payments haven’t been set there is no bleeping way that all of the pricing terms are set. These terms are interdependent.

That little slip by Miller is, my friends, a huge red flag that this deal isn’t as done as the principals claim. Huge. If that part is still under discussion, the entire thing is still under discussion.

Here is my cynical interpretation (and when Russia is involved, and China is involved, cynicism is the order of the day-and when both are involved, oi!). The failure to reach a deal was so embarrassing to Putin that he was desperate to leave Shanghai with his signature on something. So the parties basically memorialized what they had already agreed to, but there are crucial gaps to be filled, and the negotiations to fill these gaps continue. The basic contours of the deal (e.g., some sort of oil link) are known, but the exact parameters, and the upfront payment, are still TBD. The Chinese accommodated, because letting Putin save face cost them nothing, and could benefit them later.

Gazprom stock popped a couple of percent on the announcement, but given the continued ambiguity, and the past fading of these deals after the initial fanfare, I consider that market reaction to be optimistic. I won’t be convinced that this is real until I see pipe being laid. Talk is cheap, and all we have now is still just talk.

So as far as I am concerned, there are still substantial doubts over the solidity of this deal. The admitted lack of agreement over the upfront payment is telling. Until the parties agree on that, they haven’t really agreed on anything.

In other words, things are still as clear as mud.

 

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15 Comments »

  1. Either way the two sides need eack other. Simple convenience. China: Massive Demand; Russia, Massive Supply….. Absent this convenience…should the cash px ever embarass the ChiComs they simply wont perform…..same as it ever was…..that’s why RIO and BHP wanted px linked to monthly spot px. Viz., 2009 ChiCom lasc of perf. on extant Iron Ore contracts (annual)

    Comment by t c phillips — May 21, 2014 @ 5:20 pm

  2. Either way the two sides need eack other. Simple convenience. NatGas/Oil China: Massive Demand; Russia, Massive Supply….. Absent this convenience…should the cash px ever embarass the ChiComs they simply wont perform…..same as it ever was…..that’s why RIO and BHP wanted Iron Ore px linked to monthly spot px. Viz., 2009 ChiCom lack of perf. on extant Iron Ore contracts (annual)

    Comment by t c phillips — May 21, 2014 @ 5:23 pm

  3. Probably former US Gas Traders (from Enron?) wrote the contract and included “Price Majuere” clauses… ;-)

    Comment by JavelinaTex — May 21, 2014 @ 9:01 pm

  4. Last time I heard a headline number so big and shockingly full of smut, was the Enron/Blockbuster deal for $45billion. http://online.wsj.com/news/articles/SB1011217368129907240

    Comment by scott — May 22, 2014 @ 3:23 am

  5. @scott. Good memory. I’d forgotten that. Ah yes, the days when bandwidth was going to become the next big commodity market. Enron, Williams Communications, etc. And what, 99 pct of the fiber was dark?

    And here we are, a decade later and an order of magnitude more.

    And people wonder why Gazprom sells at 3x earnings.

    The ProfessorComment by The Professor — May 22, 2014 @ 10:08 am

  6. @tc. Yes, *if* price terms are ever set there will be ex post opportunism, holdups, haggling, etc. Not just from the Chinese either. The oil indexed price will always be out of alignment with value, meaning that one party will always be unhappy.

    The RIO and BHP solution worked because there is a reasonably liquid spot market for iron ore, so the index tracks value. This will not be true of an oil indexed deal.

    The ProfessorComment by The Professor — May 22, 2014 @ 10:11 am

  7. My mentor, long dead, in the Mortgage business said a contract is the starting point for negotiations when something goes wrong. Between sovereign entities, even more so. Between these two sets of Kleptocracies, both with revanchist and irredentist chips on their shoulders each the size of a small planet, this is going to be a real spectacle!

    Comment by Sotos — May 22, 2014 @ 3:38 pm

  8. @Sotos. Your mentor, God bless his soul, was very right. Indeed, there is an entire academic literature that expounds the same point, though probably more tediously and pedantically than your mentor. The contract establishes threat points in bargaining that is ongoing, basically.

    Re the specific parties to this contract (*IF* it actually exists) you are again right. Scorpions in a bottle. Declining (or declined) power and a rising one (though with big feet of clay). Both are convinced of their specialness and superiority. Like you say, both carry major grudges and resentments. (Putin goes on and on about getting respect: he did it again today at the St. Petersburg forum.)

    They deserve one another. Truly. ‘Til death do them part. And may it be soon.

    This brings to mind the old Meatloaf song, Paradise by the Dashboard Light:

    I swore I would love you to the end of time

    So now I’m praying for the end of time
    To hurry up and arrive
    ‘Cause if I gotta spend another minute with you
    I don’t think that I can really survive

    The ProfessorComment by The Professor — May 22, 2014 @ 3:59 pm

  9. Professor.

    Face it.

    Putin just pwned your azz.

    Comment by Green as Grass — May 23, 2014 @ 3:11 am

  10. Substantiate it.

    Comment by LL — May 23, 2014 @ 4:29 am

  11. @Green. Yeah. I understand. He’s just been waiting for the opportunity and I gave it to him.

    @LL-What’s “it”? To whom are you directing your question?

    The ProfessorComment by The Professor — May 23, 2014 @ 10:29 am

  12. That was directed to Green, sorry.

    Comment by LL — May 23, 2014 @ 11:35 am

  13. @LL. No sweat. Wasn’t sure. I think @Green was playing along with the intro to the post.

    The ProfessorComment by The Professor — May 23, 2014 @ 11:40 am

  14. If you want to understand the gas deal, look at the Chinese-Venezuelan energy vassal model. The Venezuelan oil deal was also political rather than commercial, Chinese up front ¨loans¨for infrastructure turned out to be tied to Venezuela single sourcing work and supplies from Chinese contractors, a large part of the ¨payment¨ is actually made up of Chinese barter goods and services at inflated prices, giving China a effective backdoor discount on the headline price. But it was worth it to Chavez so that he could still claim he was freeing Venezuela from the depredations of the ¨evil empire¨. It is no coincidence that on the deal day Russia announced a series of ¨unrelated¨ lucrative no-bid infrastructure contracts in Russia to the Chinese rather than to the usual local suspects. Look to see how much of China`s now redundant construction sector ends up pouring cement and laying pipelines in Siberia rather than building ghost cities back home to understand the actual ¨price¨.

    Comment by ramblarou — May 23, 2014 @ 10:15 pm

  15. @ramblarou-The Credit Mobilier aspect is a major part of both Chinese and especially Gazprom dealings. This makes it almost impossible to know who made how much.

    The ProfessorComment by The Professor — May 26, 2014 @ 2:00 pm

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