Streetwise Professor

October 15, 2010

Gazprom’s Future Threatened? Here’s Hoping!

Filed under: Commodities,Economics,Energy,Politics,Russia — The Professor @ 7:31 pm

Halloween is fast approaching, and Gazprom is getting into the spirit (no pun intended) of the holiday by trying to scare the children in Europe.  (No trip to the costume shop required.  Gazprom is a monster in real life.)

Specifically, Gazprom is telling lurid horror stories about what would happen if, heaven forfend, the EU limits Gazprom’s ownership and control over a pipeline from the Yamal Peninsula through Poland to Europe, and Europe moves away from long term contracts to spot contracting:

Medvedev said the EU initiatives forced Gazprom to change its operational routine to adjust to new rules under which customers have the right to change their nominations once, on the day before supply instead of several times a day. Gazprom now maintains backup transmission capacities to meet the quickly changing demand but under the new rules this is unfair competition, he said.

“It will be very difficult to provide the envisaged reliability and flexibility of supplies without such backup capacities… Taking into account seasonality and an extremely uneven demand throughout the day – reliability and flexibility are of paramount importance for the gas industry,” Medvedev said.

Medvedev also criticized EU plans to switch to a spot market mechanism of gas supplies from long-term contracts favored by Gazprom saying the new mechanism would lead to higher prices.

“Without long-term price contracts the volume of gas coming to the market starts depending on the price appeal. The gas will be available when the price is high. If the price is low, volumes may outflow to more attractive markets or stored until better times. Hence, the reliability of European gas supply will be determined by the competition with other global gas markets, primarily, with Asian ones,” Medvedev said.

He said there were also risks for the development of gas transmission and storage capacities which required heavy investment with a long payback period unattractive to anyone but gas companies.

I’m sitting in the airport waiting out a delay, so I have a lot of time–which is a good thing because The Other Medvedev’s (“TOM”) economic epistle is so chock-full of silliness it will take a while to deconstruct it.

My favorite part is the paragraph beginning: “Without long-term price contracts the volume of gas coming to the market starts depending on the price appeal.”  Uhm, isn’t that the whole idea?  Aren’t prices supposed to guide the allocation of resources to their highest value use?  Is TOM saying that gas currently doesn’t flow to the highest value users?  Isn’t it the point that high prices signal high demand and that volumes should respond accordingly?  And that the reverse is true?

A very telling example of Gazprom’s market-phobia.

Note the use of the scare word: “reliability.”  This suggests that gas will be turned off in a spot market regime.  Hardly.  If gas is scarce, the price will be high, but you can get it if you want to pay for it.

Furthermore, TOM could use a little schooling on the Coase theorem.  A long term contract with the Europeans gives them the right to receive the gas.  But if there is a higher value use for the gas–consuming it later, selling it to another market–those holding that right have an incentive to forego consumption and enter into transactions that ensure that the gas flows to that higher value use.  Basically what a long term contract would do is let the fixed price buyer capture the value of the gas when that value is high (and above the contract price), whereas Gazprom could capture it in a high price regime; the flip side is that the fixed price buyer overpays when the value is low (below the contract price).  So, to a first approximation, the form of contracting won’t affect where and when the gas flows, but will affect the allocation of surplus among the parties.

This analysis, of course, assumes that the parties adhere to the terms of a long term contract.  But Gazprom has an incentive to–and has in the past–acted in an opportunistic fashion.  When the value of gas exceeds the contract price, Gazprom has an incentive to renege opportunistically in order to capture the surplus that would otherwise go to the buyers under the contract.  If the shoe is on the other foot, of course, Gazprom will insist on rigorous adherence to the contract.  Opportunism is costly, as are the governance mechanisms to control it.

Insofar as price certainty is concerned, the development of a robust spot market for gas will facilitate the parallel development of a robust derivatives market for allocating price risk.  A spot market plus derivatives market facilitates efficient allocation of physical gas and gas price risk, while economizing on the contracting hazards inherent in the kinds of long term deals that Gazprom favors.

Note how Gazprom rattles the Asian market skeleton to scare the kiddies–another nice Halloween touch.  Sorry.  That’s getting a little old.  And especially when you’re talking about gas from Yamal, which is way out of position relative to China and other Asian markets.

Insofar as operational efficiency and flexibility are concerned, TOM acts as if he’s never heard of the vibrant North American market for natural gas that has been operating on open access principles for going on 25 years now.  Common carrier pipelines with markets for capacity, gas, storage services, and no integration of producers, transporters, and buyers work incredibly efficiently in North America.  Believe it or not, weather in North America can shift dramatically, leading to equally abrupt changes in the demand for gas.  Moreover, there can be supply disruptions (e.g., hurricanes, pipeline blowups).  Nonetheless, the price mechanism and the array of markets for the myriad, complementary services required to get gas from where it is to where it’s needed deal quite effectively with this fundamental volatility, and on a continental scale.  Gas flows from the frozen Canadian plains and the semi-tropical waters of the Gulf to every point in between on the continent, and can respond fluidly to the twists and turns of the weather, production, and industrial demand.  In short, the post-1986 experience in the US demonstrates that it is possible to achieve the “reliability and flexibility [that are] of paramount importance to the gas industry” without monopoly and vertical integration.

As to “risks for the development of gas transmission and storage capacities which required heavy investment with a long payback period unattractive to anyone but gas companies,” is TOM saying that Gazprom is willing to accept rates of return that do not compensate adequately for risk and the time value of money?  If so, that sounds like another reason to support a market-oriented approach that will employ capital more effectively.

And again, the US experience demonstrates that investors responding to market price signals are perfectly capable of making appropriate investments in transmission and storage.  Indeed, financial players have found investment in storage or acquisition of rights to use storage facilities quite profitable, and have used their knowledge of optionality to maximize the returns to such investments.  (There are a lot of real options in a storage facility, most notably over choosing the timing of inflows and outflows.)  And in the bargain, this rigorous approach to understanding and exploiting the optionality of storage has served to enhance market efficiency, flexibility, and reliability.

In brief, TOM is either a blinkered ignoramus with no knowledge of economics or of the gas market outside his cozy little (well, not little) monopoly, or he is shoveling it fast and furious. Sounds like a pick ’em to me.

This means that nobody should be scared of Medvedev’s Tales from the Crypt.  Indeed, the very developments that Gazprom fears would be a boon for its consumers.

The headline of the Ria Novosti article is “Gazprom says EU gas reform a threat to the company,” which makes it clear that Gazprom is the one running scared.  That threat may well may be a very real one.  And that would be more like Christmas than Halloween, at least to those currently dependent on Gazprom for a good share of their gas.  So this is a RN headline that I hope comes true.

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  1. SO,

    “In the long run we are all dead. I for one wouldn’t mind dying in the course of a nuclear war. It sure beats expiring with multiple tubes up one’s mouth.”

    Just as I thought…talk is cheap.

    Comment by Dixi — October 22, 2010 @ 7:09 am

  2. Lovely terrain for it.

    There’s a virtually undefended airport in Okha, right beside the Rosneft oilfields which supplies the Aliantz refinery in Khabarovsk. The Chinese could land right on the damnned runway.

    I did say the geography of Sakhalin was not your strong point, you might want to stop making it the lynchpin of your arguments.

    Comment by Tim Newman — October 22, 2010 @ 2:35 pm

  3. And any Chinese amphib TF must steam past Japan, unless you’re suggesting they go out the South China Sea and waaaay out in the Pacific.

    Oh my! What a major obstacle sailing into the Pacific to skirt around Japan must be to a Chinese blue water navy!

    Comment by Tim Newman — October 22, 2010 @ 2:47 pm

  4. Good thinking, Timmy, the longer the Chinese steam, the longer the Russians have to prepare to blow stuff up.

    Comment by rkka — October 22, 2010 @ 6:46 pm

  5. Good thinking, Timmy, the longer the Chinese steam, the longer the Russians have to prepare to blow stuff up.

    Armies do not steam into airports.

    Comment by Tim Newman — October 23, 2010 @ 3:56 am

  6. RKKA, time for you to grow up ladyboy.

    The Georgians lost less men than the Enemy forces, which consisted of Russians, South Ossetian militia (who actually had more tanks and artillery by themselves than the entire Georgian armed forces, all supplied by Russia), Russian “volunteers” and the Abkhazian armed forces.

    Now, as to the force ratios, all observers point out that the Russians had a massive and overwhelming advantage in tanks, artillery, helicopters, apc’s, and airpower. If you are too retarded to understand the advantage that this gave the Russians, well more fool you.

    By the evening of the 8th of August, the three motor rifle regiments were
    attacking the Georgians in and around Tskhinvali. The 135th was already to
    the west, the 693rd was pouring below Tamarasheni (north) and the 503rd
    was possibly by-passing the city from the east.18 The Russians were taking
    deliberate care not to enter Tskhinvali itself with their armored equipment.
    The plain on the west of the city would allow the Russians to fan out and
    dislodge the traffic jam in their rear. Some one hundred and twenty T-72
    MBTs, one hundred and ninety BMP-3s and ninety-five BTR-80s19 were
    deploying against Georgia’s twenty remaining tanks and infantry vehicles.
    Still, the GAF felt it owned the day, having repulsed the South Ossetians and
    dislodging the Russian peacekeepers to the northern edge of the city.

    By Frederic Labarre, Head of Department of Strategy and Politic, Baltic Defence College
    Volume 11, Issue 2, 2009 Baltic Security & Defence Review

    Remeber moron, that this massive advantage the Russians had in armored vehicles was on the 8th, and the Georgians did not withdraw from Tshkinvali until the 11th.

    You really are an idiot.

    Oh and by the way, it was the Russians who bombed and shelled Tshkinvali for 3 days…..

    Comment by Andrew — October 24, 2010 @ 3:01 am

  7. Just as I thought…talk is cheap.

    Who are you to judge? I genuinely don’t mind nuclear war. The more megatons the better.

    Comment by Sublime Oblivion — October 24, 2010 @ 8:41 pm

  8. “You’re behaving like Mike Averko, who has a habit of merely throwing back insults using the exact same words.”


    More like Tim Newman has a habit of “merely” stating idiotic necon drivel he gets from the intellectually challenged likes of Marko Attila Hoare and Oliver Kamm.

    Comment by A Hearty Breakfast — November 13, 2010 @ 10:22 am

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