Streetwise Professor

May 19, 2014

Russia-China Gas Deals: As Clear as Mud in the Dark

Filed under: Commodities,Economics,Energy,Politics,Russia — The Professor @ 12:18 pm

Putin travels to China this week, and the big item on the agenda is the supposed signing of a long-awaited gas deal.

I’ve seen this show many times before, going back to 2004. Much fanfare ahead of the meeting! A deal is signed! But the price is TBD. Meaning there is no real deal. And then the charade occurs again a couple of years later.

So I’ll believe it when I see it.

The Russians, per usual, are doing all the talking about the impending deal. Apparently understanding that those who have seen the earlier episodes will be skeptical about any deal that doesn’t nail down pricing, they are at pains to claim that the pricing is all but set. Deputy Energy Minister Anatoly Yanovsky said the deal is “98 percent completed.” What does that mean anyways? By word count? Meaningless, if the missing 2 percent relates to price. Gazprom’s Alexi Miller says the deal is “one digit” away from completion. Well, which digit kinda matters. Is it in the hundreds column? The tens? The ones? (Or does the single digit refer to an upraised middle finger?)

If a deal does get done, pay close attention to the price. The Chinese have the bargaining power here. As they always have. But now it is greater because this is now part of Russia’s game with Europe and Ukraine. It very much wants to put pressure on the Europeans. So Putin/Gazprom might be willing to take a lower price to further that strategy.

Just as important, look at the formula. The reports I’ve seen are saying that the Russians will sell at a fixed price, in the range of $350-$380/MCM. If the deal is truly at a fixed price, this would be a major concession, as Gazprom is an ardent defender of oil-linked pricing. If it gives up the oil-link, that would be a major concession, and would put oil-linked deals in Europe under greater pressure than is already the case.

This figure is based on leaks from Gazprom, which is kind of appropriate given the massive leakage that occurs from its pipes. Perhaps the leaker is converting an oil-based formula number to a flat price. Moreover, regardless of how arrived at, is this a number for deliveries over the entire 30 year life of the contract, or just for the near term deliveries? I can’t imagine locking into a price over 30 years. There has to be some kind of indexing, but to what? That matters a lot. Moreover, I would not be surprised if  the Chinese agree to near-term prices that are comparable to European prices in order to give Russia a propaganda victory to use in its battle with the Euros, but get more than compensated at the back end through some convoluted pricing formula that is not publicly disclosed.

It is quite possible that it will be very difficult for outsiders to know exactly what terms the parties have agreed to, and to back out a price, or a price structure over the life of the contract. Recall the Rosneft/Transneft-Chinese oil deal that was signed in 2009. The Chinese made an upfront payment to pay for a pipeline, and presumably received a discount on the price. But the pricing terms were not transparent and who got the better of the deal was hard to figure. I wouldn’t be surprised to see the same thing happen here.

Also remember that Russian-Chinese deals are not ended with “and they lived happily ever after.” The Rosneft/Transneft-China ESPO deal has been marked by chronic pricing disputes between the parties. Don’t be surprised if that happens here too. The Chinese are also notorious for re-opening pricing terms after deals are signed. And their performance on contracts generally leaves something to be desired. They are notorious for defaulting on fixed price contracts when spot prices fall below the contract price: for this reason, most iron ore and coal sales to China are on spot terms only. Iran recently canceled a $2.5 billion deal with China to develop an oil field because the Iranians claim the Chinese are not living up to the terms of the deal (though this isn’t related to pricing per se). (H/T Neil C. Levine.) In other words, any deal is just setting the stage for ex post opportunism, by either party or both.

So even if Putin walks away from Beijing beaming a beatific botoxed grin, don’t draw too many conclusions. When two of the least transparent regimes in the world enter into a contract you cannot expect disclosure of the real terms, and the public announcements relating the deal will be intended primarily for propaganda purposes rather than to enlighten the world. When the inscrutable deal with the riddle/mystery/enigma folks, you can’t ever know what is really going on.

Further thoughts (added 5/19/14 at 1730 CDT). If and when a deal is announced, look to see whether there is a take-or-pay clause. The Russians usually insist on these, and they can be a source of major friction between the contracting parties if the price terms in the contract get out of alignment with spot market conditions, as is almost inevitable in a contract that extends over 30 years. I would be surprised if the agreement has take or pay terms and the Chinese also fund the construction of a pipeline upfront. Take-or-pay is usually a mechanism for protecting the party making the investment in the specific asset (like a pipeline or gas field): if the Chinese are funding the project, Gazprom doesn’t need take-or-pay to protect it. If anything, the Chinese would need protection against Gazprom’s opportunism.  If the Chinese indeed provide a substantial sum up front, as has been rumored (with sums of around $20 billion) the pricing terms of the contract become even more important: discounts later on in the life of the contract are necessary to pay the Chinese the principal and interest on the funding. There is no way that Gazprom will get European prices for sales to China if China also finances the investment. If Gazprom boasts that it indeed received European prices for sales to China, and the Chinese fronted the investment, you know there is something being hidden. (This happened with the Rosneft/Transneft deal.)  With respect to pricing, I can’t see any way that the deal would be at a fixed price for 30 years. There must be some sort of indexing. Again, if the boasting is about some price level that is anywhere near what the Russians get currently from Europe, be very suspicious. This is likely part of some sort of Three Card Monte game, with Russia tantalizingly flashing, then palming, the Black Queen to gull the suckers. If the deal is really for thirty years, there must be some sort of indexing mechanism, with a set of discounts, and the details here would be very devilish. Lastly (for now, anyways), I’ll be interested to see if the deal includes some sort of hostage exchange to protect each party against the predations of the other.

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  1. […] Streetwise Professor is not impressed: […]

    Pingback by Leaving Rigged Systems | Global Economy Observer — May 20, 2014 @ 11:49 am

  2. Sure enough:

    Russia failed to finalise a lucrative gas supply deal with China for state-owned Gazprom as expected on Tuesday, with the Chinese reported to be driving a hard bargain on price amid tensions over Ukraine.

    However, negotiators from both countries have so far been unable to agree on a price for gas supplies to China, preventing a deal from being signed, Putin’s spokesman Dmitry Peskov was quoted as saying by Reuters in Shanghai.

    Good call, prof.

    Comment by Tim Newman — May 20, 2014 @ 1:16 pm

  3. SWP: Come for the Russian military tidbits, stay for the hot, dirty energy-market analysis.

    Comment by Blackshoe — May 21, 2014 @ 3:27 pm

  4. Welcome to SWP, @Blackshoe (you’re a Navy guy, I’m guessing.) Thanks for your comment. Then there are those who come for the energy-market tidbits, and stay for the hot, dirty Russian military analysis 😉

    The ProfessorComment by The Professor — May 21, 2014 @ 4:55 pm

  5. @SWP: I’ve left a few comments on here before, but probably with a different email address. Yup, Navy guy. It’s always fascinating reading the ongoings of the energy market, along with the perpetual train wreck that is Russia.

    Comment by Blackshoe — May 24, 2014 @ 12:55 pm

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