Russia starts to reform its internal gas market

by Simon Pirani

Russia’s domestic gas market is rolling towards price liberalisation. Prices are due to reach European netback levels by 2011 for industrial customers and by 2015 for households and public sector organisations. Sales at unregulated prices this year already account for nearly a quarter of the nearly 400 bcm of demand, and that market segment will keep growing.

For Russia, this reform is as fundamental as the consumer price shock of 1992-93 or the privatisation debacle of 1994-96 – although this time round, stable government and healthy finances mean the change will be managed. The implications for western Europe are scarcely less significant: the end of the price differential – which has sucked gas westwards ever since exports began in Soviet times – is in sight.

Price guesstimates start here

The government’s decision on price liberalisation (protocol no. 42 of November last year) is based on the principle that wholesale prices for industrial customers should by 2011 equal the netback from Gazprom’s European export prices, i.e. a two- to three-fold increase. To prepare the ground, the state agency that sets domestic prices, the Federal Tariff Service (FTS), last month published its estimates of current European netback prices, and will do so every quarter from now on.

The FTS is basing its estimated European netback prices on the average export price for the previous nine months: 6788 rubles/mcm for July 2006 to March 2007, in the case of this month’s calculation. It then subtracts export duties and transport costs to state domestic prices, which vary for 13 different geographical zones, according to their proximity to producing fields (see Box 1).

Current estimated European netback prices are 779 rubles/mcm in gas-producing Yamal-Nenets, and 4692 rubles/mcm in Moscow and surrounding regions. Moscow prices are exceeded only by those in some parts of southern Russia and in Kaliningrad, the Russian enclave on the German coast of the Baltic Sea.

The wholesale industrial prices cover regulated gas sales to industry, including the power sector; prices for residential users and public-sector customers such as schools and hospitals are roughly 75% of these.

The FTS figures are a good guide to the differential, but only a rough indication of where prices will actually go on the domestic market, say observers. For one thing, the FTS says it may adjust its methodology; for another, political factors are still at work. Politicians’ adherence to market principles will for example be strongly tested in 2015, a pre-election year, when the prices for residential users are due finally to be brought to par with the European netback.

Analysts at Alfa Bank say that whereas the FTS’s theoretical prices for 2011 are $160/mcm-$200/mcm, their own calculations give domestic prices of $100 upwards. “We believe the discrepancy originates from different oil price assumptions, and also from the FTS’s reluctance to adjust for international transportation prices”, they wrote in a report. “We also note that in a fully liberalised market, domestic prices should probably be established on the basis of netback from European market prices, not Gazprom’s long-term contract prices.”

Market reform plans

While regulated prices begin to rise, the unregulated sector of the domestic market is also expanding – albeit under Gazprom’s watchful eye, and largely under its control. At a recent briefing for journalists, Kirill Seleznev, general director of Mezhregiongaz, Gazprom’s domestic sales division, presented a breakdown of the market this year as follows:

  Sales by Gazprom to residential customers at regulated prices (75% of prices for industrial customers). Long-term contracts (with local gas distribution companies) possible.

  Sales by Gazprom to power companies and other industrial customers at regulated prices. Approx. 228 bcm. Long-term contracts possible.

  Sales by independent producers (mostly Novatek and the oil companies) at freely negotiated prices, i.e. at a 10-20% premium to regulated prices. Approx. 97 bcm. “Long-term agreements on transport are necessary”, Seleznev stated.

  Sales by Gazprom (5 bcm) and independent producers (5 bcm) on Mezhregiongaz’s electronic trading platform, at a 20% premium to regulated prices in summer and 42% in the winter. Gazprom’s volumes sold on the exchange include much of the 9.7 bcm it bought from independent producers this year, Seleznev said. He added that Mezhregiongaz is now working on developing a futures market on the exchange.

  Sales by Gazprom under new rules (government decision no. 333 of 28 May) providing for Gazprom to agree prices bilaterally with customers in the power sector who request volumes above the limits set in the 2007 gas balance, and new customers. The scheme went into operation on 1 July, and Seleznev expects up to 5 bcm of sales on this basis in 2007, and up to 11 bcm in 2008. The premium to the regulated price, under a ceiling fixed by regulators, will be up to 60%; long-term contracts can be signed with reference to prices on the electronic trading platform.

Decision no. 333 represented a partial victory for Gazprom in long-running negotiations with the power companies and the government over prices. The price liberalisation measures agreed in November last year (protocol no. 42) included a forecast of gas purchases by the power sector rising from 162.9 bcm this year to 186 bcm in 2010. No more than 103.3 bcm per year will be sold by Gazprom at regulated prices; the gap will be filled by independent producers, or Gazprom gas sold under decision no. 333.

The background to the haggling between Gazprom and the power companies is alarm at the boost given to energy demand by Russia’s unexpectedly dynamic economic growth. Gazprom’s annual reported commented that the regulation of gas prices since 1990, while other fuel prices are liberalised, had resulted in Russia’s economy becoming “the most gas-consuming in the world”, with gas’s share of the energy balance rising to 51.2% in 2006 from 42.1% in 1990. And Russia’s gas goes mainly to the power and industrial sector rather than households.

With demand so strong, and Gazprom fully stretched just maintaining output, price liberalisation puts Russia’s independent producers in to the spotlight. In 2006 their share of Russian production rose to 16.1%, i.e. 105.8 bcm (up from 93.9 bcm in 2005), Seleznev said.

The major constraint on the independents’ production is the lack of pipeline capacity, and the failure of long-running discussions with Gazprom over the financing of new pipelines. There seems to be progress here, too: the Russian Gas Association sees “the formation of mechanisms for state-private partnership on the basis of […] leasing and concessions” as the solution.

Oleg Zhilin, president of the association – in which both Gazprom and independents participate, and which is headed by the gas industry’s foremost parliamentarian Valerii Yazev – told Gas Matters: “Up until now, all trunk pipelines have been built by Gazprom. But the Sakhalin-Khabarovsk line has been built by Rosneft, and will be paid for by Gazprom over a period of time. There are plans to build infrastructure in Arkhangelsk by a consortium in which Novatek participates.”

The increase in domestic prices is already changing the economics for small producers, who are increasingly finding it worthwhile to sell their gas to Gazprom. In June, Urals Energy, an oil producer with a turnover of about $170 million (2006), signed an agreement to sell gas from its Dulisminskoe deposit in Irkutsk to Gazprom, which will use it for gasification of the region. Volumes and prices have not been made public. The company is controlled by private shareholders including Leonid Diachenko, son-in-law of the late former president Boris Yeltsin, and listed on the London stock exchange.

Gazprom has this year signed similar agreements to buy small amounts of gas from Itera and the Irkutsk oil company.

The distribution sector

Although the impact of price liberalisation will be felt soonest, and most sharply, by power generators and industry – especially chemical producers that use gas as a raw material – it is also shaking up the gas distribution sector, comprising more than 300 companies that supply gas to households and public-sector customers.

Gazprom is working to regain control of all these companies. During the 1990s some of them were part-privatised; most were neglected and undercapitalised, leaving infrastructure unrepaired and unmodernised; and nearly all built up huge debts for gas.

Rosgazifikatsiya, a state company, owns 59 majority or blocking stakes in distribution companies and minority shares in nine more; Gazpromregiongaz, a Gazprom subsidiary, owns shares in another 197. Talks are now in progress on a deal under which Gazprom will swap its own shares (a holding of about 0.89%) for Rosgazifikatsiya’s distribution business.

Valerii Lokutin, Rosgazifikatsiya general director, said recently that he hopes that consolidation and price liberalisation will come to the rescue of dilapidated and even dangerous distribution infrastructure. State inspection systems work only in Moscow region, he said: in most of the country “there is no system for checking gas equipment in apartment blocks, and this has led to a greater number of accidents”.

Successful reform of distribution and supply businesses will depend largely on the progress Russia makes with the current major reform of municipal service provision, which includes gas, water, heat and maintenance services to homes, most of which are in multi-dwelling apartment blocks, either municipally-owned or privatised.

When reform legislation was published earlier this year, the Russian Gas Association and industry bodies demanded changes to provisions under which unregulated traders would be able to enter the supply business. This is an area that Gazprom, through Gazpromregiongaz, intends to dominate.

Gasification

Gazprom’s drive to acquire control of the distribution companies goes alongside the gasification scheme that is stimulating domestic demand. The three-year scheme (2005-07) envisages the construction of 12,000 km of distribution pipelines: Gazprom funds construction of the pipelines between population centres, while the infrastructure for individual streets, houses and courtyards is funded by local government or residents.

In 2006, Gazprom spent 17.6 billion rubles on gasification and brought into operation an extra 1313 kilometres of pipeline. Gas was supplied for the first time to 655 towns and villages, i.e. 2,508,000 homes (1,733,000 urban and 775,000 rural). Gazprom’s gasification budget for 2007 is 20.2 billion rubles, and it is hoped that gas via pipelines will by the end of the year reach 62% of the Russian population, compared to 54% on 1 January 2005.

Even when the programme is complete, the majority of Russia-in-Asia will be without pipeline gas. Seleznev provided a breakdown of gas consumption by Russia’s seven federal districts: the central and Volga districts account for two-thirds of gas consumed, and the north-western, southern and Urals region share almost all the rest. Of the two vast federal districts in Asia, Siberia’s share is 3% and the Far Eastern region has no pipeline gas. (See box 3.)

In Asia, Gazprom has started gasifying Irkutsk; Altai (where it has spent 900 million rubles on the scheme); and Novosibirsk (600 million rubles); and signed an agreement with local authorities in Krasnoyarsk on gasification. But most efforts have been concentrated on areas of European Russia that can be reached from existing trunk pipelines.

The era in which Russia depended on cheap gas to help it through other reforms has ended, and the era in which it is reforming the gas market itself has begun.

Box 1: The disappearing differential

From 2011, the Federal Tariff Service will calculate the netback from European prices by taking the average export price paid to Gazprom in the preceding nine months (excluding export duties), and adjusting the price downwards to account for transport costs.

The FTS sets gas prices for eleven different geographical zones. Now it has calculated indicative prices for each of these using its netback methodology for current prices (based on the period from 1 July 2006 to 31 March 2007). The indicative wholesale industrial prices results are shown in the chart. (Prices for residential customers are roughly 75% of those for industrial customers.)

From now on, the FTS will produce a calculation of the European netback price quarterly. Actual prices will be restated each quarter, rising gradually from their current level to 100% of the European netback price by 2011.

Wholesale gas prices for industrial customers, rubles/mcm (net of VAT)

Source: Federal Tariff Service/Vedomosti. For further information on pricing structures, see also Jonathan Stern, The Future of Russian Gas and Gazprom, pp. 43-48. 

Russian gas demand – bcm/year 

Source: UBS analysts’ report, information from Gazprom, RPI Inc., UBS estimates

Source: Gazprom