On May 21, Presidents Putin and Xi Jinping signed a $400 billion Russian–Chinese gas deal in Shanghai. According to the contract, Gazprom will supply the China National Petroleum Corporation (CNPC) via Power of Siberia gas pipeline with 38 billion cubic meters (bcm) over 30 years, from 2018/2020. Gazprom’s largest contract will be based on the supplies originating from the Kovykhta and Chayanda gas fields in Eastern Siberia. The project will cost $75 billion, with the Chinese share amounting to $45 billion ($20 billion—in direct investment and $25 billion in pre-payment for the Russian gas). Gazprom will have to spend $30 billion on this project, which is already labeled the largest construction site in Russia.  The deal is frequently seen as a skillfully planned political response to the sanctions imposed on Russia by the U.S. and the EU, and also as a means of diversifying away from the European energy market. While these considerations indeed played a significant role in an expedient conclusion of ten years of negotiations, it is possible that they were not the key arguments that closed the deal. In reality, it may be that commercial and geographic interests played a greater role than pure politics did.

There are six factors that played key roles in the rapid advancement of this deal:

1. “It is geography, stupid.”

According to the contract, Gazprom will supply the China National Petroleum Corporation (CNPC) via Power of Siberia gas pipeline with 38 billion cubic meters (bcm) over 30 years, from 2018 through 2020. Gazprom’s largest contract will be based on the supplies originating from the Kovykhta (number two on map) and Chayanda (number three on map) gas fields in Eastern Siberia. The project will cost $75 billion, with the Chinese share amounting to $45 billion ($20 billion—in direct investment and $25 billion in pre-payment for the Russian gas). Gazprom will have to spend $30 billion on this project, which is already labeled the largest construction site in Russia.        

Why go to China? One reason is that East Siberian gas is too far away from Europe. Local gas demand is too low to justify development of the Chyanada and Kovykhta fields with a total reserve base of over 3 trillion cubic meters (tcm). China, with its booming economy and rapidly increasing usage of natural gas, seems to be the perfect client for Gazprom. 

The geographical imperative also played an important role in China’s decision to go ahead with the gas deal— Power of Siberia will go directly into the northeast China with a particularly high natural gas demand. Furthermore, security of supplies plays an important role in China’s “energy thinking.”  Most of the gas imported by Chinese energy companies is either shipped/transited from potentially unstable Central Asia or transported in the form of liquefied natural gas (LNG) via unprotected sea-lanes and easily lockable “choke points.” These choke points include locations such as the Ormuz Strait in the Persian Gulf or the Strait of Malacca in the Southeast Asia. Therefore, from a security of supply point of view, Russian gas allows China to mitigate the transit/transport risk and to diversify the imported energy supplies.     

2. The ”Gas Glut” in Russia and Europe pushes Gazprom towards new markets in Asia.

Russia’s internal market is oversupplied with natural gas, with the glut amounting to about 20 billion to 30 billion bcm (billion cubic metres) of supply per year. Several factors have contributed to this surplus: Slower industrial growth, particularly in Russia’s energy-intensive industries, sent annual gas consumption sharply down. In 2011, demand was 496.3 bcm, compared to last year’s record of just 456.3 bcm. While Gazprom’s exports to Europe rose unexpectedly last year to a record of 162.7 billion cm, it continued to shed market share in Russia, which fell by about 6 percent during the course of 2012. Gazprom’s Chief Executive Alexei Miller even indirectly admitted the existence of under-used spare production capacity, when he said the company’s output capacity could be rapidly increased by 130 bcm/year.

European gas markets are also over-regulated, and EU internal gas consumption is unlikely to grow fast, at least in the years to come. Present market conditions coupled with often-excessive subsidies for renewables renders the immediate future for gas in Europe rather bleak. On the contrary, natural gas consumption in Asia is set to grow as the region’s economies expand. Asian customers are often happy to pay higher prices and even provide necessary investment for the upstream hydrocarbon projects in order to attract additional supplies.    

3. Russia’s trade deficit is offset.

China is Russia’s single largest trade partner. The trade between the two countries accounted for $90 billion in 2013, and is set to increase to $200 billion by 2020. Russia has a surplus in trade with its main commercial partners—the EU, Turkey, Ukraine, the U.S. and Japan—but not with China. In 2013, Moscow had a $10 billion trade deficit in its trade with Beijing and this gap is rapidly widening. Gas exports to China which would easily reach $13-14 billion a year will help to offset growing imbalances in the trade relations between the two countries.  

4. Lack of clarity exists on prospects for a rapid shale gas revolution in China.

In 2012, the Chinese government released its Five-Year Plan for the development of unconventional gas, setting ambitious production targets. Shale gas production is set to grow from 6.5 bcm per year in 2015 to at least 60 bcm per year in 2020. However, at present only two companies—China Petroleum & Chemical Corporation (Sinopec) and a joint venture between Royal Dutch Shell and CNPC—have made visible progress with a total of 100 wells drilled in China. The progress in shale gas development is being compromised by the difficult geological structure of China’s shale gas reservoirs, lack of water supplies for fracking activities and insufficient technological base. Furthermore, China’s gas consumption is growing at a faster rate than forecasted—the country’s natural gas use increased by 13.9 percent to 167.6 bcm last year and this number is expected to reach 186 bcm by the end of 2014. In these circumstances, Beijing is forced to use all possible sources of gas, whether they might be domestically produced or bought abroad.

5. The gas deal sets LNG “Price Floor” for China and helps grow the Russian economy.

China is expected to pay for Russian gas at a rate of $10.5 - $11 per million British thermal units (BTU) or $370-$390 per thousand cubic meters. This is significantly cheaper than what Chinese companies are currently paying for their LNG imports. The LNG import price in northeast Asia oscillates between $13.5 and $19.7 per million BTU—affordable Russian gas supplies increases Beijing’s bargaining power vis-à-vis liquefied gas exporters, potentially forcing them to lower gas prices.

Russia's economy will also benefit from this deal. According to Bank of America’s report released on May 27, 2014, and the Moscow business daily paper Vedomosti, the Russia-China gas project will boost investment in Russia’s economy and might increase its’ GDP growth to 2.1 percent in 2015.

6. The Growing Strategic Significance of China’s Economy.

This agreement, conditioned mostly by economic and geographical imperatives, highlights the growing strategic significance of China’s economy. Traditionally Soviet and Russian policies were Euro-centric, which reflected the key role the Euro-Atlantic region had played in the world affairs since the 16^th century. However, in the last decade the power and economic balance was rapidly shifting towards the Asia–Pacific region, with China becoming the world’s second biggest economy. Washington was quick in responding to this shift, by partially “switching” to Asia. Until now Moscow had little to offer except rhetoric. Last year’s Rosneft deal and Gazprom’s contract were the first real steps towards this new Asian policy.        

Indeed, it would have been strange to see two neighboring countries—the world’s largest energy consumer (China) and the world’s largest energy exporter (Russia)—being engaged in anything other than a  full-scale energy trade. The deal also proves that all is not lost for pipeline gas, as it could still compete with LNG. The China-Russia deal revived Tokyo’s interest in building a pipeline link between Russia’s Sakhalin Island and Japan. The project could lower Japan’s energy bill substituting LNG supplies with a less expensive pipeline gas.

Photo credit: greg westfall via Flickr