Russia Abandons South Stream




On Monday 1 December Russian President Vladimir Putin announced that Russia would abandon the South Stream gas pipeline. The death of the project appears to be a setback to Russia and perhaps serves to highlight that in a year where Russia’s international relations have been somewhat tense its trump card – energy – has been unable to influence the EU. This article will seek to analyse and discuss the circumstances that led to the abandonment of the pipeline, potential reasons, and how various countries will be affected.


Figure 1 - Initial Pipe Welding Ceremony in Bulgaria

Competing Pipelines

The South Stream pipeline project was announced in June 2007 when Eni and Gazprom signed a Memorandum of Understanding for the construction of the pipeline. Since then the project has been somewhat symbolic of the relationship between Russia and the West.

Russia’s disputes with Ukraine in 2006 saw natural gas supply to Europe disrupted. As a result, the proposed Nabucco pipeline (romantically named after the successful Verdi opera), which would transport gas from Turkey to Austria, seemed to gain significant traction. It was shortly after this, in 2007, that the South Stream project was announced.


Figure 2 - Nabucco Pipeline

With Nabucco seeming to threaten Europe’s reliance on Russian gas, South Stream appeared the perfect tool to preserve Russia’s role in the European gas market. In 2013, the Nabucco project faltered as Azerbaijan, perhaps mindful of its own position between the EU and Russia, opted for the cheaper Trans Anatolian Pipeline (TANAP) thus, at least for now, removing the possibility of Nabucco’s construction. The decision to go ahead with TANAP, which would deliver around a third of the gas Nabucco would have to mainly southern Europe, left Russia in what appeared to be a win-win position. It could either shelve the expensive project, safe in the knowledge that its market was no longer under serious threat, or go ahead with the project; cementing its market share as rival pipelines would be unlikely to tread the same ground. Putin, perhaps sensing the strategic role South Stream could play, opted for the latter.

EU Opposition to South Stream

It is no secret that Brussels has had its misgivings about European dependence on Russia gas. This has been amplified by disputes Russia has been involved in, which have on occasion led to a disruption in gas supply, and more recently by its provocative display of foreign policy in Crimea. Clearly, disruptions to supply are unpalatable. However, EU has also been wary of Moscow increasing its leverage over the EU and its member states through increased energy supply. South Stream may have diversified supply routes, which would limit supply disruptions, but the increase in energy dependence on Russia would likely increase its leverage, in particular on Ukraine, which Russia would be able to bypass with little effect.

Although the EU has not been afraid to voice its political misgivings over the project, it is EU law preventing the pipeline's construction. Gazprom typically prefer to control the pipelines, dominating the whole supply chain and having exclusive access. This would be in violation of the Third Energy Package [1] which does not allow companies to control both supply and transportation and usually requires a granting of third party access. The legislation does allow an exemption to be granted but the EU has been reluctant to grant one.


Figure 3 - South Stream Route

Pipeline Abandonment

The abandonment of the pipeline, if it is indeed dead, is a combination of economic considerations and political realities. Even without the EU’s stance, Russia may have struggled to fund such an expensive project (estimated at $40-50bn) concurrently with other projects. With the EU seemingly unwilling to budge and market conditions (partly self-inflicted) seeming to conspire against Russia, the EU was in a stronger position to reject such a project, even with some of its members, notably Hungary, ready to defy Brussels and risk fines. Additionally, further attempts to secure the necessary exemptions, and the cooperation of Bulgaria, may have proved a waste of money.

Although strategic considerations may well have trumped the project’s numbers, Russia’s economic position appeared to be affecting its likelihood. The imposition of sanctions, although not directly affecting Gazprom, will have likely have had an effect on its ability to raise capital for the project. Additionally, the recent fall in the oil price (by $30/bbl in just 3 months) has hit Russia hard. The Rouble has been in free-fall and Russia seems destined for recession; circumstances that make such an expensive project less attractive. This does not even take into account that Russia is also developing LNG projects and a pipeline from Western Siberia to China.

The timing of the announcement was certainly a surprise. Of course, as has been suggested by some, including the Deputy Chairman of Bulgaria’s energy commission, Martin Dimitrov, the announcement could be a tactical move to save the project. It could be an attempt to pit Bulgaria et al, which has seen expenses pile up, against Brussels, whilst also forcing the EU to consider other, more expensive options. Alternatively, if genuine, Putin may well have been utilizing the chance to strike the first blow in the ever-ongoing PR battle. His statement included little subtlety in its criticism of the EU. It was clearly no coincidence that the announcement was coupled with the announcement that Russia would instead develop the project with Turkey, showing the EU that it is prepared to build other ties.

What this means for those involved

The EU:

The reaction in Brussels has been fairly indifferent. It is has mainly referred to the ongoing process and official channels. EC President Juncker has stated that the pipeline could still go ahead, and the EC still intends to go through with scheduled talks on the 9th December. Anna-Kaisa Itkonen, a European Commission spokesperson stated that 'gas pipelines must be built and operated under European legislation' offering little hope of an exemption.

The EU’s victory appears to be a case of cutting off your nose to spite your face. By standing firm (and threatening participating countries with fines, or in the case of Serbia its accession to the EU) it has avoided increasing energy dependence on Russia. This is at the expense of the diversification of supply routes. With Russia's dispute with Ukraine on going, gas disruptions are not unlikely and could leave Europe vulnerable when the economy begins to grow again. It will have to secure alternative supplies, which may come at a greater cost than Russia was offering.

Brussels may well need to act wisely in order to appease the countries that would have benefitted from South Stream. It has already had to field questions about compensation, something Russia seems to have palmed off successfully. Of course, Germany could be accused of hypocrisy given that it effectively has its own personal pipeline with Russia ensuring a low risk supply.

Russia:

Putin has always sought to maximize Russia’s political influence on a global stage, and this news certainly represents a strategic setback. It loses possible leverage on Ukraine and a chance to increase European independence on Russia gas. In this case, the EU has been able to resist Russian energy dictating its own policy. However, whilst the project may already have cost Russia financially, its mere presence has prevented Europe from establishing alternative supplies. Moreover, Russia does not face isolation after South Stream. It will continue to export significant quantities of gas into Europe, and is developing ties in China, and Turkey, a country that is increasing its gas use. Additionally, with the country facing economic troubles, and looking to develop a number of projects, it is arguably being saved from something that represented an immense expense.


Figure 4 - Vladivostok LNG

Turkey:

In the short-term Turkey will benefit from a 6% discount on the gas it already imports. In the future this discount could rise to as much as 15%. Unlike Serbia which appears to have had something to lose from a relationship with Russia, Turkey’s EU membership bid does not appear to be at a particularly advanced stage and would be unlikely to have played much of a factor in the agreement. Whether the proposed pipeline materialises remains to be seen and, given the subject of this article, hardly appears worth predicting. Of course, financially, any such project would likely be beneficial. However, if South Stream can be discarded so easily with the offshore part of the project reaching FID, what security does a Memorandum of Understanding provide?

Ukraine:

Ukraine, which resides at the heart of this political situation, can claim few victories over the last year. However, had the South Stream project gone ahead, Russia would have effectively been able to halt all supplies to Ukraine without disrupting supply to the other European importers. With Ukraine importing over 90% of its gas from Russia the South Stream pipeline would have left it in a particularly vulnerable position. Additionally, a separate pipeline would also leave it in a weaker position concerning its ability to command a transit fee.

South Stream Participants:

The countries caught between the political machinations of Brussels and Moscow are easily forgotten. Given their eagerness to be involved in the project they quite obviously lose out. They lose a greater security of supply and probably cheaper gas than they might otherwise secure. It has been suggested that Bulgaria would have gained €400 million a year from gas transit, although there is not much veracity to that statement. Russia would also have helped to develop nuclear facilities. Therefore, these countries appear to have come off somewhat worse following the news.

Other Players:

China – Whilst a deal with Turkey would potentially replace the negotiating tool Russia lost with South Stream, China’s ability to command a low price is probably strengthened by the news. Additionally, it may benefit from Russian attempts to forge closer ties.

Greece – With Russia seeking to build a pipeline to Turkey, Greece becomes the next natural destination.

The US – With Washington and Brussels coordinating on sanctions on Russia, which it should be noted have been to their own detriment as well as Russia’s, it maintains a show of strength. Although US LNG has not really been aimed at the European market, should the prices rise to an acceptable level, it could well ship LNG to Europe.

Azerbaijan/Algeria/Libya – These countries may well stand to benefit from lucrative gas contracts. Clearly, with South Stream out of the picture the EU will need to look at alternative supplies, and other than possible LNG supplies, these countries offer the best opportunity.

Conclusion

It seems extremely unlikely that given the year’s events the EU will be provoked into welcoming a project it has previously opposed, at least on the grounds of an exemption. It will force both Russia and the EU to seek other options. Russia has already picked up a potential future partner although at the moment a deal with Turkey will likely require incentives. As for the EU, it will also likely be required to pursue more costly options.

Putin’s announcement has certainly thrown up a lot of questions. The answers to these questions remain to be seen. However, at least in the short-term the meeting scheduled for 9 December may well clarify a few issues.

December 2014


Footnotes

  1. Specifically EC Directive 2009/73/EC concerning common rules for the internal market in natural gas.

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