April 2014

Oil and gas in the capitals

The Crimea crisis, Russian gas and Norway
Dr. Øystein Noreng / Contributing Editor


 The Crimea crisis highlights Europe’s dependence on Russian natural gas, by the need to transit Ukraine and by the export revenues to Russia. The crisis and the annexation of Crimea by Russia have prompted calls for scaling down Russia’s gas exports as an act of punishment for political and military aggression. Typically, these calls have been louder in the U.S. and among Russia’s immediate neighbors than in Western Europe. Norway has been singled out as an alternative supplier.

No good substitute. The numbers do not add up. In 2012, the European Union consumed about 450 Bcm of natural gas, of which 150 Bcm was domestic EU production. Thus, domestic supplies represented only about one-third of total needs. The major foreign supplier was Russia, which, in 2012, exported 124.5 Bcm to EU markets. Norway was second, supplying about 108 Bcm, followed by Algeria with 43 Bcm. There is no way Norway would be able to replace Russian supplies. Even if there was some spare capacity in the short run, the long-term challenge for Norway is to sustain the gas export levels through an enhanced effort in exploration and field development, as well as pipeline construction.

Second, even if Norway was able to replace substantial volumes of Russian natural gas, it might have second thoughts about challenging Russia over a crisis in Crimea. After protracted and successful negotiations over the maritime border, the Barents Sea is developing as a new petroleum province, to some extent based on cooperation between Norway and Russia. For Norwegian industry, offshore petroleum activities on the Russian side offer a huge potential market. Any Norwegian attempt to drive out Russian natural gas from the EU markets could easily trigger retaliation aimed at Norwegian firms, and compromise long-term political relations.

Historically, Norway and Russia have shared the northwest European natural gas market, with Norway being the major supplier to France, and Russia leading in the German market. This has been a tacit bargaining game between the two major suppliers and the major buyers, aiming at stability and risk diversification. There is little evidence of price competition between Norwegian and Russian natural gas, as the buyers have been alternating contracts in order to balance supplies. For the more costly Norwegian natural gas, this has been helpful in securing a stable market at reasonable prices. Russia has lower costs, as exports are the bonus of a huge home market—it could undercut Norway, but it lets Norwegian gas into the market to facilitate the sale of additional Russian gas. Not competing on prices for market shares is typical of a duopoly, a market dominated by two sellers.

Complimentary markets. Third, it is unlikely that the major buyers, especially Germany, would welcome a Norwegian move to push Russian natural gas out of the market. Even if Germany needed more natural gas, the preference is to balance supplies between Norway and Russia. For Germany, there is more at stake than energy supplies. Russia is an important export market for German industry. There is substantial direct investment by German firms in Russian industry. The complementarity in resource endowment, industrial prowess, human resources and markets is remarkable. In order to purchase German goods, Russia has to export. In German business, as with German politicians, there is no interest in deteriorating relations with Russia. Norway should keep its historical role as the alternative natural gas supplier to Germany, indirectly helping Russia to sell more, rather than obstructing German-Russian trade. There is no way Norway, with 5 million people, could substitute for the Russian market with 28 times as many people.

Sequence of events. The Ukrainian crisis was not caused by Russia, but rather by forces hostile to Russia. In the recent past, Ukraine has been a problem for Russia as much as for the EU. The anti-Russian Tymoshenko government in Ukraine, ruling between 2004 and 2010, mismanaged the economy and triggered natural gas supply crises in 2006 and 2009 due to non-payment. The supply cuts at the Russian-Ukrainian border not only affected Ukrainian consumers, but also EU markets. On the other routes, Russia has a record of being a secure supplier.

Consequently, the core problem is not Russia as a gas exporter, but Ukraine’s undefined position between Russia and the EU. If Ukraine had been firmly attached to either one, there would have been little problem in Russian gas transiting Ukraine to EU markets. The outlook before February 2014 was that Ukraine was being more firmly attached to the Russian economy, and in that way Ukraine could benefit from a discount on natural gas prices as well as financial assistance. Russia has no reason to give price discounts to a hostile neighbor.

An arrangement that would link the Ukraine to both Russia and the EU was rejected by the latter. This set in motion a chain of events that led to the Crimea crisis: the rejection of an exclusive deal with the EU by the Yanukovich government; that government’s overthrow by popular uprising; an agreement between Russia and the West on an interim government; and the coup. The new, unelected government seems to enjoy remarkable support in the West. This is hardly a recipe for stability. The stage may be set for new disturbances in natural gas supplies, unless Ukraine receives sufficient economic assistance to pay higher natural gas prices.

By its quick annexation of Crimea, after an instant referendum, Russia has evidently broken international law. Critics tend to overlook not only the historical context of Russia’s links with Crimea, but also the actual context, apparently pardoning the Kiev coup. An unstable Ukraine means insecure gas supplies for the EU neighbors. wo-box_blue.gif

About the Authors
Dr. Øystein Noreng
Contributing Editor
Dr. Øystein Noreng is a professor emeritus at BI Norwegian Business School. He has been an advisor or consultant to the International Monetary Fund; The World Bank; the governments of Canada, Denmark, Norway, Sweden and the U.S.; and energy companies, including Equinor, PDVSA and Saudi Aramco.
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