Today, the FT publishes an open tribune by Claude Mandil, the head of the International Energy Agency (and for very long the head of the Energy Directorate at the French Ministry of Industry, and the n°2 guy at GDF). This is the public version of a letter which the IEA sent to G7 members about Russia recently.

Russia must act to avert gas supply crisis

When European Union leaders meet for their summit in Brussels this week, energy security will continue to top the agenda. One priority is likely to be addressing concerns about Russia’s ability to provide reliable and affordable energy supplies given its current rate of investment in the natural gas sector.

Affordability may be a concern, but it has little to do with Gazprom, as most Russian gas is sold under price formulas closely linked to oil prices. Gas prices simply follow oil prices with a lag, under formulas negotiated 30 years ago and only tinkered wiht rarely.

Reliability is the brand new buzzword. I can understand journalists and bystanders interpreting the Russian-Ukrainian spat as one that shows a poor light on the supposed Russian reliability (when it shows the exact opposite - Russia gave up pressuring Ukraine as soon as its reliability was endangered) but Mandil is too knowledgeable to believe this. The coordinated assault on Russia and Gazprom in recent weeks shows that there is another agenda there.

For the 25 EU members, gas import dependence will grow from just under 50 per cent to more than 80 per cent.

(...)

Given this backdrop, the recent disruptions in Russian supplies are troubling, especially since Russia holds the world’s largest share of gas reserves and is the largest gas producer and exporter. In 2004, gas from or through Russia accounted for 70 per cent of European imports. The Russian company Gazprom accounts for 85 per cent of Russian production and 100 per cent of exports.

(...)

Can Gazprom deliver? It has for more than 30 years. Yet, disturbingly, a potential supply gap has begun to appear that will take money and time to close. (...) New gas production and transport infrastructure is required to avoid a possible supply gap, but the lack of such investments is already creating supply tensions. This could result in even higher prices to consumers and possible shortages or worse unless action starts now.

Dependence on Gazprom is growing. Yes, it has always been a relaible supplier, but...

Gee, where is this leading?

There are three important actions that Russia can take to help diminish the possibility of further supply problems in the future. First, increase energy efficiency in order to free gas for other customers. Second, reduce flaring, eventually to zero. Finally, promote investment across the gas value chain and provide real third-party access to gas pipelines in Russia and elsewhere. The first beneficiaries of these measures would be Russian citizens, but consumers globally would gain considerable peace of mind about their own gas supplies.

The first one is a reasonable request in theory, but I am not sure what can be done. Most of the big pipelines have been built with Western technology inputs and are reasonably efficient. A lot more losses happen on the distribution networks in Russia, but this is a whole other can of worms. The biggest "waste" of gas is the low efficiency of gas-fired power plants in Russia, but that will require a lot of investments in the pwoer sector, not the gas sector, to remedy.

The second one also sounds reasonable. The underlying rationale is, of course, that the only reason gas is flared is because it cannot be put into the system. That comes from mixed production oil&gas fields with no access to the network. That lack of access comes from either physical reasons (no gas pipelines nearby) or commercial reasons (Gazprom refusing to take gas produced by others). The idea is of course to force Gazprom to give access to its network to others (starting with foreign investors with oil assets).

Consumer governments must promote policies to minimise the impact of potential disruptions, including increased energy efficiency, diversity of energy sources and suppliers and an improved investment climate. Transparent markets will attract investment and enable suppliers to assure their customers of reliable energy sources.

This is flagged by the third item, which not only wants Gazprom to provide access to the network inside Russia, but also to the export pipelines. The intention is of course to break Gazprom's monopoly on exports to create "competition".

Saying that this would benefit Russian consumers is of course a lie. It might benefit a few big industrial users that already have to buy gas inside Russia on the grey market, but it would mean big price increases for all consumers, starting with all city heating and electricity utilities, which get prices at the regulated domestic gas prices. That would have a direct detrimental impact on the Russian population.

The main reason Gazprom can afford to deliver cheap gas inside Russia - a matter literally of life and death for most of the population - is precisely because it makes enough money on the export side to pay for the whole infrastructure that produces gas and delivers it both inside Russia and outside.

It makes sense to run the gas network as a whole, given the concentration of the production fields, the long distances involved and the harsh conditions it has to face, and to make sure that all Russians do get their gas. Its overall size means that it costs significant amounts of money to keep it in good working conditions, and that money can only come from export revenues (which means that, even if Russia decided to open its export pipelines to all comers, it would slap export transit tariffs to make these third parties pay for the pipelines and their upkeep - and keep the surplus value in Russia).

So when Westerners talk about opening Gazprom's network to thrid parties, what they logically want is:

• get the Russian population and industry to pay lots more for its gas (the EU has actually stated that it considered cheap gas deliveries to Russian industry an unfair subsidy, an argument that has a tiny bit of truth in it, but it has shied away form the next logical step regarding the population) - at the risk of death if they cannot afford it;

• get access to the pipelines without having to pay for their construction costs (paid in Soviet sweat, and presumed "amortised") in order to get more of the value of the gas to leave Russia;

This comes in the context of the announcement of the signature of an agreement between Russia and China to build new pipelines:

Russia pledges gas pipelines to China (March 21)

Russia on Tuesday promised to build two natural gas pipelines to China and to become one of the country’s biggest gas suppliers within the next decade.

The agreement, signed during a state visit to Beijing by Vladimir Putin, the Russian president, raised fears of shortages of Russian gas in Europe, especially since some of the Russian gas headed to China would be tapped in western Siberia at fields that supply Europe.

Russia holds the world’s largest reserves of natural gas. It appears to be playing Europe, its largest current consumer, and China, its largest potential customer, off each other, analysts said.

What's remarkable is not the agreement itself (which I'll comment in a second), but that focus by unnamed Europeans on the danger this agreement supposedly creates for Europe - and its plastering in headlines in the major newspapers.

That means two things:

• they are perfectly aware of the current dependency of Russia on Europe as its sole export market, indeed, they'd like to keep it as it is, proof if need be that they value it (and that the talk of dependency on Russian gas is pure propaganda with other purposes);

• making the issue again about Gazprom's likely future "unreliability" and thus its implicit incompetence in developing these new pipelines is part of the campaign to open the industry - upstream (production) and midstream (the pipelines) to "vitally needed" foreign investors.

The problem is that Russia, rightly, sees that as a pretty transparent power play, and is reacting in a predicatably miffed way - by playing hardball:

Gazprom dismissed IEA criticism as unfair. Sergei Kupriyanov of Gazprom said IEA estimates did not include some of the recent fields brought on line by Gazprom.

“We have a base for growing the output. We know how much gas we need over the next 10 years and it is easier and cheaper for us to produce this in western Siberia – our traditional region.”

He said Gazprom was planning to spend Rbs306bn ($11bn) on its gas fields and infrastructure this year – the equivalent of $11bn that IEA says it should be spending – and added: “Gazprom will fulfil all its current contracts and obligations to Europe.” However, the future increases in gas supplies to Europe – in response to its growing demand – “will be a subject to arbitrage between China and European countries”.

There's two threats there: the "arbitrage" on future investments between the two destination, and the notion that Western Siberian gas could be diverted to China. In a context where Gazprom has carefully cultivated the idea that they have trouble maintaining production (an idea that I personally do not believe for a second, as I see it purely motivated by internal political considerations, i.e. Gazprom's desire to see domestic prices increase and tax cut down, which can be justified by the need for more investment in production capacity), this is sure to trigger alarm bells in Europe, and it duly did.

But both sides are playing with fire.

The relationship is one of co-dependency. Like MAD, it is most stable when both sides acknowledge the co-dependency and do not try to escape it. Anti-missile systems were forbidden because they create instability (if I think I can resist the strike by the other, I may attack safely, which will encourage the other to attck before the anti-missile shiled is in place). Diversification, in the gas business, works pretty much the same way. Europe's threats to diversify its gas supplies are pushing Gazprom to focus on its own diversification, and are creating instability and tension in the relationship that cannot be broken.

The fact is that the Chinese pipelines face a number of challenges, and are unlikely to be built very easily (they will, inevitably, but it will take more time than everybody, except probably Gazprom, thinks):

• the issue of price does not seem to be solved. China is unhappy about rising gas prices, and has slowed down its plans to import LNG for that reason; the same problem will apply here. The pipeline will only be built once the price for gas is set at an appropriate level for a very long period, that necessary to repay the investment;

• the issue of which gas reserves will be used to fill that pipeline is not resolved. The idea to use Western Siberian gas is unrealistic, as it would add several thousand kilometers to the distance that would require to be build, as the existing infrastructure from Western to Easter Siberia is enough only to supply that region for its needs and not for major export volumes in addition

  

  (click for bigger version and source)

  The most likely source is Kovykta, which is currently being developed with the participation of BP-TNK, which will make all negotiations between Russia and China on tariffs all the more complicated as there will be a major foreing partner in the picture.

• the sheer cost of the project (possibily double digit billion dollars) makes the question of its financing a major one. Russia may be flush with cash, but that's just not enough to put such a massive amount on the table without all the contractual framework in place.

What this means is that the Chinese option is not a menace for the Europeans (it will come in addition to the Western projects, from separate gas resources), and thus again that the reason the Europeans are playing up the "Russian gas threat" is to break up Gazprom's export monopoly. Whether this is only out of misplaced ideology ("it's for your own good - markets must be free"), coming from the lobbying efforts of the Western oil majors desperate for a piece of business in Russia (trying to capture wealth that belongs to the Russians), or some thoughtless attempt to create unbalance in a so far extremely stable and profitable long term relationship (possibly coming from Blair panicking over the sudden dependency of the UK on imported gas), I don't know.

In either case, it is dangerous and counter-productive, and it should stop - and the primary responsibility here lies with the West.