Too few pipes to Europe, too little storage when it gets here

This has been a cathartic year so far in the European gas market. It has seen at its very outset a high-profile disruption in supply between Russia and Ukraine. This was followed by a volatile debate extending from Moscow through to Brussels and London, and even reaching as far as Washington, about security of future gas supplies internationally.

Attention has also been drawn to the stresses becoming evident in the gas infrastructure across Europe, both in terms of pipeline capacity and underground storage. Lastly, tensions have been raised about alleged corporate and political power playing around all these issues.

Overall sentiment has not been improved by an advancing oil price resulting not least from international tensions over Iran, as well as events in Nigeria and Venezuela. But the reality is that many are only just waking up to the longer-term challenges of balancing supply and demand in the gas market, particularly in Europe. This is a market that, if not at a crossroads, then is certainly one in transition.

In the former Soviet Union states there is a painful but necessary move towards a fully market-related pricing mechanism, based on a cash settlement system, and away from the opaque, previously-prevalent barter-based system. This was the backdrop to the New Year dispute between Russia and Ukraine.

In Western Europe there is recognition of dwindling EU production and a corresponding need to focus on the provenance and assuredness of future supplies both from the East and further afield in the Middle East, either conventionally or through liquified natural gas (LNG). Even in the corporate arena there are wide-ranging pressures for change and/or consolidation.

The leading supplier in Eurasia, Gazprom, is alone responsible for circa 25% of gas supply to Europe, which under existing contracts will rise to circa 30%. It is demonstrating, as it increasingly engages with the international financial markets, a more commercial, competitive and transparent approach to its business.

At its most basic level this has meant difficult discussions with its geographical neighbours about moving gas prices towards the much higher levels found in the West.

Whilst these price rises are having a short-term impact on GDP growth in the affected countries, they also have the longer-term benefit of encouraging them to restructure their economies to become more energy efficient.

Nevertheless, the tensions and emotions are rising in the ongoing debate on energy between the EU and Russia. Whilst the EU demands security of supply, Gazprom argues that there must be a corresponding security of demand and that an EU policy to reduce reliance on Russian gas undermines the integrity of existing contracts.

Putting aside some of the wilder rhetoric and emotions in this broad debate, there are some very clear structural problems in the current European gas market that lie at the heart of the situation. These are creating pressure points in the gas supply system that in turn raise political and strategic tensions.

The two most important issues are, firstly, the limited capacity of the existing gas pipeline network — going from East to West, thereby providing limited options both in supply competition and in redundancy — and, secondly, the very limited installed capacity of underground storage across Europe, notably in the EU, in turn restricting both commercial and strategic options when there are any interruptions in supply.

The main existing pipeline network from the gas fields of Turkmenistan, Uzbekistan, Kazakhstan, Russia and Ukraine to Central and Western Europe is close to full capacity, carrying circa 190 billion cubic metres per annum.

Whilst the lines through Ukraine are scheduled for upgrading by Russian and Ukrainian authorities, it is the new 1,200km North European Gas Pipeline, which is to run under the Baltic Sea from near St Petersburg to Greifswald in Northern Germany, that has attracted most interest and comment from European governments and commentators. This has once more focussed their attention on potential over-dependence on Russian gas and Gazprom as its main commercial partner.

As a result there has been renewed interest in identifying alternative means of supply, such as LNG shipped from Qatar and elsewhere. However, the fact remains that more pipeline capacity will be necessary in due course across Europe in a 10-25 year time frame, and greater capacity will also hopefully enable a freer, more secure and more competitive market.

Looking at the storage issue, Russia and Ukraine at this point in time possess by far the largest proportion of the underground storage capacity in Europe, with Germany and the UK lagging far behind.

The fire at the UK Rough gas storage platform in the North Sea in February 2006 showed the potential vulnerability of the system to disruption. In the event the ramifications were not as great as they could have been. Whilst there has been a growing realisation of the importance of increasing storage capacity in recent months as a result of this and other events, there continue to be considerable impediments to making this actually happen.

The challenge of both of these problems is that they demand substantial capital investment, but as importantly they require long-term strategic vision, political and corporate partnership and, more than anything, mutual trust and understanding.

Aside from the investment in the facilities of pipelines or storage, the cost of simply filling them can be significant; as Jonathan Stern noted in his article in the April edition of Parliamentary Brief, a strategic reserve of just an additional 10 billion cubic metres for the UK would cost $2.4bn at a gas price of $240 per thousand cubic metres.

With such large capital sums, projects such as this need long-term horizons of 20-25 years in order to cover their costs and make a return. Those corporates who would invest in them need to feel comfortable that there is a certainty of custom over such periods, or else they will not invest. Alternatively, EU governments will need to commit to and subsidise such investments in the wider public and strategic interest.

Such are the conundrums sitting unanswered in the European gas market at present. The challenge is to ensure stability and security of gas supply — and diversity of origin of such supply — and to foster competition to assure reasonable market-based prices to consumers. This will require a concerted approach by all parties concerned and can only be fostered through cooperation between governments, policymakers and commerce through the development of closer links and a transparency of interests.

One of the challenges faced by all participants in this debate is that of energy security. This will require a continuing dialogue resulting in concrete steps to be agreed by producing, transiting and consuming nations to depoliticise the debate and focus on the long-term issue to provide for the open and secure market in gas that Europe requires.

Robert Shetler-Jones is Chairman of Scythian Ltd, and adviser to Centragas, the joint venture partner of Gazprom in RosUkrEnergo.