Old Goals, New Tasks

25 september 2016

Main Areas of Russia’s International Cooperation in the Energy Sector

Alexander Novak is Minister of Energy of the Russian Federation.

Resume: In view of the accelerated development of new technologies and potentially low energy prices, the struggle for energy markets will intensify. No matter in what areas energy cooperation may develop in the future, its main task will be attracting investment, technologies and human capital into the Russian fuel/energy sector.

Energy cooperation is one of the key areas of Russia’s international activity. It helps it develop mutually advantageous trade relations and ensure energy security for itself and its partners. The implementation of international projects strengthens the positions of Russian companies on markets that interest Moscow, improves competences important for the economy, and raises the general level of competitiveness of the Russian fuel/energy sector.

In addition, international energy cooperation helps Russia achieve major goals of its foreign economic policy:

  • creating common energy markets within the Eurasian Economic Union;
  • creating legal and political conditions in Europe for uninterrupted transit of Russian energy resources;
  • developing a transport infrastructure that will reduce transit risks and ensure the competitiveness of Russian energy resources;
  • enhancing the efficiency of economic integration with Asia-Pacific countries and increasing energy supplies to the growing Asian markets;
  • promoting Russian interests in preparing final documents of high-level multilateral forums.

These objectives determine the agenda and continuity of Russia’s foreign energy policy. However, the current transformations and uncertainty in markets set new challenges to the country and pose problems that should be resolved promptly and efficiently. This article discusses Russia’s views on, and responses to, major challenges to the world energy sector.

In Search of a Market Balance

The main challenge stems from changes in basic mechanisms and conditions for achieving a stable balance in energy markets, which were caused by overinvestment in industries during the period of high oil prices and by the explosive development of technologies. Competition in all areas has sharply increased, and energy prices have plummeted, which has led to reduced investment activity and upset long-term producer-consumer relationship. High competition enhances the role of advanced technologies that can reduce the cost of energy production in the future. The new situation stimulates broader use of short-term financial instruments and their manipulation. Market uncertainty attracts ever new players who resort to dumping practices in order to take market niches or, if they have political levers, exert direct pressure on consumers. In the short term, these practices have led to overproduction of energy resources in the world market and reduced the role of producers. In the medium term, they can cause a serious shortage of energy resources due to underinvestment in the industry.

A new market balance will come anyway. The question is, How will Russia’s position in the most important markets change then? This is a major issue for the country, because the fuel/energy sector continues to play a crucial role in the Russian economy (the sector’s share in Russia’s GDP in 2015 stood at 27 percent). Energy markets will remain important to the world economy, too, for a long time yet: according to a recent forecast by the International Energy Agency and Russian estimates, during the next 20 to 30 years, the world will remain hydrocarbon-dependent and the demand for oil and gas will continue to grow, although not as fast as in the past few decades.

But before answering the question how the position of the Russian fuel/energy sector will change in the world, we should analyze the conditions in which it will have to develop. The most important long-term trends are:

  • Hydrocarbons will retain their leading positions in the energy markets in the coming decades. Their share in the world energy balance will decrease due to the spread of renewable energy technologies and the reduction of their cost, but quantitatively the consumption of hydrocarbons will keep growing. This is due to the motorization of developing countries, where cheap cars with internal combustion engines will for long be more popular than electric cars, and to the electrification of new regions: 1.5 billion people in the world still have no access to electricity.
  • Technological progress in the extraction of conventional hydrocarbons, which makes previously economically unattractive deposits profitable. The development of new deposits will allow importing countries to build up their own hydrocarbon production.
  • The growing excess refining capacity (oil refining capacity utilization is 85 percent in the world and 80 percent in Europe). Oil refineries have started moving closer to consumers, in particular, to Southeast Asian countries. Processing depth and the quality of oil products will play an increasingly important role in world trade.
  • Growing availability of liquefied natural gas. Over the past 15 years, LNG sales in the world have doubled (from 18 to 36 percent), and during the next ten years they can exceed pipeline gas sales. Obviously, this will lead to a diversification of suppliers in key markets—in China and Europe—and will increase competition in the world gas market, for Russian producers as well.
  • A possible emergence of another “black swan” in the innovative technology market. Many countries are working to improve energy storage technologies and the efficiency of extraction of hard-to-recover reserves, such as methane hydrates, and to develop new types of engines, for example, hydrogen engines. These breakthrough technologies can completely change the configuration of the world energy industry.

In the short term, energy markets will remain under pressure. The oil market has been hit by one of the most protracted oil slumps. It was provoked by the overproduction of oil due to technological progress and overinvestment during the period of high oil prices, by an expected slowdown in global economy and a gradual strengthening of the dollar.

In the medium term, oil prices will be regulated by the cost of extraction of marginal resources. Now it is shale oil, with the ceiling price of $50 to $60. In the future, technological progress may reduce the cost of shale oil production, and more expensive resources in deep-water shelves or bituminous sands will become marginal. Nevertheless, the potential of certain types of deposits and the cost of their extraction remains an open issue.

Natural gas markets have also been hit by oversupply. Demand has been growing slower than expected, while production has proved resistant to low oil and gas prices.

Similar processes are taking place in the world coal market where the decreasing cost of production and renewable energy technologies have pushed prices down. Competition is growing in power engineering, including the nuclear power industry, where players widely use political lobbyism, restrictions on access to financial markets, and artificial preferences in favor of renewable energy technologies. So, as we see, power engineering, like the entire global economy, is witnessing increased competition, and the situation is only getting worse. Meanwhile, Russia has to compete with producers that have advantages in accessing financial resources and technologies.

Russia and Competitiveness

Despite the objectively difficult situation in international markets, Russia is now one of the most competitive producers of hydrocarbons in the world. This is due to the prime cost of its staple exports, the country’s geographical location, and the technologies it uses. This is well illustrated by Russian oil and gas companies which, unlike many of their competitors, continue to earn money in the extraction sector and increase production, which explains the continued interest among international investors.

Last year, Russia retained leadership in gas supplies to world markets (20%) and regained first place in supplies of liquid hydrocarbons—crude oil (12%) and oil products (9%). Russia’s draft Energy Strategy for the period until 2035 provides for further development in many areas. In particular:

  • Russia will remain among the leaders in the production and export of oil, gas and condensate. Oil output will not decrease below 525 million tons. The output structure will change in favor of hard-to-recover resources and offshore and Arctic reserves. In addition, the oil recovery factor at existing oil fields will increase. These changes will require widespread introduction of new extraction technologies and the development of services and import substitution.
  • Russia will continue to modernize its oil- and gas-refining and oil- and gas-chemical facilities in order to increase processing depth (the depth of oil refining is to be increased from 72 to 90 percent, which will allow the production of motor fuels of higher environmental standards) and enter foreign markets with new groups of goods.
  • The pipeline infrastructure will be developed to diversify destination regions and it will include, first of all, the Eastern Siberia–Pacific Ocean (ESPO) oil pipeline and the Power of Siberia, Nord Stream 2, and South/Turkish Stream gas pipelines. Supplies to eastern consumers will increase substantially (sales of crude oil and oil products in Asia-Pacific markets will double), while supplies to the West will stay at the same level, on average. The share of the Asia-Pacific region among buyers of Russian gas, including LNG, will increase almost ten times. Russia expects a fivefold increase in its LNG production by 2035, which will allow it to increase its share in world LNG trade to 15 percent.

The Energy Strategy implies reducing the energy intensity of the economy 1.6 times by the year 2035. Measures that should be taken to this end include reducing specific fuel consumption for electricity production and energy consumption by fuel and energy facilities. Renewable energy sources will play an important role in these efforts. This sector will develop to form scientific and industrial competences in this important sphere. By 2035, the installed renewable energy capacity is to reach 7.9 GW, and electricity production by renewable energy power plants will grow 10 times.

The energy sector will see an inevitable structural transformation—an increase in investment in innovations, modernization of production, the creation of high-performance jobs, and growth in economic and energy efficiency. There are plans to change the balance between state regulation and market mechanisms in favor of the latter, which will increase the efficiency and quality of the energy sector.

Technological development of the fuel/energy sector and import substitution will enable Russia to export not only fuel and energy but also energy services and technologies. Russian companies already operate in all regions of the world (45 countries), participating in the extraction and processing of energy resources, building generation and infrastructure facilities, and supplying power equipment.

In addition, Russia has for many years been among the world leaders in the export of nuclear power technologies. It has extensive expertise in building hydroelectric and thermal power plants and competitive know-how in solar power engineering. The latter includes high-efficiency cascade heterojunction solar cells with efficiency of more than 40 percent.

Russia is increasing supplies of power equipment, including turbines. Russian companies are involved in the construction of all types of energy infrastructure, and Russia trains power engineering specialists for other countries. All these efforts will be continued.

Experience, knowledge and know-how are an important advantage. But, considering the aforementioned challenges, Russia can cash in on this advantage in international energy markets only through concerted efforts of various departments, diplomatic agencies, intergovernmental commissions and offices of Russian energy companies.

Priorities of Energy Cooperation

What are priority forms for Russia’s energy cooperation at the present stage? First of all, Russia should attract foreign partners into all stages of the production chain—from the extraction and transportation of energy resources to their deep processing, electricity generation, and marketing (for example, sales through retail gas station networks or trading operations), including in third countries. A similar approach should be taken to Russian companies abroad—they should be allowed to participate not only in the supply of energy resources but also in their processing, marketing, sales to end consumers, and the creation of infrastructure. Russia should also actively use asset swaps on the basis of the principle of reciprocity to broaden its presence in the markets of interest to it.

Russia will increasingly often use the practice of concluding swap contracts for the supply of LNG and crude oil. However, the liberalization of LNG trade does not mean that Russia will give up its unified export channel policy for pipeline gas.

In the interests of development and investment promotion, Russia needs to extend the localization of high-tech production and power engineering services in the country. A key priority in these efforts is increasing the export of power engineering technologies and competences and implementing projects jointly with leading companies in third countries.

The main principles of bilateral and multilateral energy cooperation are consistent development of mutually advantageous partner relations in this sphere, customized approaches, and the protection of Russia’s basic interests. Let me briefly list the main areas of Russia’s policy.

In multilateral cooperation, Russia seeks to continue and strengthen interaction with various organizations, such as the Organization of the Petroleum Exporting Countries (OPEC), the Gas Exporting Countries Forum (GECF) and ASEAN. It has many shared interests with BRICS countries, and there is a great potential for cooperation with them. BRICS members have many similar economic problems, among them dependence on high-tech imports. Russia has proposed boosting economic cooperation, creating joint R&D projects and promoting high-tech products of the fuel/energy sector. There are good cooperation prospects within the framework of the Shanghai Cooperation Organization Energy Club (including, the promotion of the Silk Road project). In Eurasia, the main objective is the formation of common energy markets, including the solution of the resource and transit pricing issue.

Politics vs Market

Despite the sanctions and the growing politicization of Russia’s relations with the European Union, the EU remains Russia’s key partner. Moscow is ready to resume cooperation disrupted by the policies of the EU and the United States in the past two years—naturally, on the basis of equality, non-interference in internal affairs, and respect for mutual interests. Three years ago, Russia and the EU signed a roadmap on energy cooperation until 2050, aimed at creating a Pan-European Energy Space. However, no progress has been achieved since then. Moscow’s EU partners obviously seek to politicize their cooperation with Russia.

Let me cite a few examples. The problem of using the OPAL gas pipeline has not been solved to this day. The South Stream project has been abandoned under pressure from the European Commission. Several countries, especially Poland and the Baltic States, have launched a campaign against the construction of Nord Stream 2. At the same time, we are witnessing active support from Brussels and Washington for competing projects, such as the Trans Adriatic or Trans-Caspian gas pipelines. Poland, Croatia, Greece, and the Baltic States are being pressured into building LNG receiving terminals for American natural gas which cannot stand price competition from Russian gas. By the way, LNG terminals already built in Europe now operate at only 30 percent of capacity, which proves their economic inexpediency.

Here is one more example. Negotiations on a unified energy system that would embrace Russia, Belarus, Latvia, Lithuania, and Estonia have been frozen since the summer of 2013. Meanwhile, this issue is very important for guaranteeing energy security for northwest Russia and its Kaliningrad Region (the Baltic States account for 40 percent of the transmission capacity between the power systems of central and northwest Russia). In this situation, Russia needs to ensure autonomous power supply tothe Kaliningrad Region.

Nevertheless, there are no significant barriers (including the so-called Third Energy Package) to full-scale restoration and development of energy cooperation, if it is based on market principles rather than politicized considerations. Nord Stream 2 is precisely such a market-based, commercial project, but its implementation is impeded by politicians. Another package of documents on energy security, published by the European Commission at the beginning of the year, is aimed at further centralization of powers in the energy sector at the EC level. If the documents are adopted, it will be able to administer contractual relations in the field of energy supply on the basis of the “security of supply” principle in a given member state, region or the European Union as a whole. Meanwhile, the EC has not yet established criteria for assessing the impact of agreements on the security of gas supplies within the EU, nor has it determined consequences of such an assessment. Obviously, this can hardly be called a market approach and, given the recent events, it may expectedly be anti-Russian.

The EU’s anti-market and anti-Russian moves also include attempts to force Gazprom to change the terms of gas supply contracts by relocating gas transfer facilities and waiving take-or-pay requirements, and plans to introduce mandatory coordination with the EC of all energy agreements, including non-binding documents (declarations, memoranda, etc.), between EU members and third countries even before they are signed.

Nevertheless, there are many opportunities for the development of energy cooperation with the EU: the focus should be on the development of direct contacts in “non-frozen” areas, including the regional level, and the creation of more favorable conditions for cooperation in the future.

Constructive interaction with partners in the GECF on the issues of balance between environmental safety and power engineering and the popularization of natural gas as an environmentally friendly and affordable fuel may have a positive impact on relations with the EU. There is a great potential in joint expert forums, joint R&D and projects. Cooperation with Asia-Pacific and other Asian countries is acquiring greater importance. Russia’s key partners are China, Japan, Vietnam, India, and South Korea. These countries are interested in increased Russian energy supplies as they seek to reduce their dependence on hydrocarbons from the volatile Middle East.

The markets of China and India are the fastest growing in the world, and one of Russia’s main tasks is to broaden the presence of its companies there. Cooperation with these countries can encompass many areas: in addition to increased oil supplies via the ESPO pipeline and agreements on LNG sales to China and India, investors from the two countries are showing great interest in various projects in Russia (Vankor, Eastern Petrochemical Company, Verkhnechonsk, and Yamal LNG) and provide access to projects on their own territories (Essar in India and Tianjin oil refinery in China). There is also great interest in some Russian technologies. Chinese and other partners are ready to cooperate regardless of the U.S. sanctions. The multi-billion dollar funding of Yamal LNG and the laying of an underwater cable from Taman to Crimea are illustrative examples of that.

The Middle East is another key area. Oil-rich countries—Iran, Iraq and others—are of great interest to Russian energy companies which could participate in the restoration and development of the oil and gas extraction and processing infrastructure there. Russia sees a very high potential for cooperation with all countries in the region. Tasks faced by the Gulf countries are in many respects similar to those faced by Russia. These include diversification of the economy and import substitution. Well-coordinated efforts will make the Middle East a promising market for Russian industries and will help strengthen ties with the region for years ahead.

Power engineering is a key area of cooperation with countries in Africa and Latin America, where Russian companies participate not only in developing resources but also in building electrical grid infrastructure and power generation systems.

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No matter in what areas energy cooperation may develop in the future, its main task will remain attracting investment, technologies and human capital into the Russian fuel/energy sector. In view of the accelerated development of new technologies and potentially low energy prices, the struggle for energy markets will intensify. Russia should use its advantages to make a most positive impact on the development of its energy sector and economy as a whole.

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