Will the New Power of Siberia Gas Pipeline Create a Windfall for Russia?

Is Russia enticing China to purchase its gas by employing a ‘loss leader strategy’?

Newly inaugurated on December 2, 2019, the Power of Siberia pipeline will lock-in China’s purchase from Russia of almost one trillion cubic meters of gas over the next 30 years. For sanctions-hit Russia, this will generate over $400 billion in gas revenue in total, up from less than $360 million in 2018, and broaden the scope of its cooperation with China. Or will it?

In the marketing world, loss leader pricing is a time-honored strategy that involves selling a product below cost in order to entice customers through the door to purchase items with a higher profit margin. Walmart, Toys R Us, Gillette, and Nespresso have repeatedly and successfully deployed this strategy; to this list one can add the Power of Siberia (PoS) gas pipeline based on the following considerations.

Questions over Profitability

PoS is the largest and most expensive project to date for Gazprom, the Russian state-owned operator of PoS, at a cost of around $55 billion. The company estimates that costs will be recovered after 10 to 15 years, which is routine for mega-projects.

Nevertheless, PoS may not generate as high a return for Gazprom because oil prices — to which gas is indexed — are about 40 percent lower than in 2014 when the deal was concluded. This means that PoS is either borderline profitable or an outright commercial loss.

Gazprom’s domestic problems

PoS was supposed to be a way for Gazprom to gain leverage against rival Russian gas producers that have chipped away at its domestic market share in terms of production and sales. Coupled with demand declines in post-Soviet states and flat demand in Europe, Gazprom had excess gas to sell to China.

However, the excess gas is located in west Siberian fields whereas PoS is filled by specially developed new fields in east Siberia. Ironically, PoS may open up opportunities for Gazprom’s competitor, Rosneft. The latter owns gas fields in east Siberia that can be used to fill later phases of PoS more economically than Gazprom’s fields. Rosneft also has vast experience in China thanks to its dominant role in Russia’s oil exports to China; Russia has been China’s largest oil supplier since 2016.

Leverage over the West

PoS is often regarded as blowback against sanctions imposed by Europe and the U.S. following Russia’s annexation of Crimea and military incursion into eastern Ukraine. Specifically, PoS strengthens Russia’s hand by playing off Europe’s gas demand against China’s. The pipeline also “reminds Washington that China has alternatives to US LNG [liquefied natural gas]” particularly since China was the third largest market for US LNG in 2017.

However, the resource zones that supply gas to Europe and to China are distinct as noted above; gas is also delivered by different export pipelines. Moreover, Russia is not about to replace Europe with China: Europe accounts for 70 percent of Gazprom’s revenues, Gazprom in turn contributes 5 percent of Russia’s GDP, and the company is projected to maintain a one-third share of Europe’s requirements through to 2040. In fact, Gazprom has grudgingly taken steps to modify its business practices so that they align with the European Union’s anti-monopoly policies. It is also continuing to invest in alternative pipelines into Europe. As for US LNG, northeastern China — the area fed by PoS under phase one — lies outside of the target customer base because of its inland location. Moreover, gas from PoS is meant to displace the heavy use of coal in the region, rather than compete with other sources of gas. The impact of PoS on US LNG is therefore limited for now.

Asymmetrical Russia-China relationship

Despite the close personal ties between Presidents Vladimir Putin and Xi Jinping, relations between the two countries are highly asymmetrical. China leads Russia by a wide margin in economic terms. Comparatively, the prevailing narrative is of a Russia in long-term decline. In this regard, PoS may reduce the asymmetry by increasing China’s dependence on Russian gas from almost zero to one-sixth of China’s import requirements and 9.5 percent of its total gas consumption.

At these levels, however, China is hardly beholden to Russia since China has a well-diversified base of gas suppliers and supply routes. The advantage of PoS in mitigating the vulnerability of seaborne LNG cargoes is blunted by competing overland gas pipelines from Central Asia and to a smaller extent, Myanmar. Furthermore, the dedicated pipeline to China implies that Russia has, ironically, increased its dependence on Chinese gas demand.

The loss leader strategy

The above limitations of PoS seems to suggest that the pipeline makes sense only as a loss leader; it is meant to entice China to sign off on a broader range of energy and other projects with Russia. These include China’s agreement to be a stakeholder in Russia’s Arctic LNG plants or to commit to a second gas pipeline — known as PoS2 — from west Siberia to western China. Since the west Siberian fields are already well-developed, they incur no start-up costs unlike those for PoS in east Siberia.

With PoS in progress and Xi’s promise to combat “airpocalypse” to achieve blue skies through coal-to-gas fuel switching, negotiations on PoS2 have begun. For Gazprom, PoS2 would boost its revenues and domestic prestige relative to its gas rivals. It would also allow Russia to play off European and Chinese demand since the gas for PoS2 and westward pipelines comes from the same fields in west Siberia. In addition, by making redundant the need to expand the China-Central Asian gas pipeline with a fourth line since the pipelines supply the same western areas of China, PoS2 may curtail the further spread of Chinese influence in Central Asia; Russia regards the latter as its backyard.

When PoS2 will be commissioned remains to be seen. After all, negotiations over PoS took over ten years. China’s lower rates of economic growth, the de-intensification of its coal-to-gas switching policy, the optionality of US LNG imports once tariffs are lifted with the de-escalation of the trade war, and the relatively young age of its coal-fired power plants suggest that while China’s demand for imported gas will continue to grow, the capacity of existing pipelines, including PoS, may be adequate for the next decade.

In any case, marketing gurus would probably approve of the loss leader strategy behind Russia’s Power of Siberia gas pipeline to China.